Category: Bonds

Update on Indicators, Part 2

Update on Indicators, Part 2

Posted on by David Merkel

I should mention that Assurant has been added to the S&P 500. Could not happen to a more deserving company; they are truly innovators in the insurance industry.

And now, more on indicators, bullish, bearish, and otherwise:

Bullish

  1. Low quality stocks outperformed in the first quarter, according to Merrill Lynch. That’s bullish in the short run, but not the intermediate term.
  2. LBO volume and private equity volume continue unabated.

Bearish

  1. Economy feels like stagflation-lite. Low positive growth, and rising inflation.
  2. Inflation is rising globally, particularly in India and China.
  3. Mortgage interest payments in the US are a record high (since 1989) compared to Disposable Personal Income.
  4. Corporate credit metrics are deteriorating for both junk and high grade corporate debt, but are not critical yet.
  5. Equity REITs seem to be rolling over.

That’s all for now. Tomorrow is another day.
Full Disclosure: long AIZ

Update on Indicators

Update on Indicators

Posted on by David Merkel

Usually I look at my indicators at the beginning of a month. If I look at them more frequently, the changes are too small, and I don’t get the signal. In no particular order, here are my thoughts, both Bullish and Bearish:

Bullish

  1. Contrary to what the bear in Barron’s said this weekend, the chart for the Merger Fund is bullish. They paid a dividend at year end, and the current chart shows that arbs are making money, which is bullish.
  2. ECRI’s indicators are forecasting growth up, and inflation down.
  3. Both emerging market stocks an bonds have bounced back well.
  4. Earnings yields are still high relative to Treasuries, though if profit margins mean-revert, this argument is hooey.
  5. ISI Group’s broadline retailer’s survey is showing some life.
  6. Securitization of subprime loans, and CDOs containing tranches of subprime deals rated less than AA, are not getting done. These assets are getting sold to financial intermediaries that have adequate balance sheets to fund them.

Bearish

  1. From Alan Abelson’s column in Barron’s this weekend, Henry Kauffman uses a concept akin to my “bicycle stability versus table stability” to discuss liquidity. The former is access to credit, while the latter is excess high quality assets that are readily salable.
  2. Imposing tariffs on China is a real dumbkopf move. Eventually that will bite into the capital flow that keeps our interest rates so low, in addition to decreasing the benefits from the global division of labor.
  3. M3 is falling, and significantly. The banks are pulling back from landing, and credit availability is shrinking. My M3 proxy is the total liabilities of the banking system. Works very well.
  4. Fed funds continues to miss on the high side, since the FOMC meeting. The monetary base has gone flat, and there has been only one permanent open market operation this year, on 2/26.
  5. Financial stocks are lagging the market.
  6. The yield curve is still flat.
  7. Equity REITs don’t yield enough relative to Treasuries.
  8. Housing prices are falling nationwide.
  9. Asset price changes are increasingly in two camps: safe and risky. Correlations within the two camps are high and positive. Correlations of the two camps are very negative.
  10. Inflation remains high over the Fed’s comfort zone.

Neutral, or You Call It

  1. Implied volatilities have bounced up, but are still low.
  2. Corporate bond spreads have bounced up, but are still low.
  3. Implied 5 year inflation, five years forward, has been in a channel between 2.2% and 2.8% for the last four years.
  4. TED spreads are higher, but still low.
  5. The swap curve gained slope after the recent mini-crisis.
  6. The FOMC tightened less this time relative to prior times, if the measure is inflation versus the Fed funds rate.

That’s all for now. The two biggest bits of news are the tariffs on Chinese goods, and the decline in my M3 proxy. Bearish items both.

A Good Quarter

A Good Quarter

Posted on by David Merkel

I’m still looking for a way to document my performance to readers, but let me simply say that the broad market portfolio beat the S&P by a few percent. What worked?

  • Fresh Del Monte
  • Grupo Casa Saba
  • Valero Energy
  • Helmerich & Payne
  • ABN Amro (sold too soon) 😉
  • Dorel Industries (wish they hadn’t delisted)
  • Lyondell Chemicals
  • Dow Chemicals, and
  • SPX Corp

You see any commonalities there? Energy, especially refining. Chemicals. Aside from that, I don’t see anything really correlated.

What didn’t work?

  • St. Joe
  • Barclays plc
  • Japan Smaller Capitalization Fund
  • Nam Tai Electronics
  • Cemex
  • Lithia Motors
  • Conoco Phillips
  • Magna International
  • Jones Apparel
  • Deerfield Triarc, and
  • Allstate (ouch)

Commonalities? Autos, maybe? Away from that, it seems eclectic to me.

In my balanced mandates, my foreign bonds and floating rate securities worked. High quality paid off as volatility rose. Really didn’t have any problems with my bonds.

Now I just have to do as well next quarter. 🙂

Full disclosure: long? FDP SAB VLO HP ABN DIIB LYO DOW SPW JOE BCS NTE CX LAD COP MGA JNY DFR ALL

Around the Web, and then Some

Around the Web, and then Some

Posted on by David Merkel
  1. There were two articles on reinsurers this morning suggesting that there should be a lot of consolidation via M&A. I’m not so sure. First, most players there want to acquire, not be acquired. Second, most of them don’t trust the underwriting and reserving of their competitors to the degree that they trust their own. To the extent that current players want to diversify, it is cheaper to do it organically than by acquisition. With the high degree of ease of entry into the market, the franchise value of a reinsurer is low. Now, maybe the property-centric reinsurers want to diversify (a smart idea, but they are stubborn), or the new reinsurers want to buy in a reverse merger one of the class of 2001 to eliminate the capital haircut from the ratings agencies (but they don’t have the cash for it). Those ideas make sense, but scale isn’t that much of a virtue here, and with P&C reinsurers the reserving is opaque as mud. I can see a deal or two getting done, but not a lot of them.
  2. With all the hand-wringing in the Wall Street Journal this morning on free trade, just watch, we impose some series of tariffs or restrictions that reduce the current account deficit, only to see the capital account surplus shrink also, leading to higher interest rates and a lower dollar, breaking the current cycle giving the US cheap imported goods in exchange for dollar denominated bonds.
  3. Throw a rock, hit a commentator who says that the Bank of China (or other major central bank with large dollar holdings) would never sell their positions because it would work against their interests, driving the value of the dollar down. That’s a half truth at best. Here’s why: the central bank will eventually focus on the future, realizing that sunk costs are sunk. Just because you have a big dollar position, does that mean you have to add to it to preserve its current value. Ignore the past, and let the dollar denominated securities mature. Use fresh cash and maturity proceeds to buy assets in the currencies that you like. It won’t cause a panic, but the dollar will still adjust down. Recognize from the start that the dollar assets are worth less than current exchange rates, and maximize value from there. (Large holders of any asset under pressure have to think this way to maximize value.)
  4. Buyer Beware. Or maybe, it should be borrower beware. People are generally less competent at making rational choices when they are borrowing rather than paying cash. So it is no surprise that when Beazer finances homes that they sold, buyers might have gotten less than an optimal deal. This is true with many financial transactions. In general, the more moving parts in a transaction, the worse off the average person is in evaluating a deal. Better to line up your financing separate from the decision to purchase an asset, or you could end up up with a bop on your beezer, figuratively speaking.
  5. So FASB might have a tighter leash on its neck from the SEC? Not sure whether that is good or bad. Neither organization gets high marks in my book. FASB desperately needs a more coherent overarching approach to accounting, rather than the piecemeal addjustments that they are doing. The SEC, if anything, is more beholden to political pressure, and the idiocy that that brings into accounting.
  6. Then there’s Texas, basically invalidating the GASB on reporting the liability for long term government employee benefits. You might remember my piece at RealMoney, Pensions: Things Can Always Be Worse. Well, this is an example of that, and it is not limited to Texas. Though the Texas argument may have merits, governments all over the country are finding that they have to finally recognize the present value of the pension promises that they have made, and disclose it to the citizenry. It will be a mess, because a large amount of these promises are totally unfunded, much like Social Security, Medicare, and most other programs of our Federal Government.
  7. It takes a week, but finally the market comes around to my view of the FOMC, though it takes Bernanke before Congress to correct the view of the markets. Inflation is not on hold, but the FOMC is, for now.
Bond Market Notes

Bond Market Notes

Posted on by David Merkel

What a week. The yield curve disinverted with ten-year Treasury yields moving above two year yields. 30-year bonds traded off 11 basis points, 10-years 7 bp, 5 years 5 bp. The short end of the curve was largely unchanged.

But now look at Treasury Inflation Protected Securities. TIPS 10 years and longer fell a mere 3 bp. TIPS 5 years and shorter were flat. Now, I have a large allocation of my balanced mandates in TIPS and short-term debt, so my downside was protected this week.

So why did the bond market move that way? The FOMC shifted its monetary policy language this week in a way that said that they no longer have a bias to tighten policy, but they do have have a bias to worry about inflation. The Fed’s announcement this week says that they are willing to tolerate a little more inflation. The bond market reacted accordingly, and required more yield on bonds with no inflation protection.

What else happened? The equity markets rallied, both before and after the FOMC announcement. Credit spreads largely tightened, and the dollar fell on the FOMC announcement, before rallying back to flat the rest of the week. In general, the carry trade currencies, the yen and the swiss franc, underperformed, and higher yielding currencies did better.

What can I say, then? The willingness to take risk is alive and well, and the carry trade is re-emerging. M&A isn’t suffering; note the possible deals on Tribune, ABN AMRO, Chrysler and Volkswagen. And, at least according to Bloomberg, there are a scad of CDO deals in the pipeline waiting to be done. So, let the party continue; let others ignore the rising inflation (at your peril), and enjoy the punch that the Fed is serving. As for me, I’ll just enjoy my mug of tea, slowly reduce risk, and watch the spectacle.

He Who Pays The Piper Calls The Tune

He Who Pays The Piper Calls The Tune

Posted on by David Merkel

There’s an article in the Wall Street Journal today entitled, “Credit-Ratings Firms Get Caught Up In Subprime Meltdown.” In some ways I anticipated this in my article at RealMoney, “Snarls in Insurance Investigation, Part 2.”

I experienced the difficulties that the ratings agencies had in 2001-2002 as a corporate bond manager. They are paid by the issuers, and have a conflict of interest. They can argue that they are zealous to protect their reputations, but in the short run, they get paid by issuers to rate deals. Only in times of crisis do they adjust their standards to meet the needs of the bond buyers.


In short, the problems with the ratings agencies are the same as the problems with auditors. He who pays the piper calls the tune. Except in crises, the ratings agencies are more beholden to the issuers than their subscribers. All the more reason to allow alternative ratings agencies into existence, to challenge their oligopoly.

There Is Always Enough Time To Panic

There Is Always Enough Time To Panic

Posted on by David Merkel

I always get a little amused when the permabears emerge from their dens and parade around for the media to observe.? I myself am often bearish, but I have an investment policy that keeps me from expressing too much confidence in it.? I have no doubt that the permabears will eventually be right on much of what they are claiming will happen? but permabears by their nature are too early, and miss more gains from the ?boom? than they typically make in the ?bust.?

In general, and over the long run, prudent risk taking is the best strategy.? The only exceptions are when there is war on your home soil, and aggressive socialism.? That said, in this post, I want to detail reasons to be concerned, and reasons to not be concerned.? Here we go:

Concerns

  1. Earnings growth is slowing year-over-year to about a 4% rate, and actually fell from the third to fourth quarters of 2006.
  2. Loan covenants for loans to private equity have almost disappeared.? Bullish in the very short run, but what are the banks thinking?!
  3. Anytime the bond market maxes out in a given sector, tht is usually a bad sign for that sector.? 42% or so of the whole Investment Grade corporate bond market is financials.? (Contrast that with its weight of 21% in the S&P 500.)? I would be very careful with financial companies as a result.? Were I running a corporate bond portfolio, I would deliberately tilt against financials, and give up income in the process.
  4. Have you noticed the small stocks have begun to underperform?? Not bullish.
  5. The balance sheets of US consumers are in poor shape.? The further down the income spectrum you go, the worse things are.
  6. Abandoned housing is becoming a problem in many parts of the urban US.? (Hey, I?m in the suburbs, and I have two abandoned homes on my block!)
  7. According to ISI Group, corporate capital expenditures exceeds free cash flow by $70 billion.? (That?s what?s driving corporate bonds!)
  8. In 1998, one of the causes of the volatility was a rise in the Japanese yen, which blew out the ?carry trade? at that time.? That may be happening now.
  9. Chinese and Indian inflation is accelerating.
  10. In general, central banks of the world are tightening monetary policy.? The US is an exception, which helps to explain the weak dollar.? Even China is tightening monetary policy.
  11. I don?t worry about the budget deficit; it is part of the overall current account deficit, which I do worry about ? particularly the fact that investment income we receive from abroad is exceeded by that which we pay out.? This shift occurred in 2006, and is unprecedented for at least 50 years.
  12. Inflation is above the FOMC?s comfort zone, even with the bad way that the government measures it.
  13. Private equity is overlevering otherwise stable assets.? That is bullish for the public markets in the short run, but unsustainable in the intermediate term.
  14. Merrill had to withdraw a CPDO in February; to me, this means that corporate default spreads had reached their absolute minimum.
  15. According to Bloomberg, Moody?s says that $82 billion in corporate bonds will mature between now and 2009, and 61% is rated B1 or less.
  16. Actual volatility of stock prices has risen relative to implied volatility.? Further the average holding period of stocks has declined markedly over the last four years, to around seven months, according to the WSJ citing Bernstein.
  17. Margin debt is at its highest level since the 1920s, though as a percentage of market capitalization, it is lower than it was in 2000.
  18. Troubles in subprime and Alt-A lending are leading to declines in US residential real estate prices.
  19. Mortgage equity withdrawal is declining significantly in 2007.? The higher quality the loan, the lower the equity extraction generally.? A reduction in subprime and Alt-A affects this considerably.

Not to Worry

  1. In general, stocks are better buys than bonds at present.? The earnings yield exceeds the 5-year Treasury yield by 120 basis points.? Note though, if profit margins mean-revert, bonds will be the better asset class.
  2. At present, there is no lack of financing for CDOs and private equity, and corporations are still buying stock back aggressively. ?Investment grade corporate bond issuance is robust, surpassing the amount issued in 2006 YTD. On the other hand, high yield has slowed down considerably.? (CDO mezzanine and subordinated debt spreads have widened though, particularly for asset-backed deals.? The arb spread has not been so wide in years.)
  3. Many new BBB bonds are coming with change in control covenants.
  4. The VIX hasn?t closed above 20 yet.
  5. Investment grade corporate balance sheets are in relatively good shape.
  6. The relationship of earnings yields to corporate bonds is a fuzzy one. From the seventies to the nineties, P/Es moved inversely to bond yields.? Not so, so far, this decade, or in the 1960s.? If bond yields rise due to growth expectations, P/Es may follow along.
  7. Money supply growth is robust in the US and globally.? In the short run it is difficult to have a bad market when money supply growth is strong, and measured inflation is low.
  8. There is a still a desire to purchase US assets on the part of foreigners; the recent fall in the dollar has not affected that.
  9. My view is that we won?t have a recession in 2007, and that we might have one in 2008.
  10. ECRI forecasts inflation falling in the US, together with decent growth in 2007.
  11. Proxies for systemic risk have been receding, though they are considerably higher than one month ago.
  12. Export sectors are finally showing some decent growth, partly due to the weak dollar.
  13. IPOs are outweighed by LBOs and buybacks.? With a few exceptions, IPO quality doesn?t seem too bad.
  14. Global demographics favor net saving because of the various baby booms after WWII.? Excess money growth is going into the asset markets for now.
  15. Most M&A deals are for cash, which is usually a bullish sign.? M&A waves typically crest with a bevy of stock deals.? Deal premiums are not out of hand at present.
  16. According to the ISI Group survey state tax receipts are quite robust, indicating a strong economy.
  17. Also according to ISI Group, China is now a net coal importer.
  18. Commodity indexes, scrap steel pricing, and Baltic freight rates are still robust.
  19. Foreigners are buying some of the excess US homes as second homes.? Having a residence in the US offers flexibility.

I did not aim for nineteen of each, I just went through my research pile, and summarized everything that was there.? To me, this is a fair rendering of the confusing situation that we are in today.

Up On A Down Day

Up On A Down Day

Posted on by David Merkel

Up about 1/4% today, against a lousy market. Giving extra help today were Valero Energy (though I sold a little), Helmerich & Payne, and ConocoPhillips. Hurting the cause were Royal Bank of Scotland and Lithia Automotive.

Is the recent panic over? Yes and no. No, because you can never tell what additional macroeconomic problems will crop up. Yes because CDOs [Collateralized Debt Obligations] are still getting funded. I have a saying that bubbles only pop when cash flow is insufficient to finance them. Well, the riskiest part of the debt markets, CDO equity, still has willing participants. That indicates that it is not bubble-pop time yet, and that has positive implications for the junk debt and equity markets. Party on!

Industry models tomorrow.


Full Disclosure: Long HP VLO COP RBSPF LAD

The Major Article List is Live!

The Major Article List is Live!

Posted on by David Merkel

Though it is something that will grow, the major article list section of this blog is now up-to-date. It is a complete index of my long-term writings at RealMoney (primarily).

The one thing that would make it better would be to index my long term Columnist Conversation posts. It is my favorite part of RealMoney, and that is why I have concentrated there, even though I don?t get paid for cc posts. (sad that) What would be interesting would be to scour my cc posts for long term value, though I have over 1500 cc posts. I?m not doing that anytime soon. 80% of my cc posts are ephemeral, and I?m not sure it is worth the effort to get the other 20%.

What I Have Learned Over the Past 42 Hours

What I Have Learned Over the Past 42 Hours

Posted on by David Merkel

I was a little ahead of the market yesterday, say 10-15 basis points ahead of the S&P. Leading the charge were Fresh Del Monte (my current largest loser), and Grupo Casa Saba (what a great undiscovered stock). Fresh Del Monte was upgraded from underperform to neutral after their less bad earnings. Grupo Casa Saba reported excellent earnings. They run drugstores in Mexico, an excellent industry for a country with a growing middle class. For my balanced mandates, I kicked out the QQQQs that I bought yesterday. The rally wasn’t as big as the reduction in short term risk implied by the VIX.
At RealMoney.com, I had a post late in the day called, “What I Have Learned Over the Past 36 Hours.” It attempted to put forth a dozen things that have been revealed since the recent crisis hit. Here’s an explanation:

  1. China sneezes; the world catches cold. If we needed any proof that America no longer solely dominates the global scene we saw it on Tuesday.

  2. Systemic risk may or may not be a problem now, but a lot of people acted like it was a problem. Thus the rallies in the currencies used to finance the carry trades. The Yen and the Swiss Francs are good hedges here. I am more dubious about long Treasuries, though not long TIPS. (It was neat to see the rallies in the yen and swiss francs. Thne long bond fell more today than the carry trade currencies did.)

  3. The current equity market infrastructure is marginal to handle the volume of the last two days. Given the nature of modern finance, major errors are not acceptable. I got off a couple of good trades as a result of the accident, but those trades were accidental as well.
  4. The lack of human intermediaries with balance sheets leaves markets more volatile than before. It genuinely helps to have someone who can stop the market at certain volatile points, and then restart with an auction so that a fair level can be determined after news gets disseminated. Also, liquidity providers show their value in a crisis.

  5. Algorithmic trading and quantitative money management is making stock price changes more correlated with one another than they used to be. Markets behave differently in normal times, and under stress. The methods that make money when the market is calm exacerbate volatility when market stress appears

  6. Panic rarely pays.
  7. Patience usually pays.
  8. Diversification pays.
  9. In a crisis, strong balance sheets and free cash flow are golden. During times of stress, these four bits of wisdom pay off. They protect an investor from his own worst temptations.
  10. People want the Fed to loosen more than the FOMC itself does. The FOMC doesn’t care about weak GDP if labor employment is robust. The FOMC certainly doesnot care about te stok market unless i affects the banking system, which is unlikely.
  11. The oscillator is not oversold, yet. Sad, but true. We have a decent number of days in the rear-view mirror that aren’t so bad. The intermediate-term panic level is not high.
  12. What do you know? Cyclicals are cyclical. I’m just glad I didn’t get kicked worse yesterday. That’s the danger in playing cyclical names. I take my risk therethough, rather than in growth that might not materialize.

All this said, I feel well positioned for the next few trading sessions. I am working on my quarterly portfolio reshaping, which will take out a few companies, and replace them with cheaper companies in industries with more potential. Once I complete that analysis, you will hear about it on RealMoney and here.
Long SAB FDP

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