Picture Credit: photosteve101 || Maybe we can get some glue…

I used to write about this topic after the financial crisis a lot. I stopped after the SEC made their last set of changes. But when I read this article today, I decided to tweet this:

Investment firms are wary as money-market regulation changes are studied after the run early in the pandemic. https://t.co/SS34ndPUeM My proposal makes more sense — NAV under 0.995, cancel enough shares to renormalize NAV to 1.0025, at which point runs strengthen the MMMF

— David Merkel (@AlephBlog) August 30, 2021

When I was an investment actuary, I developed and worked with a large number of insurance products that were managed to be pure savings vehicles. There was usually a short-term guarantee of crediting interest together with a full guarantee of principal. The difference between the short-term guarantee and actual earnings would get factored into the next short-term guarantee, making the short-term guarantee reflect the actual asset performance over time. Benefits would get paid at book value, while plan sponsor deciding to terminate would get something a little under the market value of the assets.

The names for those products were Initial Participation Guarantee, Guaranteed Investment Contracts, Stable Value Funds, and hybrids and synthetics of them. For fixed income investments that acted like savings accounts they worked well for pension plans and their beneficiaries in an era when interest rates started high, and kept falling. They were complex compared to running a money market fund because they ran with longer fixed income, making stability of principal much more tricky.

I even created a product that was relatively short duration that could trade like a mutual fund, making it eligible for a wide number of applications. (Sadly, I left shortly after it was created, and those who followed me didn’t run it right, and so it didn’t amount to much.)

So, when I write about money market funds [MMFs], I think I get the math going on there, and the problem is simpler because of the short duration, yet harder, because all assets are redeemable at par immediately. With the longer-dated insurance products, terminating customers would face a relatively harsh market value adjustment at termination. The challenge with MMFs is to make those demanding liquidity in a crisis pay the penalty, while those staying in do not get penalized, and possibly, get rewarded.

My proposal is slightly different than my prior proposal, but the math is the same. (Bond math is inexorable, even if bonds aren’t.) The first thing to do is define when a MMF is under stress, which is when its shadow NAV is under 0.995. If at the time the shadow NAV is calculated at the end of the day, the shadow NAV is under 0.995 then two things happen in this order:

1. Those withdrawing funds lose additional units in the MMF in order to renormalize the shadow NAV to 1.0025. If any are doing a withdrawal of funds great enough that they won’t lose enough units, they suffer a market adjustment penalty of the same amount. The maximum amount of economic loss is 10% of the amount withdrawn.
2. If the shadow NAV is still below 0.995 after step 1, units of those that remain are cancelled to the degree that the shadow NAV renormalizes at 1.0025.

Why penalize those who exit in a crisis? They are causing the crisis. Liquidity is not a free good, and certainly not in a crisis. This will make them think twice about liquidating, because they will absorb a disproportionate amount of the loss.

Why renormalize to 1.0025? Why not to 1.0000? This helps prevent further runs on the fund. If parties exit when the shadow NAV is over 1, it will boost the shadow NAV further. Even if the continuing holders lose units when the shadow NAV is renormalized, they don’t lose any value unless there are genuine defaults within the assets held in the MMF. If there are no defaults, the unit losses will be made up by a higher yield which will pay back the unit losses over the weighted average life of the assets involved.

A weak analogy to this is what Vanguard does on some funds that are less liquid. They charge a small termination penalty, but it gets paid to the fund, not Vanguard. Long -term holders get a small benefit from this.

The benefits of this proposal are:

• Allows all MMFs to have a $1 share price all of the time
• Penalizes those that grab for liquidity when an MMF is under stress
• Discourages runs on MMFs
• Would allow regulators to allow Prime MMFs to run a more aggressive investment policy

This sounds too good to be true, right? Well, it isn’t. My next post will run some scenarios to show how this would work. Personally, I think if this were adopted, corporations using Prime MMFs would appreciate the stable share price of $1, the potentially higher yield, but against that they would think about how liquidity would not be so easily available in a crisis, and that they would have to report credit losses when units are renormalized.

There is no free lunch, but there are ways to discourage people from running for the exits in the midst of a crisis, to the harm of everyone else.

PS — when I started writing tonight, I was just going to trot out my old proposals, but when I went through my history of working with guaranteed insurance products, I was reminded that our best risk-controlled products spread the losses onto those who leave at inopportune times. When I realized that, my old idea got a lot sharper.

Picture Credit: andrechinn || A cute idea stemming from contingent claims theory!

I was looking at conditions in the shipping industry today, and I thought back on a stock that I used to own — Tsakos Energy Navigation Limited [TNP]. I think I sold it in 2007 or so. I was shocked to see it selling for a tiny fraction of the price of where I sold it. And so I thought: Is it going to go broke?

I turned to my favorite measure of credit risk to try to answer this: (Long-term Debt + Short-term Debt) / Market Capitalization. Unless a company is in a very stable industry, I like that figure to be under one. For TNP, it is not a stable industry; it is in a highly cyclical business. The current value of that statistic is 11.

What’s the logic here? Debt claims are fixed as far as the debtor is concerned. For TNP, all of the debts are secured by their ships. But the best estimate of what the residual claimants (stockholders) have for the value of their holdings is market capitalization. Thus the ratio of debts to market value of equity can be a simple summary of how levered the company truly is. In this case, TNP sells at around 0.1x of its book value. Is it cheap? Yes, and particularly on a Price-to-sales basis. Is it safe? No. Will I buy some? No. Will I short it? I never short. Is it going broke? Who can tell? It doesn’t have a sufficient margin of safety for me.

If I were one of the banks lending against the TNP ships, I would look at different metrics — Value of the ship as a ratio of the loan, marginal earnings of the ship as a ratio of financing costs, etc. But if TNP decided to not pay on any ship loan in hard times, it would negatively affect their ability to finance new ships, and refinance existing ships. Not paying would be catastrophic.

The intuitive way to think about this ratio is like this: the value of a stock is the present value of the future free cash flows. The value of the debt is the present value of the future debt payments. So the higher the ratio goes, the thinner the margin is for making the debt payments. Also, equity has the optionality of “Heads I win, Tails you lose” to creditors. The most the creditors can do is get paid back, but they can lose it all (in this situation for TNP, the downside is capped by the collateral). But though the equity can lose it all, in the right situation they can multiply the value highly if the cycle turns favorably.

Anyway, I think this is the best quick take on credit risk as far as stockholders are concerned. If others have better ideas, please share them in the comments.

Picture Credit: Adam Y Zhang || What goes up… wait, we’re in orbit?!

With today's new high (4,479.71) in the S&P 500, the share of funds model now rates the market as having the highest valuation since 1945. The share of funds in stocks is over 52.3%. Projected returns over the next 10 years are -1.87%/year, not adjusted for inflation.

— David Merkel (@AlephBlog) August 16, 2021

I don’t have much more to say. The next Z.1 report comes out in late September, but will only bring the data up to June 30th. I use a pair of adjustments to adjust the share of assets invested in risk assets (stocks) between releases. So far, the adjustments seem reliable as the interim estimates have been tracking the results from new releases.

Could the model be wrong? Sure. I don’t run into many professionals who endorse the asset share model. Part of that is the industry gets compensated off of assets under management. No one wants to forecast declining future revenue. No one wants to have clients move out of stocks, as the percentage fees from stocks are higher than bonds or cash.

Aside from that, the asset share model is a balance sheet model. Most analysts prefer income statement models, even though they work as well, because P/E ratios are more intuitive to market participants. The asset share model is not the only balance sheet model — the Q-ratio is also a balance sheet model.

Though interest rates are low, they are not negative. 10-year investment grade bonds are competitive against domestic stocks at this point. Even if you are losing against inflation, you are losing less against inflation than the market as a whole. Same for cash. I don’t think that there is no alternative. Here are the alternatives:

• Investment grade bonds (market duration)
• Cash
• Value stocks
• Cyclical stocks
• Foreign stocks
• Emerging market stocks and bonds

So consider the alternatives, and consider hedging. I can’t nuance this anymore, as we are in uncharted waters. We are touching the sky.

Picture Credit: FRED and Aleph Blog || The above is the negative of the year over year change in the velocity of M2. GDP is now growing faster than M2

There was an Interesting article on Bloomberg yesterday: Liquidity Is Evaporating Even Before Fed Taper Hits Markets. It makes the case that over the last 20+ years the stock market has fallen once GDP starts growing faster than M2. More money goes to production, and less to financing assets.

As the article says:

“Put another way, the recovering economy is now drinking from a punch bowl that the stock market once had all to itself,” Doug Ramsey, Leuthold Group’s chief investment officer, wrote in a note last week.

Liquidity Is Evaporating Even Before Fed Taper Hits Markets

Looking over the last 60 years, there seems to be a weak correlation that supports this idea. Now, for those that follow my S&P 500 valuation model, we are very close to the all-time peak valuation level. The peak was a -1.87%/year expected nominal return over the next 10 years. We are at -1.81%/year now. (Again, not adjusted for inflation.)

Anybody else noticing that interest rates have been rising recently? The 30-year Treasury bond yields 2.00%! (I remember my first boss saying to me in 1987, “Interest rates will never go below 10%.”)

In the Bloomberg article, Ed Yardeni is skeptical and said the following:

Ed Yardeni, the president and founder of Yardeni Research Inc., says he prefers to plot not the growth rates but the absolute level of M2 against GDP to measure liquidity. Based on that, liquidity stood near a record high. “Some people start to freak out about the M2 growth rate,” he said in an interview on Bloomberg TV and Radio. “What they don’t really appreciate is M2 today is $5 trillion higher than it was before the pandemic. There is just a tremendous liquidity sitting there.”

Liquidity Is Evaporating Even Before Fed Taper Hits Markets

I disagree with Yardeni here, but that doesn’t mean that I fully believe that danger is imminent. Economics has always improved by analyzing in terms of how marginal values are affected, not absolute values. Ben Bernanke uttered the word “taper” and forward interest rates roared higher as he protested that monetary policy was “accommodative.” Monetary policy is as loose as what economic actors can borrow money at. Rates are rising — tight. Rates are falling — loose. Yellen and Fischer made the same errors.

The Fed is tightening as they reduce QE, and begin raising the Fed Funds rate in 2022. It will end in a market meltdown in late 2022 as an overly indebted economy cannot tolerate the increase in the financing rate. The Fed will find itself trapped and interest rates will remain low.

My confidence level on this idea is only 70%. But valuations are high, and the Fed is tightening, even if they say they are not doing so. There will be far worse times to speculate on a fall in the market. It can’t go much higher. It can go a lot lower. Short bonds and cash are alternatives.

Photo Credit: Mindy Georges || The umbrella belongs to Travelers

This is a bug in my bonnet, and I have written about this for at least 13 years, and maybe as long as 16 years, but insurance conglomerates don’t work well. After suggesting at least three times that AIG should break itself up, we are finally to the last stage of it doing so.

There is a saying in the industry “Life Insurance is sold, P&C Insurance is bought.” They are different markets, and there is no reason for shareholders to own a company that does both. But some companies diversify. Who does that benefit?

The main beneficiary is the management, as it gives them cover for underperformance. They can always blame transitory factors for underperformance of one division or another.

And much as Hank Greenberg blamed his successors for the failure of AIG, the main cause of longer-term underperformance stemmed from the purchases of SunAmerica and American General at high prices.

AIG was highly profitable in 1989 with its foreign and domestic P&C operations, and its foreign life operations. What should it have done with its profits?

It should have paid a higher dividend, bought back stock, and shrunk the company as many other successful insurers have done. Companies is mature industries should return capital to shareholders.

Big companies develop a culture, and it makes them less willing to change. That was true of AIG. Hank Greenberg should have eliminated all life companies early on, and run a domestic P&C company with high underwriting standards. Then maybe it would not have had to rely on Berkshire Hathaway to reinsure them.

Just as GE has suffered, so has AIG. Both CEOs were lionized, then despised. The main idea to take away from this is conglomerates where businesses have different sales models don’t work.

Picture Credit: Ron Mader || Humility is underrated. Without it everything is a fight.

“Size expectations to resources and you will rarely be disappointed.”

I would think that this one would be “common sense,” but I have another saying, “Common sense isn’t.” Many people engage in magical thinking, overspending and assuming that things will work out in the end. Under most conditions, it does not work out in the end.

Living in reality is a key to happiness. Delay gratification, have a buffer, and invest for the future. What could be simpler?

You might or might not be surprised at how many let short-term pleasure dominate over long-term well-being. I think it is hard if one is single to have the gumption to think long-term. There is a temptation to play when there is no one else relying on you.

The lessons of the Great Depression have been lost. Be self-reliant, or family-reliant.

Patience and humility are underrated virtues. Perhaps it seems like those who are proud and impatient do better, but that’s just the unequal signal problem. What’s the unequal signal problem, you say? Those that publicly succeed get more notice than the many more that privately fail because they offend others with their pride and impatience.

I’m not saying don’t take moderate risks to improve your position in life. I am saying that trying to hit home runs begets a lot of strikeouts. If you are not capable of bearing the losses of strikeouts, don’t try to hit home runs. Instead, try to hit singles more reliably.

This is one reason why I say to diversify. Here’s something I haven’t said before, but when I was a kid, I used to read Value Line. They would talk about cash as a diversifier, and highlight stocks that were growth at a reasonable price, and had momentum of earnings and price. It’s good to keep short bonds (cash) on hand for the opportunity to invest at lower prices when they become available. Or, to use the cash in an emergency, because you can’t always be sure of future spending needs.

Investing in stocks requires patience. Holding cash (short bonds) requires humility. With patience and humility you can take on the markets and not worry much about the future. You know you can hold your positions. You know you can meet surprising cash needs. You are ready for anything, because you have enough slack in your asset allocation to hold onto your risk positions under almost all circumstances.

For me, humility meant paying off my mortgage debt early, even though my investing was going well. My investing went well because I didn’t have to worry in market downdrafts about how we would live. Really, I haven’t had a significant personal economic worry in 18 years.

Patience for me meant slowing down buying and selling stocks. Hold them longer. Think harder about the purchase decision. Business plans take time to develop. Owning stock is owning a business. Real success comes over time, not by day-trading.

And, find happiness where you are. Retirement can be fulfilling even if you don’t have a lot of assets. Find work that isn’t too taxing, and keeps you in touch with others. Having purpose in life aids happiness. Then use your assets carefully to aid your life over the long haul. Remember that longevity is a risk, so don’t overspend.

Does this sound hard? Yes, it does. And that is our lives. Humility helps at this point, realizing that growing old isn’t easy. But if you size your expectations to your resources, it will be easier, recognizing that you did your best, and that you are getting a reasonable living in your old age.

Photo Credit: Lonnon Foster || Oh no! The cookie jar is empty!

(This is another of my occasional experiments. I know it’s not perfect. Please bear with me.)

James: Can I have a cookie?

Accountant: That’s not the right way to ask.

J: I did not know an accountant could be a grammarian as well. MAY I have a cookie?

A: Sorry, there are no cookies left in the jar.

J: I thought there were always cookies in the jar. I saw some people eating cookies recently.

A: Well, they may have gotten cookies via side agreements.

J: Side-agreements? What are those?

A: You know the cookie rules?

J: Uh ,no. What are they?

A: Listen then:

• I gather the money for cookies each year from everyone.
• I use the money to buy cookies, usually around 950 of them.
• The amount that actually arrives varies — sometimes more, sometimes less, rarely near 950, but on average 950.
• Some want more cookies than received, and they enter into side agreements to request early delivery of cookies from future years. The catch is that the cookie merchant can demand immediate repayment at his whim. He tends to be lenient, but occasionally demands full repayment.
• The side agreements are supposed to be deposited in the cookie jar when it is empty.
• Side agreements get called in in order from the most recent to the oldest.

A: My purchase of cookies for 2021 paid off side agreements entered into in 2015 for cookies fronted then.

J: Can I do a side-agreement? I would like some cookies.

A: Wouldn’t we all. Look, the Cookie Merchant calls in the side agreements newest first. Are you ready to repay if he calls on you? Do have the resources?

J: Not really, but I do want a cookie.

A: No such thing as a free cookie. Hmm… let’s look at the jar. Yes, here is the most recent side agreement that I remember– in 2017, fronting the cookies from 2024 through 2026.

J: What’s that under the jar?

A: What do you mean under the…. ehhh, what is this? A 2019 side-agreement fronting cookies from 2027 and 2028? Urk, I wish I had known this,

J: It looks like there’s two more under that.

A: Uh, a 2020 side-agreement fronting cookies from 2029 and 2030, and a 2021 side-agreement fronting cookies from 2031 and 2032. My this is bad.

J: What’s so bad?

A: I wasn’t the accountant for this back then, but the last time cookies were fronted 11 years ahead was 1999. In 2000-2002 the cookie merchant started calling in the side-agreements like mad.

J: So there are no cookies?

A: No cookies without extreme risk.

J: I wish I had a cookie… but no.

A: Would you like a cracker? I may have some of those.

J: I could be interested.

A: We get only 500 of these per year on average, and the side-agreements aren’t as thick. Let me look in the cracker tin. It seems you are in the right place at the right time. There are side-agreements fronting crackers from 2022 through 2025, but I have 100 crackers remaining out of the 2021 allotment. Have a cracker.

J: Thanks. Umm… that’s a good cracker. Not as good as a cookie, but still good.

A: I’m glad you liked it. Supposedly back in the early 1980s the cookie jar and cracker tin were filled to overflowing, but nobody wanted any.

J: I would always want a cookie. Are you sure you don’t have any?

A: Aside from domestic cookies and crackers, we do have some foreign cookies and crackers as well. They aren’t as popular because of the unusual tastes, and payment must be made in another currency, adding to uncertainty. Oddly, in this case, many foreign crackers have a large number of side-agreements, but the foreign cookies have almost none.

J: Could I try a foreign cookie then?

A: Of course you could. [Pulls jar off shelf.] Reach in and pull out a cookie.

J: It crackles. Hey, this is a fortune cookie.

A: Well, eat it and read the fortune.

J: Typically, I throw the fortune away, because I don’t believe in luck.

A: Well, you ended up with a cookie by favorable circumstances, so humor me, and read it to me for my sake.

J: [Eats cookie.] Okay.

“Contemplate cookies

Eat and observe tiny crumbs

The cookies are gone”

Fortune cookie

J: Wait, this was a fortune cookie, and it had a haiku inside it. This is bizarre.

A: Almost as bizarre as our domestic cookie deficit. I would say that fortune cookie was the most honest that I have heard.

J: I guess that’s the way the cookie crumbles.

Photo Credit: amanda tipton || When I was younger, I wanted to read the whole local library. Now that I am older, I doubt the value of most books.

I’m getting older, and so are my readers. A practical impact of getting older is lightening up on possessions so that your heirs won’t have so much to dispose of when you die. My wife and I went through the whole house recently and eliminated 50% of the books that we owned.

We threw away 5% of the books, thinking that no one should read them, they were too damaged, or, they were out of date. We gave 15% to our children, after inviting them to peruse what we were getting rid of. We also gave them four bookcases. We gave 30% of the books away to Goodwill.

That still leaves us with around 1,500 books. But they are the books that we like, and as far as kids books go, the ones we think our grandchildren will like. Oh, yeah, I’m a grandpa now. Two grandsons, a granddaughter on the way, and yet another child coming first quarter of 2022. Wow.

My wife thought she would be more severe at eliminating books, but it turned out to be the opposite. I probably eliminated two-thirds of my economics, finance, and investing books. All of my finance and investing books are now in my office, and fit into one ordinary six foot tall, 27 inches wide bookshelf. The economics books fit on one shelf. Economic history books fit on two shelves. Why did I give away so many?

Longtime readers know I am not a fan of the neoclassical school of economics. I think economics is best understood apart from detailed mathematics. Even in finance and investing, you should never need calculus. We don’t live in a continuous time world.

Though actuaries are tested on calculus, they almost never use it. Early in my career, I tried applying calculus to some of my models, and it didn’t make much of a difference.

I probably jettisoned 75% of my economics, investment and finance books. I did it because I didn’t think they represented reality well. Usually “ad hoc” modeling is superior to trying to apply academic models, if modeling is warranted at all.

I realize that authors have many reasons to write books.

• They have a passion for the topic.
• They want to gain name recognition to benefit their business.
• They are trying to make money off the book (bon chance)

Not that authors or publishers should listen to me, but most books don’t deserve to be published. Why?

• They don’t break new ground.
• They aren’t well-written or well-edited.
• They are wrong in the way they view the world. (They engage in wish-fulfillment.)
• They don’t deliver on what the cover promises.

The last one deserves amplification. Back when I was reviewing many books, this was my single largest complaint. Many books were advertised to answer a crunchy problem, and the book didn’t address the topic significantly. In talking with some of the authors, they told me that it was the publishers who engaged in chicanery to sell the books, even though the authors wrote the books with a different purpose.

Now, if I live long enough, I may write a book. I don’t expect that you will buy it. Why? I will probably have disclosed enough of the book at this blog. Why pay for what you don’t have to?

My main point here is to be skeptical, but not cynical. I eliminated some of my books, not all of them. There is truth in some books. Be careful and analyze the arguments made in books closely. Keep what you think is valid, and toss the rest, unless it is a classic error like “The Communist Manifesto.” The classic errors are worth keeping so that you can remain aware of the ways that important twisted people think.

Photo Credit: Mike Cohen || Certainty versus volatility

One question that many ask is “Should I invest or pay down debt?” Let me quote from a prior article Retirement — A Luxury Good.

What is a safe withdrawal rate?

A safe withdrawal rate is the lesser of the yield on the 10 year treasury +1%, or 7%. The long-term increase in value of assets is roughly proportional to something a little higher than where the US government can borrow for 10 years. That’s the reason for the formula. Capping it at 7% is there because if rates get really high, people feel uncomfortable taking so much from their assets when their present value is diminished.

How should you handle a significant financial windfall?

If you have debt, and that debt is at interest rates higher than the 10 year treasury yield +2%, you should use the windfall to reduce your debt. If the windfall is still greater than that, treat it as an endowment fund, invest it wisely, and only take money out via the safe withdrawal rate formula.

I have been debt-free for eighteen years. Being debt-free enables me to take more risk with my assets if I think it is warranted. At present, I think that if someone has debts with interest rates higher than 3.4%/year, it makes sense to pay down debt rather than invest more. Now there may be tax reasons why one would not liquidate assets to pay down debt, but if you have free cash not needed for a buffer fund, then use the excess cash to pay down debt. Don’t use the Dave Ramsey method, which is stupid. Pay down the highest interest rate debt first.

I can say this with greater confidence at present, because most stock portfolios and private equity portfolios will lose money in nominal terms over the next ten years much like the 2000-2010 decade. Valuations are comparable to that of the dot-com bubble, and unless you are invested in stocks with low valuations and low debt, you will get whacked when the next crisis hits, as growth stocks will decline by more than 50% unless the Fed intervenes, which it might NOT do if inflation is hot.

All other things equal, a debt-free lifestyle is pleasant — there is less worry. Anytime you lower the amount of money that must go out each month, life gets easier.

What’s that, you say? When would I be willing to invest rather than decrease debt? If I had an investment that I thought would return more than 7% over the interest rate of my highest yielding debt, I would invest, assuming that the investment has a sustainable competitive advantage.

I’ve given two rules here, and there is a considerable possibility that neither rule may apply. In that case, do half. Take half of the excess cash and pay down debt, and invest the other half. The “Do Half” rule exists to make good decisions easier when situations are uncertain. It’s not perfect but it will give you the second-best solution. And if you always do second-best, you are beating most of the world.

My bias is to pay down debt. It’s a happier lifestyle, and most people don’t do well acting like mini-hedge funds — borrowing to invest. In a bull market, it looks like genius, but when the bear cycle hits it is traumatic, and many don’t survive it well, particularly if they get laid off.

With that, in the present environment, I encourage you to reduce debt. Unless you invest in unpopular stocks, as I do, future returns will be poor. Reducing debt gives you a relatively high return, and with certainty. Take the opportunity to reduce debt when it makes sense.