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Redacted Version of the December 2015 FOMC Statement

Posted on 16 December 2015 by David Merkel

Photo Credit: Day Donaldson

October 2015	December 2015	Comments
Information received since the Federal Open Market Committee met in September suggests that economic activity has been expanding at a moderate pace.	Information received since the Federal Open Market Committee met in October suggests that economic activity has been expanding at a moderate pace.	No change.
Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft.	Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft.	No change.
The pace of job gains slowed and the unemployment rate held steady. Nonetheless, labor market indicators, on balance, show that underutilization of labor resources has diminished since early this year.	A range of recent labor market indicators, including ongoing job gains and declining unemployment, shows further improvement and confirms that underutilization of labor resources has diminished appreciably since early this year.	Shades labor employment up.
Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.	Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.	No real change.
Market-based measures of inflation compensation moved slightly lower; survey-based measures of longer-term inflation expectations have remained stable.	Market-based measures of inflation compensation remain low; some survey-based measures of longer-term inflation expectations have edged down.	Little change and mixed.? TIPS are showing lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.71%, down 0.08% from September.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.	The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen.	Shifts language to reflect moving from easing to tightening.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring global economic and financial developments.	Overall, taking into account domestic and international developments, the Committee sees the risks to the outlook for both economic activity and the labor market as balanced.	Flips the sentence around with little change in meaning.
Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.	Inflation is expected to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee continues to monitor inflation developments closely.	CPI is at +0.4% now, yoy.? Not much change in the meaning.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.	The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.	Sentence moved from below.? I reordered the last FOMC Statement to reflect the change. Language changes to reflect the move to tightening.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate.	Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent.	Language changes to reflect the move to tightening.
In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.	The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.	Language changes to reflect the move to tightening.
	In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.	New sentence.? Gives expected measures for analysis of policy.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	No change.? Gives the FOMC flexibility in decision-making, because they really don?t know what matters, and whether they can truly do anything with monetary policy.
	In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.	New sentence.? Says that they will go slowly, and react to new data.? Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	Says it will keep reinvesting maturing proceeds of agency debt and MBS, which blunts any tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.		Sentence no longer needed.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	All agree on tightening, but do they agree on why?
Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting.		Lacker got what he wanted.

Comments

They finally tightened. The next two questions are how much and how quickly.? The last question is what they do when something blows up.
The only data change for the FOMC is that labor indicators are stronger. I still don?t see it, aside from the unemployment rate.? Too many people dropped out of the labor force.
Equities steady and bonds rise. Commodity prices rise and the dollar falls.? Maybe some expected a bigger move.
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 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.

Seven Thoughts on the Markets

Posted on 16 December 2015 by David Merkel

Photo Credit: t m || Seven sisters sitting on the hill

1) I started in this game as an amateur, and built up my skills gradually, reading widely. ?My academic studies ended at age 25, and it was after that that I began learning the practical knowledge. ?Though I had investment-related jobs, I never held a position in investing, until I was 38, and I never wrote on investing for the public in any significant way until I was 42, when Cramer invited me to write for RealMoney. ?I’m now 55, and I think I am still growing in my knowledge of investing.

i write this to simply say that you don’t have to take a traditional path into the investment business. ?I am grateful that I want through the circuitous path through the insurance industry, because it deepened my perspective on investing. ?All of the asset-liability modeling, where I often tried to challenge existing paradigms, helped me to understand why often the conventional wisdom is true. ?Where it is not true, there is usually an anomaly to profit from.

The other reason that I write this, is that it is possible to get significant knowledge as an amateur, and on a book basis, as good as many professionals. ?You won’t get the respect from professionals until you are a professional, but who cares? ?You can do better for yourself in investing. ?Just don’t get arrogant and forget to put risk control forst.

2) After all of the political fights are over, OPEC nations will once again agree that they will cut production as a group. ?Remember, much of OPEC has a low cost of production, and so when production decreases in a coordinated way, profits will rise for almost all OPEC nations.

In the long run, economics triumphs over politics. ?The challenge comes in the short-run from trying to figure out who cuts how much from what baseline. ?Even after that, discipline takes a while to achieve, because the incentive to cheat is high.

I stand by the view that in the intermediate term, crude oil prices will be around $50. ?Demand for crude oil is growing globally, not shrinking, and marginal supplies would price out at around $50/barrel, if OPEC nations act to maximize their profits, rather than engage in a market share war. ?(Prices would be higher still ?if OPEC nations acted to maximize the present value of their long-run profits, but I doubt that will happen until the profligate producers deplete their reserves.

3) The ferment in high yield bonds is unlikely to peak before there are significant defaults. ?It’s possible that we get a rally from here in the short run — yield spreads are relatively wide compared to earnings yields on stock. ?At this point, it doesn’t pay so well to borrow money and buy back stock. ?That isn’t stopping many corporations from doing their buybacks. ?Buybacks should be tactical rather than constant. ?Only buy back when there is a significant discount to the fair market value of the firm.

That said, it’s unusual for a large amount of credit stress to go away without defaults. ?It’s rare to see a credit problem work out by firms growing out of it. ?Thus what might be more likely than a junk rally is a fall in stock prices. ?Perhaps the most optimistic scenario would be that only energy is affected — it has defaults, and the rest of the market continues to rally. ?Not impossible.

4) Regarding F&G Life — congrats to holders, you won. ?A dumb aggressive foreign buyer jumped on the grenade for you. (Now let’s see, has that ever happened before to F&G Life?) ?Be grateful and sell. ?Let the arbs take the risk of the deal not going through.

5) One phrase that all investors should learn is, “I missed that one.” ?You can’t catch every opportunity. ?Some will pass you by despite your best efforts. ?Rather than jump on late, it is better to look for the next opportunity, lest you buy high and sell low.

On the opposite side of timing, if you tend to get to opportunities too early, maybe consider waiting until the price breaks the 200-day moving average from below. ?Let the market confirm that it agrees with your thesis, and then invest.

6) Regarding the Fed, I think too much is being made out of them for now. ?I will be watching the yield curve for clues, and seeing if the curve flattens or steepens. ?I expect it to flatten more quickly than the market currently expects,?limiting the total amount of Fed tightening.

As it is, every time the Fed tightens, the short interest-bearing deposits at banks reprice up, with some lesser amount pass-through to lending rates. ?I would expect bank profits to be squeezed.

Aside from that, most of what the FOMC will say tomorrow will just be noise. ?They don’t have a theory that guides them; they are just making it up as they go, so they wander and try to discover what their goals should be.

7) I’ve sometimes commented that at the start of a tightening cycle that those who have been cheating blow up, like Third Avenue Focused Credit, which bought assets far less liquid than the shares of its mutual fund. ?At the end of the tightening cycle, something blows up that would be a surprise now, which sometimes jolts the FOMC to stop tightening. ?The question here is: what could that group of economic entities be? ?China, Brazil, repo markets, agricultural loans, auto loans, or something else? ?Worth thinking about — we know about energy, but what else has issued the most debt since the end of 2008?

(As an aside, the recent moves to make China more integrated with the global economy also make it more subject to financial risks that are global, and not just local, of which it has enough.)

How Much is that Asset in the Window? (III)

Posted on 12 December 2015 by David Merkel

A: How are you doing? Are you here for more enlightening banter?

Q: Not so well. ?Have you heard of the Third Avenue?Focused Credit Fund [TFCIX]?

A: Uh, the one that is in the news?

Q:?Come on.

A: Yes, I know about it, but not much more than I have recently read. ?Of all of Third Avenue’s Funds I know it least well.

Q: Weren’t you a bond manager who liked to take concentrated positions though? ?You should be able to say something about this mess.

A: I dealt mainly with investment grade credit. ?What’s more, I had a real balance sheet behind me at the life insurance company. ?An ordinary open-end mutual fund has investors that can leave whenever they want — often at the worst possible time for them, or in this case, those that could not get out.

The main difference was that I could never be forced to sell, under most conditions. ?I could buy and hold, and if the eventual credit of the borrower was good, my client would receive all that he expected. ?TFCIX faced significant redemptions, and increasingly had mostly bonds that could not be quickly sold, and thus, were difficult to value. ?That’s why they cut off redemptions — they couldn’t?liquidate assets to give cash to customers on a favorable basis. ?Personally, I think setting up the liquidation trust was the best that could be done. ?That will allow Third Avenue to negotiate with interested buyers of the bonds without being rushed by redemptions. ?The remaining fundholders should be grateful for them doing this now, though it would have been better to act sooner.

Q: But I own shares in?TFCIX and need the money now. ?What can I do?

A: Oh, my. ?My sympathies. ?You can’t do?much. ?There might be some off the beaten track lenders out there that might take it off your hands, but they wear “panky rangs,” as a mortgage borrower once said to me.

Q: Panky Rangs?

A: Pinky rings. ?He was from the deep South. ?I.e., no one is going to give you a decent bid for your shares, even if you could find someone willing to do so. ?First, the value of the bonds is questionable, and the timing of the sales are?uncertain.

In some ways, this reminds me a little of The London Whale incident.

Q: How is that relevant?

A: JP Morgan became too great of a part of the indexed credit derivatives market, and as a result, they lost the ability to value their positions, because they were too big relative to the market in which they traded. ?Their very buying and selling had a huge impact on the pricing. ?Though a value was placed on the positions, the entire situation was impossible to value accurately; ?you couldn’t assemble a group to buy it all.

Some clever hedge funds took note of it, and began taking the opposite positions, thinking that they were overvalued, and fed JP Morgan more of what it was already bloated with. ?Now maybe, if there hadn’t been so much press furor over it, together with the accounting questions that affected the financials of JP Morgan, they could have found a way out. ?JP Morgan’s balance sheet was big enough, and if you left them alone, they would have all self -liquidated. ?They might not have made the money they wanted that way, but it could have been done. ?As it was, they were forced to liquidate more rapidly, and if I recall, they even called upon one of the opposing hedge funds to help them.

In any case, the forced liquidation led to losses. ?Most forced liquidations do.

Q: So, what do think my shares are worth?

A: They are worth the liquidating distributions that you will receive.

Q: That’s no help.

A: Is the Federal Reserve willing to step up and buy the assets as they did with?the Maiden Lane Trusts? ?No one has a bigger balance sheet than they do, oh, oops. ?Maybe they can’t do that anymore… who know where those emergency lending rules go…

Look, I’m sorry that you are stuck. ?The Madoff “investors” were stuck also. ?They had to wait quite a while. ?In the end, they got paid more than most imagined they ever would. ?Subject to credit conditions,?I would suspect that the more time Third Avenue takes to liquidate, the more you will get.

Q: But that’s dribs and drabs over time, and I need it now.

A: Patience is a virtue. ?Make other adjustments; sell something else; scale back plans… it’s no different than most people have to do when they have a loss. ?It happens.

Q: I guess… but it would help to know what it was worth, so that I could estimate tradeoffs.

A: yes, it would, but the timing and amount of liquidations are uncertain, and the “market prices” don’t really exist for the underlying — they are too influenced by Third Avenue’s holdings.

Maybe they could have converted it into a closed-end fund, ?but that would have cost money, and there still would have been the valuation issue. ?People could have gotten paid now if that had happened, but I bet they would have blanched at the size of the unrealized losses. ?I would just accept the payments as they come, that will probably give the best return, subject to future credit conditions.

Q: Do we have to modify?your statement was true when we first started this discussion:

Q: What is an asset worth?

A: An asset is worth whatever the highest bidder will pay for it at the time you offer it for sale.

After all, if it is worth the liquidating distributions if I wait, maybe you should add, “or the cash flows you receive over time.”

A: I will do that, and that is part of what I have been arguing for here, but the price here and now is not that. ?Just because you can’t sell it now doesn’t mean it doesn’t have value… we just don’t know what that value is.

Anyway, lunch is on me today, because there is another thing that you can’t sell that has value.

Q: What’s that?

A: Me. ?A friend.

Q: Let’s go…

The Limits of Risky Asset Diversification

Posted on 11 December 2015 by David Merkel

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Stock diversification is overrated.

Alternatives are more overrated.

High quality bonds are underrated.

This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best. ?First, I don’t like infographics or video. ?I want to learn things quickly. ?Give me well-written text to read. ?A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.

Here’s the problem. ?Do you want to reduce?the volatility of your asset portfolio? ?I have the solution for you. ?Buy bonds and hold some cash.

And some say to me, “Wait, I want my money to work hard. ?Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?” ?In a word the answer is “no,” though some will tell you otherwise.

Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments. ?Those buying stocks stuck to well-financed “blue chip” companies.

Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:

Growth stocks
Midcap stocks (value & growth)
Small cap stocks (value & growth)
REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
Developed International stocks (of all kinds)
Emerging Market stocks
Frontier Market stocks
And more…

And initially, it worked. ?There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left? ?Not much. ?The diversification from investor behavior is largely gone (the liability side of correlation). ?Different sectors of the global economy don’t move in perfect lockstep,?so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). ?Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them. ?How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets? ?Hmm…

Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:

Timberland
Real Estate
Private Equity
Collateralized debt obligations of many flavors
Junk bonds
Distressed Debt
Merger Arbitrage
Convertible Arbitrage
Other types of arbitrage
Commodities
Off-the-beaten track bonds and derivatives, both long and short
And more… one that stunned me during the last bubble was leverage nonprime commercial paper.

Well guess what? ?Much the same thing happened here as happened with non-“blue chip” stocks. ?Initially, it worked. ?There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left? ?Some, but less. ?Not everyone was willing to do all of these. ?The diversification from investor behavior was reduced?(the liability side of correlation). ?These don’t move in perfect lockstep,?so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). ?Yes, there are some?that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short. ?Many of those blew up last time. ?How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets again? ?Hmm…

That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point. ?Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.

But beyond that, hold dry powder. ?Think of cash, which doesn’t earn much or lose much. ?Think of some longer high quality bonds that do well when things are bad, like long treasuries.

Remember, the reward for taking business risk in general varies over time. ?Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%). ?This isn’t a call to go nuts and sell all of your risky asset positions. ?That requires more knowledge than I will ever have. ?But it does mean having some dry powder. ?The amount is up to you as you evaluate your time horizon and your opportunities. ?Choose wisely. ?As for me, about 20-30% of my total assets are safe, but I?have been a risk-taker most of my life. ?Again, choose wisely.

PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification. ?You will have to wait for those ideas to be forgotten. ?Wait to see a few fund closures, and a severe reduction in AUM for the leaders…

Ten Investing Books to Consider

Posted on 5 December 20156 December 2015 by David Merkel

Recently I got asked for a list of investment books that I would recommend. These aren’t all pure investment books — some of them will teach you how markets operate in general, but they do so in a clever way. I have also reviewed all of them, which limited my choices a little. Most economics, finance, investment books that I have really liked I have reviewed at Aleph Blog, so that is not a big limit.

This post was also prompted by a post by another blogger of sorts publishing at LinkedIn. ?I liked his post in a broad sense, but felt that most books by or about traders are too hard for average people to implement. ?The successful traders seem to have systems that go beyond the simple systems that they write about. ?If that weren’t true, we’d see a lot of people prosper at trading for a time, until the trades got too crowded, and the systems failed. ?That’s why the books I am mentioning are longer-term investment books.

General Books on Value Investing

The Intelligent Investor?(Ben Graham)
The Aggressive Conservative Investor?(Marty Whitman)
Margin of Safety?(Seth Klarman)
Accounting for Value?(Stephen Penman)

Don’t get me wrong. ?I like many books on value investing, but the first?three are classic. ?Graham is the simplest to understand, and Klarman is relatively easy as well. ?Like Buffett, Klarman recognizes that we live in a new world now, and the simplistic modes of value investing would work if we could find a lot of stocks as cheap as in Graham’s era — but that is no longer so. ?But even Ben Graham recognized that value investing needed to change at the end of his life.

Whitman takes more of a private equity approach, and aims for safe and cheap. ?Can you find mispriced assets inside a corporation or elsewhere where the value would be higher?if placed in a different context? ?Whitman is a natural professor on issues like these, though in practice, the?stocks he owned during the financial crisis were not safe enough. ?Many business models that were seemingly bulletproof for years were no longer so when asset prices fell hard, especially those connected to housing. ?This should tell us to think more broadly, and not trust rules of thumb, but instead think like Buffett, who said something like, “We’re paid to think about the things that seemingly can’t happen.”

The last book is mostly unknown, but I think it is useful. ?Penman?takes apart GAAP accounting to make it more useful for decision-making. ?In the process, he ends up showing that very basic forms of quantitative value investing work well.

Books that will help you Understand Markets Better

The first link is two books on the life of George Soros. ?Soros teaches you about the nonlinearity of markets — why they overshoot and undershoot. ?Why is there momentum? ?Why is the tendency for price to converge to value weak? ?What do markets look and feel like as they are peaking, troughing, etc? ?Expectations are a huge part of the game, and they affect the behavior of your fellow market participants. ?Market movements as a result become self-reinforcing, until the cash flows can by no means support valuations, or are so rich that businessmen buy and hold.

Consider what things are like now as people justify high equity valuations. ?At every turning point, you find people defending vociferously why the trend will go further. ?Who is willing to think differently at the opportune time?

Triumph of the Optimists is another classic which should teach us to be slightly biased toward risk-taking, because it tends to win over time. ?They pile up data from around 20 nations over the 20th century, and show that stock markets have done very well through a wide number of environments, beating bonds?by a little and cash by a lot.

For those of us that tend to be bearish, it is a useful reminder to invest most of the time, because you will ordinarily make good money over the long haul.

Books on Managing Risk

The Crisis of Crowding?(Chincarini)
Pandora?s Risk?(Osband)
Risk and the Smart Investor?(Martin) also?The Nature of Risk?(also Martin)
The Hedge Fund Mirage?(Lack)

After the financial crisis, we need to understand better what risk is. ?Risk is the likelihood and severity of loss, which is not constant, and cannot be easily compressed into simple figure. ?We need to think about risk ecologically — how is an asset priced relative to its future prospects, and is there any possibility that it is significantly misfinanced either internally or by its holders. ?For the latter, think of the Chinese using too much margin to carry stocks. ?For the former, think of Fannie Mae and Freddie Mac. ?They took risks that forced them into insolvency, even though over the long run they would have been solvent institutions. ?(You can drown in a river with an average depth of six inches. ?Averages reveal; they also conceal.)

Hot money has a short attention span. ?It needs to make money NOW, or it will leave. ?When an asset is owned primarily by hot money, it is an unstable situation, where the trade is “crowded.” ?So it was with housing-related assets and a variety of arbitrage trades in the decade of the mid-2000s. ?Momentum blinded people to the economic reality, and made them justify and buy into absurdly priced assets.

As for the last book, hedge funds as a group are a dominant form of hot money. ?They have grown too large for the pool that they fish in, and as a result, their returns are poor as a group. ?With any individual hedge fund, your mileage may vary, there are some good ones.

These books as a whole will teach you about risk in a way that helps you understand the crisis in a systemic way. ?Most people did not understand the situation that way before the crisis, and if you talk to most politicians and bureaucrats, they still don’t get it. ?A few simple changes have been made, along with a bunch of ineffectual complex changes. ?The financial system is a little better as a result, but could still go through a crisis like the last one — we would need a lot more development of explicit and implicit debts to get there though.

An aside: the book The Nature of Risk is simple, short and cute, and can probably reach just about anyone who can grasp the similarities between a forest ecology under threat of fire, and a financial system.

Summary

I chose some good books here, some of which are less well-known. ?They will help understand the markets and investing, and make you a bigger-picture thinker… which makes me think, I forgot the second level thinking of?The Most Important Thing, by Howard Marks. ?Oops, also great, and all for now.

PS — you can probably get Klarman’s book through interlibrary loan, or via some torrent on the internet. ?You can figure that out for yourselves. ?Just don’t spend the $1600 necessary to buy it — you will prove you aren’t a value investor in the process.

One Dozen Thoughts on Dealing with Risk in Investing for Retirement

Posted on 31 October 2015 by David Merkel

Photo Credit: Ian Sane || Many ways to supplement retirement income... — Photo Credit: Ian Sane || One of many ways to supplement retirement income…

Investing is difficult. That said, it can be harder still. Let people with little to no training to try to do it for themselves. Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell. They get there late, and then their emotions trick them into action. A rational investor would say, ?Okay, I missed that move. Where are opportunities now, if there are any at all??

Investing can be made even more difficult. ?Investing reaches its most challenging level when one relies on his investing to meet an anticipated and repeated need for cash outflows.

Institutional investors will say that portfolio decisions are almost always easier when there is more cash flowing in than flowing out. ?It means that there is one dominant mode of thought: where to invest?new money? ?Some attention will be given to managing existing assets ? pruning away assets with less potential, but the need won?t be as pressing.

What?s tough is trying to meet a?cash withdrawal?rate that is materially higher than what can safely be achieved over time, and earning enough?consistently to do so. ?Doing so as an amateur managing a retirement portfolio is a particularly hard version of this problem. ?Let me point out some of the areas where it will be hard:

1) The retiree doesn?t know how long he, his spouse, and anyone else relying on him will live. ?Averages can be calculated, but particularly with two people, the odds are that at least one will outlive an average life expectancy. ?Can they be conservative enough in their withdrawals that they won?t outlive their assets?

It?s tempting to overspend, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs. ?It is incredibly difficult to?avoid paying for an immediate pressing need, when the soft cost?is harming your future. ?There is every incentive to say, ?We?ll figure it out later.? ?The odds on that being true will be low.

2) One conservative estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%. ?That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero near the end of a bull market.

That said, most?people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets. ?At present, if interest rates don?t go lower still, that will likely (60-80% likelihood) work. ?But if income needs are greater than that, the odds of obtaining those yields over the long haul go down dramatically.

3) How does a retiree deal with bear markets, particularly ones that occur early in retirement? ?Can?he and?will he reduce his expenses to reflect the losses? ?On the other side, during bull markets, will he build up a buffer, and not get incautious during seemingly good times?

This is an easy prediction to make, but after the next bear market, look for a scad of ?Our retirement is ruined articles.? ?Look for there to be hearings in Congress that don?t amount to much ? and if they?do amount to much, watch them make things worse by?creating R Bonds, or some similarly bad idea.

Academic risk models typically used by financial planners typically don?t do path-dependent analyses.? The odds of a ruinous situation is far higher than most models estimate because of the need for withdrawals and the autocorrelated nature of returns ? good returns begets good, and bad returns beget bad in the intermediate term.? The odds of at least one large bad streak of returns on risky assets during retirement is high, and few retirees will build up a buffer of slack assets to prepare for that.

4)?Retirees should avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield ? it?is the oldest scam in the books. ?This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc. ?They have no guaranteed return of principal. ?On the plus side, they may give capital gains if bought at the right time, when they are out of favor, and reducing exposure when everyone is buying them.? Negatively, all junior debt tends to return worse on average than senior debts.? It is the same for equity-like investments used for income investing.

Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because many people are buying them as if they are magic. ?The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.

5) Leaving retirement behind for a moment, consider the asset accumulation process.? Compounding is trickier than it may seem. ?Assets must be selected that will grow their value including dividend payments over a reasonable time horizon, corresponding to a market cycle or so (4-8 years). ?Growth in value should be in excess of that from expanding stock market multiples or falling interest rates, because you want to compound in the future, and low interest rates and high stock market multiples imply that future compounding opportunities are lower.

Thus, in one sense, there is no benefit much from a general rise in values from the stock or bond markets. ?The value of a portfolio may have risen, but at the cost of lower future opportunities. ?This is more ironclad in the bond market, where the cash flow streams are fixed. ?With stocks and other risky investments, there may be some ways to do better.

Retirees should be aware that the actions taken by one member of a large cohort of retirees will be taken by many of them.? This makes risk control more difficult, because many of the assets and services that one would like to buy get bid up because they are scarce.? Often it may be that those that act earliest will do best, and those arriving last will do worst, but that is common to investing in many circumstances.? As Buffett has said, ?What a?wise man?does in the beginning a?fool?does in the?end.?

6) Retirement investors should avoid taking too much?or too little risk. It?s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree. ?If a person can do that successfully, he is rare.

What is achievable by many is to maintain a constant risk posture. ?Don?t panic; don?t get greedy ? stick to a moderate asset allocation through the cycles of the markets.

7) With asset allocation, retirees should overweight out-of-favor asset classes that offer above average cashflow yields. ?Estimates on these can be found at GMO or?Research Affiliates. ?They should rebalance into new asset classes when they become cheap.

Another way retirees can succeed would be investing in growth at a reasonable price ? stocks that offer capital growth opportunities at an inexpensive price and a margin of safety. ?These companies or assets need to have large opportunities in front of them that they can reinvest their free cash flow into. ?This is harder to do than it looks. ?More companies look promising and do not perform well than those that do perform well.

Yet another way to enhance returns is value investing: find undervalued companies with a margin of safety that have potential to recover when conditions normalize, or find companies that can convert their resources to a better use that have the willingness to do that. ?After the companies do well, reinvest in new possibilities that have better appreciation potential.

8 ) Many say that the first rule of markets is to avoid losses. ?Here are some methods to remember:

Always seek a margin of safety. ?Look for valuable assets well in excess of debts, governed by the rule of law, and purchased at a bargain price.
For assets that have fallen in price, don?t try to time the bottom ? buy the asset when it rises above its 200-day moving average. This can limit risk, potentially buying when the worst is truly past.
Conservative investors avoid the areas where the hot money is buying and own assets being acquired by patient investors.

9) As assets shrink, what should be liquidated? ?Asset allocation is more difficult than it is described in the textbooks, or in the syllabuses for the CFA Institute or for CFPs.? It is a blend of two things ? when does the investor need the money, and what asset classes offer decent risk adjusted returns looking forward?? The best strategy is forward-looking, and liquidates what has the lowest risk-adjusted future return. ?What is easy is selling assets off from everything proportionally, taking account of tax issues where needed.

Here?s another strategy that?s gotten a little attention lately: stocks are longer assets than bonds, so use bonds to pay for your spending in the early years of your retirement, and initially don?t sell the stocks.? Once the bonds run out, then start selling stocks if the dividend income isn?t enough to live on.

This idea is weak.? If a person followed this in 1997 with a 10-year horizon, their stocks would be worth less in 2008-9, even if they rocket back out to 2014.

Remember again:

You don?t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities.

That goes double in the distribution phase. The objective is to convert assets into a stream of income. ?If interest rates are low, as they are now, safe income will be low. ?The same applies to stocks (and things like them) trading at high multiples regardless of what dividends they pay.

Don?t look at current income. ?Look instead at the underlying economics of the business, and how it grows value. ?It is far better to have a growing income stream than a high income stream with low growth potential.

Deciding what to sell is an exercise in asset-liability management.? Keep the assets that offer the best return over the period that they are there to fund future expenses.

10) Will Social Security take a hit out around 2026? ?One interpretation of the law says that once the trust fund gets down to one year?s worth of?payments, future payments may get reduced to the level?sustainable by expected future contributions, which is 73% of expected levels. ?Expect a political firestorm if this becomes a live issue, say for the 2024 Presidential election. ?There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.

Even if benefits last at projected levels longer than 2026, the risk remains that there will be some compromise in the future that might reduce benefits because taxes will not be raised.? This is not as secure as a government bond.

11) Be wary of inflation, but don?t overdo it. ?The retirement of so many people may be deflationary ? after all, look at Japan and Europe so far. ?Economies also work better when there is net growth in the number of workers. ?It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.

Also consider other risks, and how assets may fare. ?Retirees should analyze what exposure they have to:

Deflation and a credit crisis
Expropriation
Regulatory change
Trade wars
Changes in taxes
Asset illiquidity
Reductions in reimbursement from government programs like Medicare, Medicaid, etc.
And more?

12) Retirees need a defender of two against slick guys who will try to cheat them when they are older. ?Those who have assets are a prime target for scams. ?Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make assets stretch further. ?But there are other scams as well ? retirees should run everything significant past a smart younger person who is skeptical, and knows how to say no when it is necessary.

Conclusion

Some will think this is unduly dour, but this?is realistic. ?There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.

Even with skilled advisers helping, retirees need to be ready for the hard choices that will come up. They should think through them earlier rather than later, and take some actions that will lower future risks.

The basic idea of retirement investing is how to convert present excess income into a robust income stream in retirement. ?Managing a pile of assets for income to live off of is a challenge, and one that most people?are not geared up for, because poor planning and emotional decisions lead to subpar results.

Retirees should?aim for the best future investment opportunities with a margin of safety, and let the retirement income take care of itself. ?After all, they can?t rely on the markets or the policymakers to make income opportunities easy.

Redacted Version of the October 2015 FOMC Statement

Posted on 28 October 2015 by David Merkel

Comments

This FOMC statement was yet another great big nothing. Only notable changes were shading household spending up, and employment and GDP down.
Don?t expect tightening in December. People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever.? The FOMC says that any future change to policy is contingent on almost everything.
On the new phrase, ?whether it will be appropriate to raise the target range at its next meeting,? I would not make much of it. It gives the impression that a change might be coming at the next meeting, but the way the FOMC thinks about monetary policy is currently scattered, to say the least.? I wouldn?t make too much of this change.? The FOMC is big on their newfound flexibility, and isn?t going to be very predictable for some time.
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.
Equities fall and bonds rise. Commodity prices fall and the dollar rises.? This is a sign that the markets anticipate more economic weakness.
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 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.
We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.? We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

Commissions Matter

Posted on 27 October 2015 by David Merkel

Before I start on this tonight, let me say that I never begrudge any salesman a fair commission. ?When I was a bond manager, I made a point of never letting my brokers “cross bonds” to me, i.e., at no commission. ?I would raise my purchase price a little to compensate them. ?Had my client known that I did that, he might have objected, but it was in his best interests that I did it. ?As a result of that and other things that I did, my brokers were very loyal to me, and worked to give my client excellent executions whether buying or selling. ?They were also more frank with me about bonds they thought I should sell. ?Fairness begets fairness under most conditions, and suspicion and tightness also have their way of breeding as well. ?Consider that in all of your dealings.

My main reason for writing tonight is to remind investors to think about how the parties you transact with are compensated.

If they are compensated on?transactions, expect to see a lot of buying and selling.
If they are compensated on asset-based fees, expect them to try to get business, and then retain it.
If they are compensated on profits, they will try to get profits. ?Be wary of how much control they might have over the accounting, they will be incented to be liberal if they have any control. ?They will also be incented toward volatility, because volatile assets offer the best possibility of a big score, even if the probability is moderate at best.

The greater the potential compensation, the greater the tendency to act along the incentives offered. ?As a result, if a life insurance salesman has a product offering a high commission, and one offering a low commission, he may act in the following way:

Figure out if you are price-sensitive or not.
Figure out if you are willing to accept a product that has a long surrender charge. ?Long surrender charges lock in business, and allow for high commissions to be paid.
Also analyze how much complexity you are willing to accept — more complex permanent policies and especially ancillary riders are far more profitable because even external actuaries would have a tough time analyzing them.
If you are price-sensitive, bring out the low commission policy that is more competitive.
If you are price-insensitive, bring out the high?commission policy that is less?competitive.

(Note: there are state laws in every state that constrain this behavior for life insurance agents, but it can never be eliminated in entire.)

Now, many agents will act in your interests in spite of their own interests, but some won’t, so be aware. ?Always ask a question like, “This seems expensive. ?Don’t you have another policy that is less expensive that accomplishes only the main goal that I am shooting for?”

You could always ask them what commission is that they will earn. ?Most won’t answer that. ?First, it’s kind of offensive, and second, they will argue that it is not material to your decision.

But it is material to your decision. ?Here’s why:

The size of the commission directly affects the size of the premium that you pay.
It also directly affects?the length and size of the surrender charge that you would pay if you terminate the policy early.
After all, the actuaries or other mathematical businessmen are trying to avoid the risk of paying a commission that they can’t recover under ALL circumstances. ?They will get their fees from you to recoup the commission cost. ?They will either get it from you coming or going, but they WILL?get it from you, at least on average.

If the?salesmen?disagree with you after mentioning this (or showing them this), you can say to them that every actuary knows this is true, don’t argue with the actuaries, they know the math. ?(And its why we tend to buy term and other simple policies. ?Shhh.)

I’ve seen more than my share of ugly products in my time. ?I’m happy I never designed any. ?I did kill a few of them. ?That said, one of the most unpleasant duties I ever had as a life actuary was about 18 years ago when I inherited a department to clean up, and I got the responsibility of talking to the clients that were the most irate, demanding to talk to the man in charge. ?I never created those products, but I was nominally in charge of the division as I cleaned up the pricing, reinsurance, reserving, accounting, and asset-liability management.

I’ll tell you, it is no fun talking to people who conclude that they have been had. ?It is even less fun to be the one who has been had. ?Thus I would tell you to view all salesmen of financial with skepticism. ?It is hard to assure a good result with intangible products that are hard to compare. ?Thus aim for simplicity and lower surrender charge and commission products.

Now, I used life insurance as my example here because I know it best, and it excels in complexity. ?But this applies to all financial products, especially illiquid ones. ?Be wary of:

Brokers who make money off of commissions
Those who sell private REITs and structured notes
Any product where you have a limited ability to liquidate or sell it.
Any product that you can’t understand how the company and salesman are making money off it.
Any product where you can’t understand what the legal form of the investment is (Stock, bond, mutual fund, partnership, derivative, insurance, etc.)

Here are some final bits of advice:

Look for advisers who are fiduciaries, and are responsible to look out for your interests (but still be wary)
Look at the fee structures, and look for lower cost alternatives.
Seek competing products,?salesmen and companies.
Negotiate lower compensation where possible.
Remember that higher yields are almost never free… what yields more typically has more risk. ?Yield is the oldest scam in the books.

Remember, regardless of what laws exist, you are your own best defender when it comes to your own economic interests. ?Be aware of the economic incentives of those who seek your business with financial products, and be reasonably skeptical.

Book Review: Financial Tales

Posted on 24 October 201525 October 2015 by David Merkel

This financial book is different from the 250+ other financial books that I have reviewed, and the hundreds of others I have read. ?It tells real life stories that the author has personally experienced, and the financial ramifications that happened as a result. ?Each?of the 60+ stories illustrates a significant topic in financial planning for individuals and families. ?Some end happy, some end sad. ?There are examples from each of the possible outcomes?that can result from people interacting with financial advice (in my rough large to small probability order):

Followed bad advice, or ignored good advice, and lost.
Followed good advice, and won.
A mixed outcome from mixed behavior
Followed bad advice, or ignored good advice, and won anyway.
Followed good advice, and lost anyway.

The thing is, there is a “luck” component to finance. ?People don’t know the future behavior of markets, and may accidentally get it right or wrong. ?With good advice, the odds can be tipped in their favor, at least to the point where they aren’t as badly hurt when markets get volatile.

The stories in the book mostly stem from the author’s experience as a financial advisor/planner in Maryland. ?The stories are 3-6 pages long, and can be read one at a time with little loss of flow. ?The stories don’t depend on each other. ?It is a book you can pick up and put down, and the value will be the same as for the person who reads it straight through.

In general, I thought the author advocated good advice for his clients, family and friends. ?Most people could benefit from reading this book. ?It’s pretty basic, and maybe, _maybe_, one of your friends who isn’t so good with financial matters could benefit from it as a gift if you don’t need it yourself. ?The reason I say this is that some people will learn reading about the failures of others rather than being advised by well-meaning family, friends, and professionals. ?They may admit to themselves that they?have been wrong when they be unwilling to do it with others.

I recommend this book for readers who need motivation and knowledge to guide themselves in their financial dealings, including how to find a good advisor, and how to avoid bad advisors.

Quibbles

The book lacks generality because of its?focus on telling stories. ?It would have been a much better book if it had one final chapter or appendix where the author would take all of the lessons, and weave them into a coherent whole. ?If nothing else, such a chapter would be an excellent review of the lessons of the book, and could even footnote back to the stories in the book for where people could read more on a given point.

I know this is a bias of mine regarding books with a lot of unrelated stories, but I think it is incumbent on the one telling the stories to flesh out the common themes, because many will miss those themes otherwise. ?In all writing, specifics support generalities, and generalities support specifics. ?They are always stronger together.

An Aside

I benefited from the book in one unusual way: it gave me a lot of article ideas, which you will be reading about at Aleph Blog in the near term. ?I’ve never gotten so many from a single book — that is a strength of reading the ideas in story form. ?It can catch your imagination.

Summary / Who Would Benefit from this Book

You don’t need this book if you are an expert or professional in finance. ?You could benefit from this book?if you want to improve what you do financially, improve your dealings with your financial advisor, or get a good financial advisor. ?if you want to buy it, you can buy it here: Financial Tales.

Full disclosure:?The author sent a free copy?to me directly. ?Though we must live somewhat near to one another, and we both hold CFA charters, I do not know him.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Too Many Vultures, Too Little Carrion, Redux

Posted on 22 October 2015 by David Merkel

Photo Credit: TexasEagle || A: Do you see any prey? B: No, I don't. Do *you* see any prey? — Photo Credit: TexasEagle || A: Do you see any prey? B: No, I don’t. Do *you* see any prey?

I was surprised to find that I wrote another piece with the same title — 8.5 years ago, before the housing bubble crashed. ?It was a short piece (with dead links). ?Here it is:

I had a cc post over at RealMoney called Too Many Vultures, Too Little Carrion . The idea was that there?s too much money ready to rescue dud assets at present. Yesterday, Cramer had his own blog entry suggesting that the absorption of subprime assets at relatively high prices implied that the depositary financial sector is a sound place to invest. I disagree. In the early phases of any secular change, there are market players who snap up distressed assets, and later they find out that they could have gotten a better bargain had they waited.

The good sale prices for subprime portfolios is not a sign of strength, but a sign that there is a lot of vulture capital looking for deals. The true problems will surface when the vulture capital gets burned through or scared away.

That last paragraph is the “money shot.” ?When there is too much vulture capital waiting to invest in distressed securities, marginal business concepts don’t get destroyed, clearing the way for a reduction in capacity, and healthy firms pick up the pieces. ?At such a time, you have to wait until the distressed players get hosed, or get smart.

Today’s topic is the debt and equity of companies producing energy, or providing services to them, all of which get hurt by a lower oil price. ?In the recent past, you have had marginal energy companies able to get financing amid decreasing opportunities for decent profits. ?Thus the article at the Wall Street Journal talking about hedge funds losing money on recently placed bets on energy.

Aiding the financing of marginal companies can pay off if the companies will be profitable within a reasonable window of time, or, if you are trying to buy assets cheap for a reorganization. ?But if there is too much capacity, and thus low prices for products, the profits after financing may never emerge, and the value of the assets may sag.

Let me talk about another group of oil companies on the global scene. ?They are relatively high cost players with large-ish balance sheets that are presently pushing to recover market share. ?Yes, I am talking about OPEC countries. ?Not the national oil companies of those countries, but the countries themselves.

Think of the countries as the companies, because the companies themselves fund the government of these countries. ?Consider this quotation from the Bloomberg article to which I linked, regarding one of the stronger OPEC countries, Saudi Arabia:

Saudi Arabia, the main architect of OPEC?s new strategy, will have a budget deficit of 20 percent of gross domestic product this year,?the International Monetary Fund estimates. While the kingdom has been able to tap foreign currency reserves and curb spending to cope with the slump, financial assets may run out within five years if the government maintains current policies and prices stay low, the IMF said Wednesday.

Less wealthy OPEC members have even fewer options. The threat of political unrest is mounting in the ?Fragile Five? of Algeria, Iraq, Libya, Nigeria and Venezuela, according to RBC Capital Markets LLC.

Think of the budget deficits that the OPEC countries have to fund in the same way you think about the debt service of a US E&P company. ?The deposits of oil being produced may be low cost in and of themselves, but any profits go to cover debt service of the greater enterprise, and whatever is not covered, more will be borrowed, should the markets allow it.

What’s the longest that this game could be played? ?Never say never, but I would be shocked if this could continue ?to 2020. ?That said, there are a lot of OPEC countries that won’t make it that far, and a lot of E&P and services businesses that won’t make it that far either. ?Now, the countries could face severe political turbulence, but eventually, they will have to reduce what they borrow and spend. ?That doesn’t mean the oil stops flowing, though a new government could decide to cut spending further, and save the patrimony (crude oil) for a better day.

The free market oil producers are another matter… they can go under, and production would likely stop. ?The question is what side of the solvency line you end up on when enough production capacity is eliminated. ?If you are still solvent, you will reap some reward for your fiscal rectitude as prices rise again, and the Saudis breathe a sigh of relief, congratulating themselves for winning a very expensive game of “chicken,” or, a Pyrrhic economic war.

As such, be careful playing in heavily indebted companies that benefit from higher energy prices. ?That they are limping along should be no comfort, because those that they presently rely on for financing will eventually have to give up, much as those snatching up bargains in subprime?had to give up when the financial crisis hit.

And for those watching the price of crude oil, this is yet another reason why Brent crude should remain near $50/bbl, for a few years. ?It is the uneasy equilibrium where producers are both entering the market and giving up. ?The Saudis don’t want it much lower — there are limits to the pain that they want to take, as well as impose on the rest of OPEC.