Bonds – Page 17 – The Aleph Blog

A Few Investment Notes

Posted on 9 August 201410 August 2014 by David Merkel

Just a few notes for this evening:

1) I’ve been a bull on the long end of the Treasury curve for a while. ?It’s been a winning bet, and the drumbeat of “interest rates have nowhere to go but up” continues. ?Here’s an argument from Jeffrey Gundlach on why long rates should remain low, and maybe go lower:

Gundlach, however, was one of the very few people?who believed rates would stay low, especially with the Federal Reserve committed to keeping rates low with its loose monetary policy.

It’s important to note that U.S. Treasuries don’t have the lowest yields in the world. French and?German government bonds have yields?that are about 100 basis points lower than those of Treasuries. In other words, those European bonds actually make U.S. bonds look cheap, meaning that yields have room to go lower.

This will trend toward lower rates will eventually have to end, but neither GDP growth, inflation, or business lending justifies it at present.

2) From Josh Brown, he notes that correlations went up considerably with all risk assets in the last bitty panic. ?Worth a read. ?My two cents on the matter comes from my recent article, On the Recent Anxiety in High Yield Bonds, where I noted how much yieldy stocks got hit — much more than expected. ?I suspect that some asset allocators with short-dated or small stop-loss trading rules began selling into the bitty panic, but that is just a guess.

3) That would help to explain the loss of liquidity in the bond market during the bitty panic. ?This article from Tracy Alloway at the FT explores that topic. ?One commenter asked:

Isn’t it a bit odd to say lots of people sold quickly *and* that there isn’t enough liquidity??

Liquidity means a number of things. ?In this situation, spreads widened enough that parties that wanted to sell had to give up price to do so, allowing the brokers more room to sell them to skittish buyers willing to commit funds. ?Sellers were able to get trades done at unfavorable levels, but they were determined to get the trades done, and so they were done, and a lot of them. ?Buyers probably had some spread target that they could easily achieve during the bitty panic, and so were willing to take on the bonds. ?Having a balance sheet with slack is a great thing when others need liquidity now.

One other thing to note from the article is that it mentioned that retail investors now own 37%?of credit, versus?29% in 2007, according to RBS. Also that?investment funds has been able to buy?all?of the new corporate debt sold since 2008.

There’s more good stuff in the article including how “matrix pricing” may have influenced the selloff. ?When spreads were so tight, it may not have taken a very large initial sale to make the estimated prices of other bonds trade down, particularly if the sales were of lower-rated, less-traded bonds. ?Again, worth a read.

4) Regarding credit scores, three articles:

Are We Giving Americans Too Much Credit?
FICO Recalibrates Its Credit Scores
On Credit Scores?(an old article of mine)

From the WSJ article:

Fair Isaac?Corp.?said Thursday that it will stop including in its FICO credit-score calculations any record of a consumer failing to pay a bill if the bill has been paid or settled with a collection agency. The San Jose, Calif., company also will give less weight to unpaid medical bills that are with a collection agency.

I think there is less here than meets the eye. ?This only affects those borrowing from lenders using the particular FICO scores that were modified. ?Not all lenders use that particular score, and many use FICO data disaggregated to create their own score, or ask FICO to give them a custom score that they use. ?Again, from the WSJ article:

Fair Isaac releases new scoring models every few years, and it is up to lenders to choose which ones to use. The new score will likely be adopted by credit-card and auto lenders first, says John Ulzheimer, president of consumer education at CreditSesame.com and a former Fair Isaac manager.

Mortgages are likely to lag, since the FICO scores used by most mortgage lenders are two versions old.

The?impact of the changes on borrowers is likely to be significant. Accounts that are sent to collections, including credit-card debts and utility bills, can stay on borrowers’ credit reports for as long as seven years, even when their balance drops to zero, and can lower their scores by up to 100 points, said Mr. Ulzheimer.

The lower weight given to unpaid medical debt could increase some affected borrowers’ FICO scores by 25 points, said Mr. Sprauve.

But lowering the FICO score by itself doesn’t do anything. ?Some lenders don’t adjust their hurdles to reflect the scores, if they think the score is a better measure of credit for their time-horizon, and they want more loan volume. ?Others adjust their hurdles up, because they want only a certain volume of loans to be made, and they want better quality loans at existing pricing.

Megan McArdle at Bloomberg View asks a different question as to whether it is good to extend more credit to marginal borrowers? ?Didn’t things go wrong doing that before? ?Her conclusion:

That in itself [DM: pushing for more loans to marginal borrowers as a matter of policy] is an interesting development. Ten years ago, politicians were pressing hard for banks to extend the precious boon of homeownership to every man, woman and shell corporation in America. Five years ago, when people were pushing for something like the CFPB, the focus of the public debate had dramatically shifted toward protecting people from credit. Oh, there were complaints about the cost of subprime loans, but ultimately, on most of those loans, the problem?wasn?t the interest rate but the principal: Too many people had taken out loans that they could not realistically afford to pay, especially if anything at all went wrong in their lives, from a job loss to a divorce to an unexpected illness. And so you heard a lot of complaints about predatory lenders who gave people more credit than they could handle.

Credit has tightened considerably since then, and now, it appears, we?re unhappy with that. We want cheaper, easier credit for everyone, and particularly for the kind of financially struggling people who have seen their credit scores pummeled over the last decade. And so we see the CFPB pressing FICO to go easier on people with satisfied collections.

That?s not to say that the CFPB is wrong; I don?t know what the ideal amount of credit is in a society, or whether we are undershooting the mark. What I do think is that the U.S. political system — and, for that matter, the U.S. financial system — seems to have a pretty heavy bias toward credit expansion. Which explains a lot about the last 10 years.

Personally, I look at this, and I think we don’t learn. ?Credit pulls demand into the present, which is fine if it doesn’t push losses and heartache into the future. ?We are better off with a slower, less indebted economy for a time, and in the end, the economy as a whole will be better off, with people saving to buy in the future, rather than running the risk of defaults, and a very punk economy while we work through the financial losses.

On the Recent Anxiety in High Yield Bonds

Posted on 8 August 2014 by David Merkel

Quoting the beginning of a recent article at Bloomberg.com:

As?junk bonds?plunge in value, many investors are wondering why.

There?s no obvious explanation for the 1.5 percent decline in U.S. high-yield securities in the past month, or the $9.9 billion of cash pulled from mutual funds that buy the debt. The most likely reason is that investors are increasingly uncomfortable hanging onto bonds that are expensive by historical measures.

Chalk this one up to a collective bout of angst that looks quite different from the 3.2 percent drop in speculative-grade bonds in May and June of last year. That rout was triggered by the prospect of less Federal Reserve stimulus and, while a withdrawal of easy-money policies still weighs on investors? minds, that?s not the full story now.

On June 24th, the junk bond markets were fairly tightly bid, and volume in the main high yield ETFs [JNK & HYG] were moderate. ?By August 1st, that bid had seemingly disappeared, but volume in the main high-yield ETFs were high. ?Many running for the exits. ?Things have calmed down?since then, at least it seems that way. ?Have a look at this set of credit yield curves:

Source: FRED

Credit quality goes down as you go from left to right on my chart. ?The lower rated the?bonds, the more they fell, which was the opposite of slower moving but long-lasting bull phase. ?Let’s look at what the losses/gains were like in percentage terms:

Date	5-yr Tsy	AAA	AA	A	BBB	BB	B	CCC	JNK ($/sh)	HYG ($/sh)	SPY ($/sh)	DVY ($/sh)
6/24/14	1.70	2.57	2.44	2.67	3.44	4.20	5.09	7.91	41.80	95.24	194.70	76.51
8/1/14	1.67	2.54	2.45	2.70	3.50	4.89	6.05	9.16	40.21	92.04	192.50	73.67
8/6/14	1.66	2.52	2.44	2.68	3.50	4.83	5.97	9.11	40.54	92.64	192.07	72.79
Divs									0.86	0.39
Return to 8/1	0.30%	0.39%	0.21%	0.16%	0.12%	-2.32%	-3.31%	-4.18%	-1.75%	-2.95%	-1.13%	-3.71%
Return to 8/6	0.36%	0.50%	0.29%	0.27%	0.17%	-2.03%	-2.92%	-3.87%	-0.96%	-2.32%	-1.35%	-4.86%

The return calculations are approximations. ?These are indicative, not exact. ?The losses on high yield debt haven’t been horribly large over this period — around 3% give or take, and the ETFs surprisingly did a little better. ?No panic in investment grade bonds, and the losses of the stock market have been minor over that time, leaving aside the fact that the market rallied for a few more weeks after high yield began to slide.

But here’s an odd bit — take a look at the last column in my table. ?That last column is the iShares Select Dividend?ETF [DVY], a very popular place for getting alternative yield. ?It yields about 3.1% now — a little less than you can get on BBB bonds, but ?maybe the dividend will grow. ?(It usually does.)

When you have many different parties going into the markets seeking income, not caring where they get it from, and a shock hits one part of the market, the effect flows to other areas ?If all of a sudden yields on junk bonds look cheaper, the yield trade-offs of buying junk and selling dividend paying common stocks looks attractive.

Now there are few permanent rules for yield relationships — even in corporate debt on its own. ?We can calculate average spread differences, sure, but there is a LOT of variation around those means (which may even bear no resemblance to future means). ?If it is that difficult asking what the right spread tradeoffs are?with?bonds different qualities, then how would we ever come up with the right tradoffs for common stocks, preferred stocks, REITs, MLPs, bonds of varying qualities, etc?

The best we can do is something like GMO does, and go to each asset class?and try to estimate the free cash flow yield of each asset class over the next full market cycle (5-10 years) given the current prices being paid. ?The higher the price paid, the lower future returns will be, and vice-versa. ?Assume that valuations will normalize over the forecast horizon, and don’t just look at valuations using earnings. ?Try book, free cash flow and sales as well. ?Results will vary.

So remember,?The Investments Matter More than their Form. ?Also remember,?Ignore Yield. ?Focus on what is building value for you in every investment. ?I like to own stocks where earnings quality is high,?valuations are low, and free cash flow gets put to good use. ?Do I always get that? ?No. ?But if I get it right enough of the time, then returns will be good enough.

Back to the beginning, though. ?Is this move in the junk bond market a hiccup, or the start of something big? ?I’m open to other opinions, but for it to be something big, you have to have a lot of things that look misfinanced. ?Where are there economic entities with short-term debt financing long term assets that look overvalued? ?Where have debts grown the most? ?I can’t identify a class like that unless we try student loans, or government debts. ?Corporate debt has grown, but doesn’t seem unreasonable now.

So, with high yield, I lean toward the hiccup. ?But even at current yields, it is not cheap. ?Speculators may play; I will stay away.

Ignore Yield

Posted on 6 August 2014 by David Merkel

Yield is not an inherent feature of an asset. ?Why?

Dividends can be cut.
Bonds can default.
Taxable income can fall for REITs, BDCs, and MLPs, thus lowering their distributions.
Bonds sometimes have funny features where they can be called away from you, and you get to reinvest in a lower yield environment.
With structured notes, your income or principal can be considerably reduced when bad events happen that you thought were unlikely, but really aren’t so unlikely.

Rather, focus on the things that drive the increase in value of an asset. ?You can create your own “dividends” by selling off pieces of investments that you own. ?Commissions are small if you have the right broker.

Why do I write this, this evening? ?I keep running into writers and investment advisors that say, “You need a certain yield? ?I can get you that yield!”

Yes, and I can get you that yield too, but I would hate doing it because it would expose you to risks that I would not like to take with my own money. ?People forget all of the dividend cuts in the ’70s. ?They forget how many times REITs have failed as a group over the past 50 years. ?They forget how much money was lost on Limited Partnerships in the ’80s while trying to cheat the taxman.

Even Jonathan Clements, a writer who I would recommend to everyone, is somewhat duped by the need for yield. ?Getting yield from stocks is an uncertain proposition. ?Focusing on the highest quality stocks, and it is less uncertain, but still uncertain.

One thing is a constant with stocks and dividends — it is better to focus on stocks with low dividends that are growing rapidly, than on stocks with high dividends that grow slowly. ?The reason for this is that good management teams pay out a conservative amount of free cash flow as dividends, and reinvest most of the free cash flow to grow the company.

It is also not certain that bond yields will rise. ?The US economy is not strong, and there is no great demand for business loans at banks.

At a time like this, charlatans arrive telling you how high yields can be achieved in a low yield environment. ?Investment banks offer structured notes with high yields. ?Don’t believe them. ?Instead focus on the investments that might preserve or increase value best.

Now for the controversial bit: time to increase allocations to cash and gold (or commodities). ?You might think, “Wait, are you you saying in a low yield environment, I ought to drop my yield further?” Yes. ?I am also saying that when yields are too low, the opportunity costs of holding gold or cash are also low, and maybe that will help to preserve value if things go wrong.

I manage stocks and bonds for total return. ?I don’t look at yield as an important guide to future?total return in an environment like this. ?I try to ?view all investments through a “What could go wrong?” lens, rather than a “How much cash will this investment send to me next year?” lens.

Here’s a way to think about it. ?Pretend that all investments don’t make distributions. ?What investments would you want to own? ?Which grow value the best? ?That is your first pass in how you should think about investments. ?The second refines it by adjusting for tax rules, because some types of income are tax-favored. ?That said, put value generation first, and tax consequences second.

On Management Fees

Posted on 6 August 2014 by David Merkel

Yet another letter from a reader:

Hi David –

Thank you for your commitment to sharing your wisdom, ideas, and experience.? I aspire to one day enjoy the success and happiness that you have in your life and career as an investor.

My question may be a bit more tactical than others that you have profiled: In our current world of 2% & 20% fee structures and where in past eras Buffett promoted a 25% performance fee above a 6% threshold (with the objective of aligning partners’ wealth creation incentives), why do investment managers choose to promote % of AUM only fee structures?? I believe you also promote a similar fee only structure??

I’m curious about your insights on the rationale for fee only versus performance only structures.? Does your philosophy have anything to with your faith or past experience working at a hedge fund??

Many thanks and much continued success to you!!

Personally, I like the flat 1% of assets?fee (0.3% for bonds), because it does not make me swing for the fences. ?I don’t take extra risks or chances with client assets because of a performance fee. ?The main goal of investing is to avoid losing money. ?That is what I aim to do over a full market cycle, and I have been successful at it over the last 20+ years.

I respect those who do performance only, like Buffett’s formula, but?my value proposition is that those who invest alongside me get what I get, less the small fee. ?If I underperform in the future, I will be dejected, and it will hurt me far more, than any money I receive in fees. ?I aim to do as well as Buffett, but charge less. ?I am not driven by profits, but by service to clients.

Another way to say it is to hire guys who will do this business even if they weren’t paid. ?That is the way I feel about investing.

I am out to do well, and?not to give my clients a bad deal.

Can the “Permanent Portfolio” Work Today?

Posted on 6 August 20146 August 2014 by David Merkel

Another letter from a reader:

Dear Mr. Merkel:

I just discovered your blog through Valuewalk, which I read most days. I haven’t read much yet on your blog, but from what I’ve seen, I really like your insights and comments.

I’ve been thinking for a long time about the idea of a permanent portfolio concept, based on writing from years ago of an investment analyst, Harry Browne, now deceased. I’ve been thinking about this for my own investment requirements and also because I intend to write a book on the subject.

The big problem with a permanent portfolio today, versus 30 years ago, in my judgement, is identifying a long term fixed income vehicle would survive a major financial collapse. Browne always used 30 year US Treasury bonds, in an era when it seemed clear those bonds could survive a monetary deflation.

Of course, the Fed isn’t about to institute a policy of sustained monetary deflation any time soon, on a voluntary basis. Any such deflation would occur, either because the Fed were unable or unwilling to monetize assets fast enough to head off cascading cross defaults and massive bonk failures; or because the Fed decided to let the house of cards collapse, in some future recession-panic, because it became obvious to a plurality of Fed governors that to prop up the house of cards would guarantee hyper inflation in short order. Of course, a hyper inflation would not only destroy the financial system, including the central bank; it would overturn the established political order, and cause a famine as the division of labor fell apart.?

I think a monetary deflation will happen sooner or later, because of a financial “accident” (that reasonable people can foresee). Even if the central banks were to cause a hyper inflation, when that inflation ends after two or three years, the currency must be renounced. Then we would get deflation for a while via some new currency.

Since I think the deflation risk is realistic, I’m trying to figure out what-if any-bond instruments could survive deflationary destruction. Obviously, in a monetary deflation, all investment prices plummet, except default-free bonds. Default free bonds would rise in price, as interest rates plummeted. However, I’m not clear as to what bonds might work as vehicles in a permanent portfolio, because T bonds are no longer a reliable safe haven from eventual political default.

There might well be sovereign bonds in other countries that are more friendly to free enterprise and private property than contemporary US, and hence less prone to sovereign bond default,? but this introduces the risk of currency fluctuations. So it’s not a perfect solution. Perhaps some foreign sovereign debt combined with US Treasury debt would partly work. It has also occurred to me that some US utility or pipeline firm etc. might offer debt or preferred stock or other forms of fixed income debt/equity ownership that would survive default. In a terrible depression, I’d assume some utility companies would continue to function although, of course, not flourish. Obviously, any such debt or equity would be a very special situation, since most firms are now loaded to the gills with debt, making them poor risks to survive a crushing deflation.

My impression is all this is right up your ally. (Except for my musing-theorizing about the risk of monetary deflation, which no doubt makes me seem like a religious fanatic or political crazy.) Anyway, I’d be interested if you think this problem can be solved. In other words, do you think some private debt issues that are long term or even medium term exist to be discovered that could avoid default in a huge deflationary depression? How would you go about conducting a search for such safe U.S. corporate bonds or other fixed income instruments?

What I really need to do is immerse myself in reading about fixed income analysis. Which I hope to get to in a few months.

None of my fixation with bonds has to do with forecasting a decline in interest rates; until the next crisis, rates on the long end could easily climb. I’m looking for a secure volatile instrument that would gain in price as other investments were falling during a financial panic and subsequent depression.

Thanks for reading through all this. I look forward to spending a lot of hours in the future on your blog.

Yours truly,

Dear Friend,

I have written about the Permanent Portfolio concept here. ?I think it is valid. ?At some point in the near term, I will update my analysis of the Permanent Portfolio, and publish it for all to see, which I have not done before.

In a significant inflation scenario, gold would soar, long T-bonds would tank, T-bills would actually earn nominal but not real money, and stocks would likely trail inflation, aside from investors that invest in low P/E stocks. ?The permanent portfolio would likely do okay.

Same ?for a deflation scenario. ?Stocks will muddle. T-bonds will do well. ?T-bills will do nothing. ?Gold will do badly. ?That said, the permanent portfolio concept is meant to be an all-weather vehicle, and has done well over the last 44 years, with only 3 losing years, and returns that match the S&P 500, but with half the volatility.

I’m usually not a friend of ideas like this, but the Permanent Portfolio chose four assets where the price responses to changes in real rates and inflation fought each other. ?The rebalancing method is important here, as it is a strategy that benefits from volatility.

With respect to where to invest in fixed income?to benefit from a depression is a touchy thing — it’s kind of like default swaps on the US government, which are typically denominated in Euros. ?How do you know that the counterparty will be solvent? ?How do you know that the Euro will be worth anything?

Personally, I would just stick with long US Treasuries. ?The US has the least problems of all the great powers in the world. ?You could try to intensify you returns by overweighting long Treasuries, but that is making a bet. ?The Permanent Portfolio makes no bets. ?It just takes advantage of economic volatility, and rides the waves of?of the economy. ?As a group, stocks, T-bonds, T-bills, and gold, react very differently to volatility, and as such do well, when many other strategies do not.

Warren Buffett is “scary smart,” so says Charlie Munger, who is “scary smart” himself. ?I think Harry Browne was “scary smart” with respect to the Permanent Portfolio idea. ?But am I, the recommend-er “scary smart?” ?I do okay, but probably not “scary smart,” so take my words with a grain of salt.

Sincerely,

David

PS — As an aside, I would note that if everyone adopted the “Permanent Portfolio” idea — gold would go through the roof, because that is the scarcest of the four investments.

The Investments Matter More than their Form

Posted on 2 August 20143 August 2014 by David Merkel

Open-end Mutual Funds, including index funds
Closed-end Mutual Funds
Exchange Traded Funds, including index funds
Separately Managed Accounts
Unit Investment Trusts
Hedge Funds
Private Equity
Other Limited Partnerships [LPs], including MLPs
Variable Annuities (and Life Insurance)
Equity-Indexed Annuities (and Life Insurance)

What do all of the above have in common? ?The first one is the easiest — they are all investments. ?The second one is harder — they are all ways of investing in the ownership interests of corporations.

Think of the underlying investments within these investment forms when analyzing the forms as investments. ?Now the forms aren’t entirely neutral:

Index funds don’t take a lot of fees.
Hedge Funds, Private Equity, and Insurance Products do take a lot of fees.
Insurance Products are tax favored. ?LPs,?MLPs and Private Equity have some tax advantages. ?Separately managed accounts can have tax advantages, if managed right. ?If you make the right investment, buying and holding has tax advantages, especially if you take it to the grave.

Thus, you should look at the manager, to try to analyze if he has skill. ?You should look at the fees to see what you are giving up. ?You should look at the tax advantages.

You should also think about the sensitivity of the investments to the overall risk cycle. ?I don’t like the concept of beta, because it is not a stable concept, but in broad hedge funds have low beta, and private equity has high beta, relative to an S&P 500 index fund. ?But neither in aggregate have much outperformance, after adjusting for the beta.

There are many clever investors scouring the world of investments looking for underpriced assets. ?At a time like now, there aren’t a lot of underpriced assets. ?I might find 2-4 per quarter, but they are only relatively underpriced, not absolutely underpriced (I.e. at this price, you should buy it regardless the the economic environment).

Every now and then, the market falls apart. ?At such a time, two things happen.

1) Because some sector of the economy had too much debt, prices for the stocks and corporate bonds (or trade claims) fall, and the market as a whole falls along with them, though to a lesser extent.

2) During the crisis, many assets get oversold, and those with better knowledge can profit from the overselling. ?The best example I can think of all of the hedge funds that bought non-agency mortgage-backed securities, when they were thrown out the window indiscriminately in 2008, and many of those securities have returned to par.

The ability to achieve alpha (outperformance) increases after a crisis. ?Some who prepare for that, like Seth Klarman and Warren Buffett, create their own outperformance by taking more risk when other investors are running away in panic.

As my boss asked me in 2007, “Why have you not done so well for us the last few years, when you did so well 2003-5? ?I answered, “When I came to you, the market was like an apple cart ?that had fallen over and I picked up the undamaged apples. ?Today, the market is rational, and there are not a lot of easy pickings to be had. ?That is the difference between the bust and the boom. ?It is much easier for a fundamental investor to act during the bust.

Thus I would encourage the following:

Pay attention to fees
Pay attention to tax advantages.
The time at which you invest matters ?a great deal: try to invest when opportunities are the greatest (and others are scared stiff)
Ignore the form of investing, but invest with skilled managers (if you can find them, otherwise index funds).

Think of Seth Klarman who hands back money to his clients when markets are not promising. ?Few professionals have the intelligence?to do that. ? Fewer have the ethics and courage to do so.

For my equity clients, I have reduced exposure, and I am close to my maximum cash level of 20%. ?I am watching the market, and am willing to add to my positions, 10%, 20%, and 30% lower. ?I own good companies. ?As has been true in the past, I get close to zero cash as the market bottoms. ?The market is somewhat high now — I think of it as the 80th percentile. ?But it is not at nosebleed levels.

Analyze your investments, and sense the skill of managers, and lack thereof, and the degree of sensitivity to the market as a whole, which is likely higher than you expect.

Then adjust as you see fit. ?Every situation is different, except for the parts that are the same.

All for now.

Redacted Version of the July 2014 FOMC Statement

Posted on 30 July 2014 by David Merkel

Comments

The two main points of this FOMC statement are: 1) ?The Fed recognizes that inflation has risen, and is likely to persist. 2) ? Despite lower unemployment levels, labor market conditions are still pretty punk.? Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
Markets don’t move much on the news. ?Really, not a lot here.
Small $10 B/month taper.? Equities and long bonds both rise.? Commodity prices rise.? The FOMC says that any future change to policy is contingent on almost everything.
Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
The FOMC needs to chop the ?dead wood? out of its statement.? Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
In the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do?? I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

The Best of the Aleph Blog, Part 25

Posted on 29 July 2014 by David Merkel

In my view, these were my best posts written between February and April 2013:

Wall Street Hates You

I have a saying, ?Don?t buy what someone wants to sell you. Buy what you have researched.?

And so I would tell everyone: don?t give brokers discretion over you accounts, and don?t let them convince you to buy unusual bonds, or obscure securities of any sort.? By unusual bonds, I mean structured notes, and eminent men like Joshua Brown and Larry Swedroe encourage the same thing: Don?t buy them.

The Education of a Mortgage Bond Manager, Part III

Why being careful with credit ratings is smart.

The Education of a Mortgage Bond Manager, Part IV

Be wary of odd asset classes; they are odd for a reason.

The Education of a Mortgage Bond Manager, Part V

Where I do odd things in order to serve my client.

The Education of a Mortgage Bond Manager, Part VI

The Education of a Mortgage Bond Manager, Part VII

The Education of a Mortgage Bond Manager, Part IX

Odd stuff, but particularly insightful into some of the perverse dynamics inside investment departments.

The Education of a Mortgage Bond Manager, Part VIII

How I led the successful effort to modify the Maryland Life Insurance Investment Law, and acted for the good of the public.

The Education of a Mortgage Bond Manager, Part X (The End)

Where I explain the odd bits of being portfolio manager, while succeeding with structured bonds amid difficult markets.

Berkshire Hathaway & Variable Annuities

I explain the good, bad, and ugly off of Berkshire Hathaway’s reinsurance deal with CIGNA.

Advice to Two Readers

Where I opine on some Sears bonds, and also on flu pandemic risk at RGA.

What I Would & Would Not Teach College Students About Finance

Mostly, I would teach them to think broadly, and realize the most of the complex investment math is easy to get wrong.

My Theory of Asset Pricing

My replacement for MPT using contingent claims theory.

On Insurance Investing, Part 4

On finding companies with conservative insurance reserving

On Insurance Investing, Part 5

On the squishy stuff, where there are no hard guidelines.

On Time Horizons

People shorten and lengthen their time horizons at the wrong time.

The Education of an Investment Risk Manager, Part IV

On two odd situations inside a life insurance company.

The Education of an Investment Risk Manager, Part V

On how we replaced a manager of managers.

Value Investing Flavors

Explains how there are many ways to do value investing.

Classic: Using Investment Advice, Part 1

Classic: Using Investment Advice, Part 2

Classic: Using Investment Advice, Part 3

Classic: Using Investment Advice, Part 4 [Tread Warily on Media Stock Tips]

Understand yourself, understand the advisor, understand the counsel that is offered, and finally, we wary of what you here through the media, including me.

Classic: Avoid the Dangers of Data-Mining, Part 1

Classic: Avoid the Dangers of Data-Mining, Part 2

There are many ways to torture the data to make it confess what you want to hear. ?Avoid that.

Classic: The Fundamentals of Market Tops

Where I explain what conditions are like when market tops are near.

At the Towson University Investment Group?s International Market Summit, Part 5

Where I answer the question:?Where does academic theory fail in finance and in economics?

Classic: Separating Weak Holders From the Strong

Classic: Get to Know the Holders? Hands, Part 1

Classic: Get to Know the Holders? Hands, Part 2

Articles that explain the fundamental??basis that underlies technical analysis.

Classic: The Long and Short of Trend Investing

How to play trends without getting skinned.

Full Disclosure: long RGA and BRK/B

On Learning Compound Interest Math

Posted on 19 July 201420 July 2014 by David Merkel

When I read articles like?this where people get scammed borrowing money, I say to myself, “we need to teach children the compound interest math.”

Even my dear wife does not get it, and she sends the children to me when they don’t get it. ?But beyond learning the math, a healthy skepticism of borrowing needs to be encouraged, especially for depreciating items like autos.

The compound interest math is really one of the more simple items of Algebra 2. ?Everyone should be able to calculate the value of a non-contingent annuity at a given interest rate.

Once people learn that, they might have more skepticism regarding the long-dated pension-like promises that the government makes, because they can look at the future payment stream, and say, “I can’t see how we fund that.”

All for now.

On Current Credit Conditions

Posted on 18 July 201418 July 2014 by David Merkel

This should be short. ?Remember that credit and equity volatility are strongly related.

I am dubious about conditions in the bank loan market because Collateralized Loan Obligations [CLOs] are hot now and there are many that want to take the highest level of risk there. ?I realize that I am usually early on credit?issues, but there are many piling into CLOs, and willing to take the first loss in exchange for a high yield. ?Intermediate-term, this is not a good sign.

Note that corporations take 0n more debt when rates are low. ?They overestimate how much debt they can service, because if rates rise, they are not prepared for the effect on earnings per share, should the cost of the debt reprice.

It’s a different issue, but consider China with all of the bad loans its banks have made. ?They are facing another significant default, and the Chinese Government looks like it will let the default happen. ?That will not likely be true if the solvency of one of their banks is threatened, so keep aware as the risks unfold.

Finally, look at the peace and calm of low implied volatilities of the equity markets. ?It feels like 2006, when parties were willing to sell volatility with abandon because the central banks of our world had everything under control. ?Ah, remember that? ?Maybe it is time to buy volatility when it is cheap. ?Now here is my question to readers: aside from buying long Treasury bonds, what investments can you think of that benefit from rising implied volatility and credit spreads, aside from options and derivatives? ?Leave you answers in the comments or email me.

This will sound weird, but I am not as much worried about government bond rates rising, as I am with credit spreads rising. ?Again, remember, I am likely early here, so don’t go nuts applying my logic.

PS — weakly related, also consider the pervasiveness of BlackRock’s risk control model. ?Dominant risk control models may not truly control risk, because who will they sell to? ?Just another imbalance of which to be wary.