Bonds – Page 7 – The Aleph Blog

Redacted Version of the July 2016 FOMC Statement

Posted on 27 July 2016 by David Merkel

Comments

This statement was a nothing-burger.
Policy continues to stall, as the economy muddles along.
But policy should be tighter. Savers deserve returns, and that would be good for the economy.
The changes for the FOMC?s view are that labor indicators are stronger, and GDP and household spending are weaker.
Equities and bonds rise a little. Commodity prices rise and the dollar falls.? Everything is a little looser.
The FOMC says that any future change to policy is contingent on almost everything.
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 much, absent much higher inflation, or a US Dollar crisis.

In Human Affairs “Never Say Never”

Posted on 5 July 2016 by David Merkel

Picture Credit Bloomberg — Picture Credit: Bloomberg

=-=-=-=-=-=-=-=-=-

Rates can go lower from here. ?For as long as I can remember, I have been told by many experts that rates can’t go lower, or, that they must go up — there is no way they can go lower. ?I have argued with that idea, as has Hoisington (Lacy Hunt), Gary Shilling and a few others.

Note also that the Fed and most central banks have been on the wrong side of this as well. ?They keep saying that inflation will come, economic activity will pick up,?and that interest rates will rise.

The Fed keeps saying that they will tighten policy. ?I’ll tell you this — with only 0.82% between the yields on 10- and 2-year Treasuries, the Fed is not tightening.

WIth debt levels as high as they are (both government and private), trying to influence economic activity though interest rates is a dumb idea. ?Incenting borrowers to borrow more is difficult, aside from the government — and they rarely do anything with the money that helps produce opportunities for greater economic activity.

We would be better off without “policymakers” trying to “stimulate” the economy, “manage” it, “stabilize” it, etc. ?(But where is the political will to change things — the populace wants easy prosperity, and who is there to tell them to accept a rough world where work and competition is tough, and there is no “Big Daddy” to make life easy? ?The people are the problem. ?The politicians are only a symptom.)

There is one thing that could change this, but it would lay bare the intellectual and moral bankruptcy of what policymakers have been trying to do, which is try to maintain the real value of debt claims while still trying to “stimulate” the economy. ?They could burn away the value of debt claims through an inflation greater than that of the 1970s.

So far, they aren’t willing to do that. ?But their existing policies will prolong the stagnation.

And as such, rates can fall further — with a lot of noise/variation around it.

Redacted Version of the June 2016 FOMC Statement

Posted on 15 June 2016 by David Merkel

=-=-=-=-

Comments

The FOMC meets too frequently. Often the economic signals at one meeting get reversed at the next meeting, as was true this time.? Rather than hyper-interpreting every wiggle, maybe the FOMC should meet every six months, with the proviso that the chairman could call an interim meeting if the situation demanded it.
That this is true regarding economic aggregates has been known since the ?50s. For a variety of reasons, it is difficult to distinguish signal from noise over periods of less than a year.
Then again, maybe the FOMC meets to make it look like they are doing something. 😉
This statement was a nothing-burger.
Policy continues to stall, as the economy muddles along.
But policy should be tighter. Savers deserve returns, and that would be good for the economy.
The changes for the FOMC?s view are that labor indicators are weaker, and GDP and household spending are stronger.
Equities fall and bonds rise a little. Commodity prices rise and the dollar falls.
The FOMC says that any future change to policy is contingent on almost everything.
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 much, absent much higher inflation, or a US Dollar crisis.

Estimating Future Stock Returns, March 2016 Update

Posted on 10 June 2016 by David Merkel

You might remember my post?Estimating Future Stock Returns, and its follow-up piece. ?If not they are good reads, and you can get the data on one file here.

The Z.1 report came out yesterday, giving an important new data point to the analysis. ?After all, the most recent point gives the best read into current conditions. ?As of March 31st, 2016 the best estimate of 10-year returns on the S&P 500 is 6.74%/year.

The sharp-eyed reader will say, “Wait a minute! ?That’s higher than last time, and the market is higher also! ?What happened?!” ?Good question.

First, the market isn’t higher from 12/31/2015 to 3/31/2016 — it’s down about a percent, with dividends. ?But that would be enough to move the estimate on the return up maybe 0.10%. ?It moved up 0.64%, so where did the 0.54% come from?

The market climbs a wall of worry, and?the private sector has been holding less stock as a percentage of assets than before — the percentage?went from 37.6% to 37.1%, and the absolute amount fell by about $250 billion. ?Some stock gets eliminated by M&A for cash, some by buybacks, etc. ?The amount has been falling over?the last twelve months, while the amount in bonds, cash, and other assets keeps rising.

If you think that return on assets doesn’t vary that much over time, you would?conclude that having a smaller amount of stock owning the assets would lead to a higher rate of return on the stock. ?One year ago, the percentage the private sector held in stocks was 39.6%. ?A move down of 2.5% is pretty large, and moved the estimate for 10-year future returns from 4.98% to 6.74%.

Summary

As a result, I am a little less bearish. ?The valuations are above average, but they aren’t at levels that would lead to a severe crash. ?Take note, Palindrome.

Bear markets are always possible, but a big one is not likely here. ?Yes, this is the ordinarily bearish David Merkel writing. ?I’m not really a bull here, but I’m not changing my asset allocation which is 75% in risk assets.

Postscript for Nerds

One other thing affecting this calculation is the Federal Reserve revising estimates of assets other than stocks up prior to 1961. ?There are little adjustments in the last few years, but in percentage terms the adjustments prior to 1961 are huge, and drop the R-squared of the regression from 90% to 86%, which also is huge. ?I don’t know what the Fed’s statisticians are doing here, but I?am going to look into it, because it is?troubling to wonder if your data series is sound or not.

That said, the R-squared on this model is better than any alternative. ?Next time, if I get a chance, I will try to put a confidence interval on the estimate. ?Till then.

The Dead Model

Posted on 21 May 2016 by David Merkel

-=-=-=-=-=-=-

Nine years ago, I wrote about the so-called “Fed Model.” The insights there are still true, though the model has yielded no useful signals over that time. It would have told you to remain in stocks, which given the way many panic,, would not have been a bad decision.

I’m here to write about a related issue this evening. ?To a first approximation, most investment judgments are a comparison between two figures, whether most people want to admit it or not. ?Take the “Fed Model” as an example. ?You decide to invest in stocks or not based on the difference between Treasury yields and the earnings yield of stocks as a whole.

Now with interest rates so low, belief in the Fed Model?is tantamount to saying “there is no alternative to stocks.” [TINA] ?That should make everyone take a step back and say, “Wait. ?You mean that stocks can’t do badly when Treasury yields are low, even if it is due to deflationary conditions?” ?Well, if there were only two assets to choose from, a S&P 500 index fund and 10-year Treasuries, and that might be the case, especially if the government were borrowing on behalf of the corporations.

Here’s why: in my?prior piece on the Fed Model, I showed how the Fed Model was basically an implication of the Dividend Discount Model. ?With a few simplifying assumptions, the model collapses to the differences between the earnings yield of the corporation/index and its cost of capital.

Now that’s a basic idea that makes sense, particularly when consider how corporations work. ?If a corporation can issue cheap debt capital to?retire stock with a higher yield on earnings, in the short-run it is a plus for the stock. ?After all, if the markets have priced the debt so richly, the trade of expensive debt for cheap equity makes sense in foresight, even if a bad scenario comes along afterwards. ?If true for corporations, it should be true for the market as a whole.

The means the “Fed Model” is a good concept, but not as commonly practiced, using Treasuries — rather, the firm’s cost of capital is the tradeoff. ?My proxy for the cost of capital?for the market as a whole is the long-term Moody’s Baa bond index, for which we have about 100 years of yield data. ?It’s not perfect, but here are some reasons why it is a reasonable proxy:

Like equity, which is a long duration asset, these bonds in the index are noncallable with 25-30 years of maturity.
The Baa bonds are on the cusp of investment grade. ?The equity of the S&P 500 is not investment grade in the same sense as a bond, but its cash flows are very reliable on average. ?You could tranche?off a pseudo-debt interest in a way akin to the old Americus Trusts, and the cash flows would price out much like corporate debt or a preferred stock interest.
The debt ratings of most of the S&P 500 would be strong investment grade. ?Mixing in equity and extending to a bond of 25-30 years throws on enough yield that it is going to be comparable to the cost of capital, with perhaps a spread to compensate for the difference.

As such, I think a better comparison is the earnings yield on the S&P 500 vs the yield on the Moody’s BAA index if you’re going to do something like the Fed Model. ?That’s a better pair to compare against one another.

=-=-=-=-=-=-

That brings up another bad binary comparison that is common — the equity premium. ?What do?stock returns?have to with the returns on T-bills? ?Directly, they have nothing to do with one another. ?Indirectly, as in the above slide from a recent presentation that I gave, the spread between the two of them can be broken into the sum of three spreads that are more commonly analyzed — those of maturity risk, credit risk and business risk. ?(And the last of those should be split into a economic earnings ?factor and a valuation change factor.)

This is why I’m not a fan of the concept of the equity premium. ?The concept relies on the idea that equities and T-bills?are a binary choice within the beta calculation, as if only the risky returns trade against one another. ?The returns of equities can be explained in a simpler non-binary way, one that a businessman or bond manager could appreciate. ?At certain points lending long is attractive, or taking credit risk, or raising capital to start a business. ?Together these form an explanation for equity returns more robust than the non-informative academic view of the equity premium, which mysteriously appears out of nowhere.

Summary

When looking at investment analyses, ask “What’s the comparison here?” ?By doing that, you will make more intelligent investment decisions. ?Even a simple purchase or sale of stock makes a statement about the relative desirability of cash versus the stock. ?(That’s why I prefer swap transactions.) ?People aren’t always good at knowing what they are comparing, so pay attention, and you may find that the comparison doesn’t make much sense, leading you to ask different questions as a result.

The Fed Minutes are Noise

Posted on 20 May 2016 by David Merkel

Photo Credit: duncan c || It wasn't my intent initially to compare the words of the FOMC with the scrawlings of a vandal, but ya know some things are surprise fits — Photo Credit: duncan c || It wasn’t my intent initially to compare the words of the FOMC with the scrawlings of a vandal, but ya know, some things are surprise fits

*/*/

I wasn’t surprised to hear in the FOMC minutes that members of the committee thought:

For these reasons, participants generally saw maintaining the target range for the federal funds rate at 1/4 to 1/2 percent at this meeting and continuing to assess developments carefully as consistent with setting policy in a data-dependent manner and as leaving open the possibility of an increase in the federal funds rate at the June FOMC meeting.

and

Participants agreed that their ongoing assessments of the data and other incoming information, as well as the implications for the outlook, would determine the timing and pace of future adjustments to the stance of monetary policy. Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June. Participants expressed a range of views about the likelihood that incoming information would make it appropriate to adjust the stance of policy at the time of the next meeting. Several participants were concerned that the incoming information might not provide sufficiently clear signals to determine by mid-June whether an increase in the target range for the federal funds rate would be warranted. Some participants expressed more confidence that incoming data would prove broadly consistent with economic conditions that would make an increase in the target range in June appropriate. Some participants were concerned that market participants may not have properly assessed the likelihood of an increase in the target range at the June meeting, and they emphasized the importance of communicating clearly over the intermeeting period how the Committee intends to respond to economic and financial developments.

I was surprised to see some of the markets take it seriously. ?Here’s why:

1)?The FOMC loves to talk hawk and them be doves. ?They don’t think the?costs to waiting are significant, particularly given how low measured inflation and and implied future inflation are. ?Five-year inflation, five years forward implied from TIPS spreads is?not high at present as you can see here:

2) The FOMC is well known for giving with the right hand and taking with the left. ?They would like if possible to have the best of both worlds — gentle movement of what they view as key variables, while usually not dramatically changing the forward estimates of those

3) The FOMC’s natural habitat is wishful thinking. ?Their GDP forecasts are usually high, and they suspect their policy tools will move the economy the way they want and quickly, and it’s just not true.

4) LIBOR rates have done a better job of the FOMC at estimating future policy, and they have barely budged since the FOMC minutes came out.

5) The FOMC always has more doves than hawks, and that is the way the politicians who appoint and approve the board members like it. ?They will live with inflation. ?That was yesterday’s problem. ?Today’s problem is stagnant median incomes — and looser monetary policy will help there, right?

Well, no, but I’m sure they clapped when Peter Pan asked them to save Tinkerbell. ?There is no link between inflation and faster real growth over the long haul. ?There may be measurement errors in the short run.

6) They don’t like moving against foreign rates, but that’s not a big factor.

7) GDP isn’t showing much lift at all.

Summary

Unless we have a change in management at the Fed, where they are?not trying to manipulate markets through their words, but maybe one that said little and acted quietly, like the pre-1986 FOMC, they really aren’t worth listening to. ?They act like politicians. ?Let them study Martin and Volcker, and learn from when the FOMC was more effective.

PS — I’m not saying they can’t tighten in June. ?I’m just saying it’s unlikely, and to ignore the comments in the FOMC minutes. ?What the FOMC says is of little consequence. ?It’s what they do that counts. ?They are like a little dog that barks a lot, but rarely bites.

You Can Get Too Pessimistic

Posted on 7 May 20169 May 2016 by David Merkel

Photo Credit: Kathryn || Truly, I sympathize. ?I try to be strong for others when internally I am broken.

Entire societies and nations have been wiped out in the past. ?Sometimes this has been in spite of the best efforts of leading citizens to avoid it, and sometimes it has been because of their efforts. ?In human terms, this is as bad as it gets on Earth. ?In virtually all of these cases, the optimal strategy was to run, and hope that wherever you ended up would be kind to foreigners. ?Also, most common methods of preserving value don’t work in the worst situations… flight capital stashed early in the place of refuge?and?gold might work, if you can get there.

There. ?That’s the worst survivable scenario I can think of. ?What does it take to get there?

Total government and?market breakdown, or
A lost war on your home soil, with the victors considerably less kind than the USA and its allies

The odds of these are very low in most of the developed world. ?In the developing world, most of the wealthy have “flight capital” stashed away in the USA or someplace equally reliable.

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-=-=-=-=-=-

Most nations, societies and economies are more durable than most people would expect. ?There is a cynical reason for this: the wealthy and the powerful have a distinct interest in not letting things break. ?As Solomon observed a little less than 3000 years ago:

If you see the oppression of the poor, and the violent perversion of justice and righteousness in a province, do not marvel at the matter; for high official watches over high official, and higher officials are over them. Moreover the profit of the land is for all; even the king is served from the field. — Ecclesiastes 5:8-9 [NKJV]

In general, I think there is?no value in preparing for the “total disaster” scenario if you live in the developed world. ?No one wants to poison their own prosperity, and so the?rich and powerful?hold back from being too rapacious.

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-=-=-=-=-=-

If you don’t have a copy, it would?be a good idea to get a copy of?Triumph of the Optimists. ?[TOTO] ?As I commented in my review of 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 1929-1932, 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.

Capitalist republics/democracies tend to be very resilient. ?This should make us willing to be long term bullish.

Now, many people look at their societies and shake their heads, wondering if things won’t keep getting worse. ?This typically falls into three?non-exclusive buckets:

The rich are getting richer, and the middle class is getting destroyed ?(toss in comments about robotics, immigrants, unfair trade, education problems with children, etc. ?Most such comments are bogus.)
The dependency class is getting larger and larger versus the productive elements of society. ?(Add in comments related to demographics… those comments are not bogus, but there is a deal that could be driven here. ?A painful deal…)
Looking at moral decay, and wondering at it.

You can add to the list. ?I don’t discount that there are challenges/troubles. ?Even modestly healthy society can deal with these without falling apart.

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-=-=-=-=-=-

If you give into fears like these, you can become prey to a variety of investment “experts” who counsel radical strategies that will only succeed with very low probability. ?Examples:

Strategies that neglect investing in risk assets at all, or pursue shorting them. ?(Even with hedge funds you have to be careful, we passed the limits to arbitrage back in the late ’90s, and since then aggregate returns have been poor. ?A few niche hedge funds make sense, but they limit their size.)
Gold, odd commodities — trend following CTAs can sometimes make sense as a diversifier, but finding one with skill is tough.
Anything that smacks of being part of a “secret club.” ?There are no secrets in investing. ?THERE ARE NO SECRETS IN INVESTING!!! ?If you think that con men in investing is not a problem, read?On Avoiding Con Men. ?I spend lots of time trying to take apart investment pitches that are bogus, and yet I feel that I am barely scraping the surface.

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-=-=-=-=-=-

Things are rarely as bad as they seem. ?Be willing to be a modest bull most of the time. ?I’m not saying don’t be cautious — of course be cautious! ?Just don’t let that keep you from taking some risk. ?Size your risks to your time horizon for needing cash back, and your ability to sleep at night. ?The biggest risk may not be taking no risk, but that might be the most common risk economically for those who have some assets.

To close, here is a personal comment that might help: I am natively a pessimist, and would easily give into disaster scenarios. ?I had to train myself to realize that even in the worst situations there was some reason for optimism. ?That served me well as I invested spare assets at the bottoms in 2002-3 and 2008-9. ?The sun will rise tomorrow, Lord helping us… so?diversify and take moderate risks most of time.

Redacted Version of the April 2016 FOMC Statement

Posted on 27 April 201627 April 2016 by David Merkel

Caption from the WSJ: Regulators don?t think it is the place of Congress to second guess how they size up securities. Fed Chairwoman Janet Yellen said recently that legislation would ?interfere with our supervisory judgments.? PHOTO: BAO DANDAN/ZUMA PRESS — PHOTO CREDIT: BAO DANDAN/ZUMA PRESS

Comments

Policy continues to stall, as the economy muddles along.
But policy should be tighter. Savers deserve returns, and that would be good for the economy.
The changes for the FOMC?s view are that labor indicators are stronger, and GDP and household spending are weaker.
Equities rise and bonds rise. Commodity prices flat and the dollar falls.
The FOMC says that any future change to policy is contingent on almost everything.
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 much, absent much higher inflation, or a US Dollar crisis.

Estimating Future Stock Returns

Posted on 9 April 201610 April 2016 by David Merkel

Idea Credit: Philosophical Economics Blog — Idea Credit: Philosophical Economics, but I?estimated and designed the?graphs

There are many alternative models for attempting to estimate how undervalued or overvalued the stock market is. ?Among them are:

Price/Book
P/Retained Earnings
Q-ratio (Market Capitalization of the entire market /?replacement cost)
Market Capitalization of the entire market / GDP
Shiller?s CAPE10 (and all modified versions)

Typically these explain 60-70% of?the variation in stock returns. ?Today I can tell you there is a better model, which is not mine, I found it at the blog?Philosophical Economics.? The basic idea of the model is this: look at the proportion of US wealth held by private investors in stocks using the?Fed?s Z.1 report. The higher the proportion, the lower future returns will be.

There are two aspects of the intuition here, as I see it: the simple one is that when ordinary people are scared and have run from stocks, future returns tend to be higher (buy panic). ?When ordinary people are buying stocks with both hands, it is time to sell stocks to them, or even do IPOs to feed them catchy new overpriced stocks (sell greed).

The second intuitive way to view it is that it is analogous to Modiglani and Miller’s capital structure theory, where assets return the same regardless of how they are financed with equity and debt. ?When equity is a small component as?a percentage of market value, equities will return better than when it is a big component.

What it Means Now

Now, if you look at the graph at the top of my blog, which was estimated back in mid-March off of year-end data, you can notice a few?things:

The formula explains more than 90% of the variation in return over a ten-year period.
Back in March of 2009, it estimated returns of 16%/year over the next ten years.
Back in March of 1999, it estimated returns of -2%/year over the next ten years.
At present, it forecasts returns of 6%/year, bouncing back from an estimate of around 4.7% one year ago.

I have two more graphs to show on this. ?The first one below is showing the curve as I tried to fit it to the level of the S&P 500. ?You will note that it fits better at the end. ?The reason for that it is?not a total return index and so the difference going backward in time are the accumulated dividends. ?That said, I can make the statement that the S&P 500 should be near 3000 at the end of 2025, give or take several hundred points. ?You might say, “Wait, the graph looks higher than that.” ?You’re right, but I had to take out the anticipated dividends.

The next graph shows the fit using a homemade total return index. ?Note the close fit.

Implications

If total returns from stocks are only likely to be 6.1%/year (w/ dividends @ 2.2%) for the next 10 years, what does that do to:

Pension funding / Retirement
Variable annuities
Convertible bonds
Employee Stock Options
Anything that relies on the returns from stocks?

Defined benefit pension funds are expecting a lot higher returns out of stocks than 6%. ?Expect funding gaps to widen further unless contributions increase. ?Defined contributions face the same problem, at the time that the tail end of the Baby Boom needs returns. ?(Sorry, they *don’t* come when you need them.)

Variable annuities and high-load mutual funds take a big bite out of scant future returns — people will be disappointed with the returns. ?With convertible bonds, many will not go “into the money.” ?They will remain bonds, and not stock substitutes. ?Many employee stock options and stock ownership plan will deliver meager value unless the company is hot stuff.

The entire capital structure is consistent with low-ish?corporate bond yields, and low-ish volatility. ?It’s a low-yielding environment for capital almost everywhere. ?This is partially due to the machinations of the world’s central banks, which have tried to stimulate the economy by lowering rates, rather than letting recessions clear away low-yielding projects that are unworthy of the capital that they employ.

Reset Your Expectations and Save More

If you want more at retirement, you will have to set more aside. ?You could take a chance, and wait to see if the market will sell off, but valuations today are near the 70th percentile. ?That’s high, but not nosebleed high. ?If this measure got to levels 3%/year returns, I would hedge my positions, but that would imply the S&P 500 at around?2500. ?As for now, I continue my ordinary investing posture. ?If you want, you can do the same.

=–==-=-=-=-=-=–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==–=

PS — for those that like to hear about little things going on around the Aleph Blog, I would point you to this fine website that has started to publish some of my articles in Chinese. ?This article?is particularly amusing to me with my cartoon character illustrating points. ?This is the English article that was translated. ?Fun!

If All Investments Were Private

Posted on 2 April 20163 April 2016 by David Merkel

Photo Credit: Falcon? Photography? || In this story, TSB stands for “The Storage Bank”

This piece is another one of my experiments, please bear with me.

“Measure Twice, Cut Once” — A very intelligent woman (I suspect) whose name never got recorded the first time it was uttered

“Only buy something that you?d be perfectly happy to hold if the market shut down for 10 years.” — Warren Buffett

Imagine for a moment:

The public secondary markets didn’t exist
Investment pooling vehicles were all private, and no one published NAV estimates
Stocks and bonds existed, but they were only formally offered through the companies themselves, and all private secondary trading was subject to a right of first refusal on the part of the issuing corporation. ?This includes short-term debts like commercial paper.
Banks and life insurance companies still offer products to retail savers/investors, but nonforfeiture laws didn’t exist, and CD penalty clauses were very ugly. ?In other words, because of no public secondary markets, the price of liquidity was very high, with a strong incentive to hold financial instruments to their maturity date.
Accounting rules are only partially standardized.
Deposit insurance still exists.
So does limited liability.

In this thankfully fictitious world, what would investing be like?

The main factor would be that liquidity would be dear. ?Because the “out” doors for liquidity are thin or closed for a long time, money would go into any investment only after great study. ?The 4 Cs of credit would be present with a vengeance –?character, capacity, capital and conditions — and character would be chief among them as J. P. Morgan famously said.

This would be true even if one were investing in the stock of a firm, rather than the debt. ?Investing in such a world, even with limited liability, is tantamount to an economic marriage back in a time where divorce was mostly for cause, and not easy to get.

You’d have to be very certain of what you were doing. ?Perhaps you would diversify, but one would quickly realize how difficult it can be to keep up with a bunch of private firms — we take for granted how information flows today, but with private firms, you are subject to the board and management. ?What do they choose to share with outside passive minority investors?

Excursus: It is said that it is easy to teach a child to say “please,” because it is the equivalent of “gimme.” ?It is harder to teach them “thank you,” until they realize that it means, “I’d like an option on the next deal.”

Why would private firms choose to be open with outside private minority investors? ?They want a continuing flow of capital, and with no secondary markets, that can be difficult. ?Granted, there are always hucksters that say with P. T. Barnum, who is alleged to have said, “There’s a sucker born every minute.” ?Those characters exist regardless of market structure, but in a healthy culture, they are a small minority in the markets.

The same would apply to the debt markets. ?The fourth C, Conditions, would also impact matters. ?If you can’t get out easily/cheaply, then you will limit the term of the borrowing at which you are willing to lend, unless there are features allowing for participation in the upside, such as stock conversion rights.

You might also find that insolvency becomes a very personal matter, as prior capital providers who know the business better than others, are invited to “prepackaged reorganizations” when the business is illiquid or insolvent. ?The bankruptcy code might still exist, but gaining enough data on a firm in trouble would probably prove difficult. The board and management, unless legally?compelled, might not find it in their interests to be open. ?Control is a valuable option, one that is only surrendered when the situation is virtually hopeless.

That said, a man very good at estimating character and business value could make some amazing profits, because “in the land of the blind, a one-eyed man is king.” ?And, the opposite would be true for many, as they get taken advantage of by less scrupulous management teams.

Back to the Present

“…[R]isk control is best done on the front end. ?On the back end, solutions are expensive, if they are available at all.” ?– Me, in this article, and a bunch of others.

The purpose of what I just wrote is to get you to think about an illiquid world as a limiting concept. ?All of the problems of our world are there, usually in a form that is less severe than we experience because of the benefit of liquid secondary markets and vehicles for diversification.

If valuable for no other reason, market panics make liquidity disappear, and it is useful to think about what you will do in an absence of liquidity before the time of trouble happens. ?The same is true of corporations needing liquidity. ?Buffett said something to the effect of, “Get financing before you need it; it may not be available later.”

It’s also useful to consider more carefully the financial commitments that you make, so that you don’t make so many blunders. ?(True for me, too.) ?The ability to trade out of investments is useful but limited, because we don’t always recognize when we are wrong, and mechanical trading rules can lead us to the “death by one thousand cuts.”

Beyond that, realize that character does matter. ?A lot. ?The government tries as hard as it can, but it is far better at punishing fraud after the fact than it is catching fraud before the fact. ?It will always be that way because the law is tilted in favor of the one in control; it has to be, or property rights are meaningless. ?But consider those that try to warn about financial disasters — they do not get listened to until it is too late. ?Madoff, Enron, housing bubble, various short sellers alleging improprieties, etc., etc. ?Very few listen to them, because seeming success talks far louder than an outsider.

My counsel is the same as always, just look at the risk control quote above. ?But to make it stark, ask yourself this, a la Buffett, “Would you still buy this if you couldn’t sell it for ten years?” ?Then measure twice, thrice, ten times if needed, and cut once.