Category: Macroeconomics

The Longer View, Part 5

The Longer View, Part 5

Posted on by David Merkel

There’s no order to this post, so enjoy my reflections on broader trends that are affecting the markets.

  1. Corn-based ethanol is costly, and a mistake for our government to subsidize it, when we could buy sugar-based ethanol from Brazil. I’m no environmentalist, but even I can see the advantages of eliminating sugar subsidies and quotas here in the US. The only people hurt are some rich farmers that bribe Washington to keep the subsidies. With a little encouragement from the US, Brazil could adopt more environmentally friendly harvesting techniques, while not kicking up costs that much. Such a deal, better economics, and better for the environment.
  2. Stories like this always make me skeptical. Remember cold fusion? Maye there is a real innovation here that produces more energy than it consumes on net. I wouldn’t bet on it, though.
  3. Since the creation of the Earth, farming has been the dominant occupation of man, until now. More people are employed outside of farming, than inside it. This is not big news, except to confirm that what happened to the developed world 80 years ago is happening to the world as a whole now.
  4. ETFs are not open end mutual funds, where there is one price struck per day for liquidity. For small ETFs, the bid-ask spread can be quite wide on small funds. This shouldn’t be too surprising; the same is true of any small stock. If there is demand for an ETF concept, more units will get created as people bid for them, and the bid-ask spread will narrow.
  5. Rationality in markets is misunderstood. You can bring bright people to manage money, and they will still in aggregate become prey to the speculative aspects of the markets. Some will resist it, but most won’t. It is not a question of intelligence, but of discipline.
  6. Give Hersh Shefrin some credit. I think that behavioral finance is a much richer explanation of the markets than modern portfolio theory. MPT exists because it is easily mathematically tractable, which allow professors to publish, and not because it is a correct description of reality.
  7. It’s tough to be an orphan company. Much as I like investing in companies that have no analyst coverage, if they are cheap enough, when a company loses analyst coverage, the stock price typically declines, and often, the company disappears within a few years. Perhaps the lack of analyst coverage is a proxy for the demand for a company to be public, rather than private.
  8. Here’s a good article on why the market crashed in October of 1987. My quick summary for why it happened was that bonds were more attractive relative to stocks, and dynamic hedging left the market unstable, as many player were willing to sell on big down days.
  9. Will junk defaults triple from 2007 to 2008? Seems reasonable to me; given all of the CCC and single-B issuance over the last few years, the companies that have recently issued bonds seem weak to me.
  10. Can Thompson-Reuters give Bloomberg a run for its money? My guess would be no. Bloomberg is a much richer system, and for those that need that level of complexity, that is where you can get it with great ease.

Enough for the evening. More to come tomorrow.

Another Delisting — The Cost of Sarbanes-Oxley

Another Delisting — The Cost of Sarbanes-Oxley

Posted on by David Merkel

I know why Sarbanes-Oxley [SOX] came into existence: to give one of America’s least productive Senators a fitting legacy.? I think the legislation was perhaps well-intended, but on the whole, it has perhaps imposed more costs than produced benefits.? Today I am faced with one of the costs: Lafarge SA has delisted, and now trades on the pink sheets.? Now, big institutional investors will buy and sell shares of this fine firm on the Paris bourse, but I’m not big, so I end up with an illiquid nonsponsored ADR.? This is the third time this has happened to me since the passage of SOX, because my investing travels the world in a cheap way, through ADRs.

It has been said in many ways, but I will summarize it in this way: there is price, quantity, and quality.? You can at most regulate two out of three, and usually, it’s not wise for a government to regulate more than one variable at a time.? Often, it is wisest not to regulate, unless there are material problems in quality that ordinary people cannot verify, and yet ordinary people have a common need for (think of food safety, and our government does well at that, but could do better).

Large companies are complex, and the accounting is more so.? The personal burdens placed on the CEO and CFO are misplaced, in my opinion, and the degree of auditing/testing prior to SOX was adequate to catch most abusive situations.? Are financial statements higher quality now?? Yes, but at a cost: Higher accounting costs, particularly for smaller firms, more firms going private, and fewer foreign firms listed in the US.? (Note to those pushing for unification of GAAP and IFRS.? If you’re trying to get more listings in the US, it would be better to aim for reform of SOX.? If GAAP and IFRS are the same, and I were a medium-sized US firm, maybe I would list in London.)

There is a logical balancing point to regulation, and SOX tipped the balance, imposing more costs than the value of improvements in quality.

Full disclosure: long LFRGY (not LR 🙁 )

Watching the Maple Leaves Rise as Fall Approaches, or, Maybe I’m Just Looney

Watching the Maple Leaves Rise as Fall Approaches, or, Maybe I’m Just Looney

Posted on by David Merkel

What a day.? We’ve had too many “What a days” lately, and its late.? Over at RealMoney today, I posted this:


 David Merkel
Watching the Maple Leaves Rise as Fall Approaches
9/20/2007 12:49 PM EDT

It brings a lump to my throat, but the Canadian dollar briefly traded over parity to the U.S. dollar today. My guess is that it decisively moves above the U.S. dollar, and stays there for a while. Why not? Their economy is in better shape.Oh, and to echo one of Doug’s points, watch the 10-year swap yield. Nothing correlates better with the prime 30-year mortgage rate. It’s up 13 basis points since the FOMC move.

Looking at slope of the yield curves 10-years to 2-years, the Treasury curve has widened 20 bp and the swap curve 23 bp. If all Bernanke is trying to do is calm the short-term lending markets, that’s fine, but the long-term markets are getting hit.

Even in the short-term markets, things aren’t that great. We’re past the CP rollover problem, but the TED [Treasury-Eurodollar] spread is 135 bp now, and that ain’t calm.

I’m not a bear here, but there are significant risks that we haven’t eliminated yet… most of them stemming from the need for residential real estate to reprice down 10%-20% in real terms. Hey, wait. Hmm… what if the FOMC doesn’t really care about inflation anymore? They could concoct a rise in the price level of 20% or so, which would presumably flow through to housing, bailing out fixed-rate borrowers with too little margin (ignore for a moment that floating and new financing rates will rise also).

Okay, don’t ignore it. It will be difficult to inflate our way out of the problem. Even as the dollar declines, it will cause our trading partners to decide whether they want to slow their export machines by letting their currencies rise or buying more eventually depreciating dollar assets.

I would still encourage readers to be cautious with real-estate-related assets and those who finance them. Beyond that, just be wary of firms that need financing over the next two years. It may not be available on desirable terms.

Position: none, but who is not affected by this?

Interesting Times

We are within a half percent of taking out the all time low (1992) on the Dollar Index [DXY].? Since the move by the FOMC the ten-year Treasury has moved up 21 basis points.? That’s not stimulative.? Then again, maybe the FOMC wants to address the short term lending crisis, but could care less about stimulating the economy as a whole.? If this is their goal, let’s stand up and applaud their technique, but perhaps not their goals.

All that said life has returned to the investment grade bond market, and may be returning to the junk market, and maybe even the LBO debt market, if the banks will take enough of a loss to get things moving.? What I am finding attractive currently in fixed income right now is prime residential mortgage paper (this is rare — I usually hate RMBS).? Implied volatilities in are high, just look at the MOVE index, but they will eventually come down, at which point, the prices of mortgage bonds should improve (on a hedged basis).

Beyond that, I like foreign bonds, but am uncertain as to what currencies to go for; I still like the Canadian dollar, yen and the Swiss franc, but beyond that, I don’t know.? Aside from that, keep it short and high quality, because the long end isn’t acting well, and the junk credit stress is starting to arrive.

Away from that, I also still like inflation protected bonds, but they have run pretty hard since April.? TIPS overshot on the FOMC announcement, and have undershot since.? What a whipsaw.

So where would that leave me if I were a bond manager?? Foreign, mortgages, inflation-protected, and short duration high quality.? Sometimes the game is about capital preservation, and nothing more.

Investing in a Stagflationary Environment

Investing in a Stagflationary Environment

Posted on by David Merkel

I intend to get back to answering more reader questions, and doing it through posts.? I’ve been somewhat derelict in responding to comments, and I want to do it, but time has been short.? Here is a start, because I think the answer would be relevant to a lot of readers.

From a reader in Canada:

I enjoy your writing as many of your comments generate a wider perspective than my own.? There is always something to learn.

I was too young to appreciate the last stagflationary period.? Yet, I need to manage my portfolio.? My approach is more ETF based, whereas, I see that you prefer specific stocks.

I struggle in anticipating the currency impact on my foreign holdings.? I’m a Canadian based investor.? The simple solution is to pull in my exposure and be more Canada centric.? This idea conflicts with my goal to have my portfolio weighted in similar fashion to the global markets (i.e., Canada is a very small percentage relative to the total).? I also do not subscribe to the excessive weighting in gold as a major investment theme.? To me, it’s insurance to help offset risk elsewhere.

I’m not asking for specifics as you are not familiar with my situation.? Do you have any recommended reading or suggestions to help me test my thoughts and to identify options, so that I can arrive at a better decision?

Well, I’m not that old either.? During the last stagflation, I was aged 13 to 22, from junior high through my Master’s Degree in Economics at Johns Hopkins.? That said, I have read a lot on economic history, so I understand the era reasonably.? I also spent many of my Friday evenings as a teenager watching Wall Street Week with my first teacher on investments.? (Hi, Mom! 🙂 )? Another thing I remember is being the student representative to the school board for two years 1977-1979, when our district in Brookfield, Wisconsin decided to do a wide number of capital improvements in order to save energy, at the peak of the “energy crisis.”? I remember that the payback periods were 15 years or so, not counting interest that they would have to pay on the munis that they issued.? No way that project saved money on a net present value basis.? (And it was depressing to see 2/3rds of the windows covered up.)

During the last Stagflation, bonds were called “certificates of confiscation” by many professionals in fixed income.?? It paid to have your fixed income assets as short as possible.? Money market funds, a new invention at the time, were the optimal place to be until about 1982, when the cycle shifted, and the longest zero coupon bonds were the new best place to be.? Timing the shift between cycles is difficult, so don’t try to time it exactly, but add more longer bonds as long rates rise.? Right now, I would stay in money market funds, inflation protected bonds, and foreign currency denominated bonds.? You have enough Canadian exposure, so aside from you money market funds, consider bond investments in the yen, Swiss franc and Euro.

As for equities, pricing power is critical.? Who can raise prices more than the cost of their inputs?? Producers of global commodities like oil, metals, etc., typically do well here.? Financial companies with short duration assets or exposure to hard assets should do better here.? Staples should do better versus durables.? Growth investing should beat value investing (uh, oh, what do I do?? All of my processes are geared toward value investing).?? Cyclical names may beat them both.

If inflation really takes off, hard assets will offer some shelter though housing will lag until the inflation of real estate exceeds the deterioration of the debt.? I occasionally like gold, but it’s not a panacea.? I’d rather own the economically necessary commodities.

But what if stagflation does not become a reality?? That’s why we diversify.? I don’t tie my whole portfolio to one macroeconomic view.? Instead, I merely tilt it that way, leaving enough exposure elsewhere to compensateif my economic forecast is wrong.? I am a value investor, and almost always have a a few companies that will do well even if my economic forecast fails.

In summary: keep your domestic bonds short.? Diversify into foreign currency bonds.? Keep a diversified equity portfolio, but focus on companies that are immune to, or can benefit from inflation.

Eight Notes on a Distinctive Day

Eight Notes on a Distinctive Day

Posted on by David Merkel
  1. My broad market portfolio trailed the market a little today. I’ve been a little out of favor over the past three months; I’m not worried, because this happens every now and then. That said, we are coming up on another portfolio rebalancing, where I will swap out 2-3 stocks, and swap in 2-3 others. Watch for that in the next few weeks.
  2. Every group in the S&P 1500 was up today. I can’t remember when I have seen breadth like that before. Financials and Energy led the pace. Names like Deerfield Triarc flew on the Fed cut. They will benefit from cheaper repo rates, and the excess liquidity injected the system should eventually ease repo collateral terms.
  3. If the US dollar LIBOR fix at 6AM (Eastern) tomorrow follows the move in the US futures markets today, then we should see LIBOR drop by 27 basis points or so. Given the smaller move down in T-bill yields, 14 basis points, that would leave the TED spread at 132 basis points, which is still quite high, and higher than the 10-year swap spread. (LIBOR would still be higher than the 10 year swap yield.) This indicates that there is still a lack of confidence among banks to lend to each other on an unsecured basis. Things are better than they were two weeks ago, but still not good.
  4. The short term crunch from the rollover of CP, especially ABCP is largely over. The good programs have refinanced, the bad programs have found new ways to finance their assets, or have sold them, or used backup guarantors, etc.
  5. Watch the slope of the yield curve. It is my contention that the slope of the yield curve changes relatively consistently through loosening and tightening cycles. In the last tightening cycle, the curve flattened dramatically through the cycle, making the word “conundrum” popular. This is only one day, but the yield curve slope, measured by the difference in yields between 10-year and 2-year Treasuries, widened 10 basis points today. (The curve pivoted around the 7-year today.) If I were managing bonds at present, I would be giving up yield at present by selling my speculative long bond positions that served me well over the past few months in my model portfolio. I would be upping my yen and Swiss Franc positions.
  6. We learned some new things about the FOMC today: a) They don’t talk their book publicly, so don’t take their public comments too seriously. b) They are willing to risk more inflation for the sake of the non-bank financial system (which is under threat), or economic growth (which may not be under threat). c) They are flagging the Fed funds rate changes any more by letting rates drift nearer the new target in the days before the meeting. d) Beyond that, we really can’t say yet whether this is a “one and done” or not yet. We just don’t have enough data. e) The FOMC really isn’t interested in transparency.
  7. It would be historically unusual for this to be a “one and done.” Fed loosenings are like potato chips. It’s hard to stop at one. Just as there is a delay in the body saying, “that’s enough,” with the potato chips, the in the economy in reacting to monetary policy is slow as well, often leading policy to overshoot, as the FOMC reacts to political complaints to do more because things aren’t immediately getting better. It’s hard to sit in front of the short-term oriented Congress, or listen to the manic media, and say, “But the FOMC has done enough for the economy. It doesn’t look good now, but in 18 months, our policy will take effect and things will be better. Just trust us and wait.” That will not fly rhetorically; it will take a strong-headed man to not overshoot policy. On that Bernanke is an unknown.
  8. To me, it’s a fair assumption then that this cut will not be the last. Investment implications: in fixed income stay in the short to intermediate range, and remain high quality. Buy some TIPS, and have some foreign bonds as well. I like the Yen, Canadian Dollar, and the Swiss Franc. In equities, think of high quality sectors that can use cheap short-term credit, and sectors that benefit from inflation and a weaker dollar. So, what do I like? High quality insurers, mortgage REITs that have survived, (maybe trust banks?), basic materials, energy, goods transportation, staples, some areas in healthcare and (yes) information technology (if I can find any more cheap names there that I like).

Full disclosure: long DFR

Seven Reasons Why the FOMC Will Not Cut 50 Basis Points

Seven Reasons Why the FOMC Will Not Cut 50 Basis Points

Posted on by David Merkel

As I have said before, my view on the FOMC has gone cloudy.? That said, I’ll put forth my best guess for you what the FOMC will do and say today.? I think the FOMC will ease the Fed funds target 25 basis points, or maybe a little more, but not 50 basis points.? (Stuck my neck out there, hope I don’t get chopped.)? Here’s why:

  1. Not all lending crises are over, but the crisis in the CP market largely is over.? There was some paper that had to be taken back by the banks, and some that had to be rolled over at relatively high rates, but the refinancing of the bulk of short term credit is done for now.
  2. Total bank liabilities are growing smartly since the change in the discount window, leverage changes, and temporary liquidity adjustments took effect.? Little effect on the Fed’s monetary base, M1, MZM, or M2 yet.? This is just a bank leverage thing.
  3. The NY Fed Open Markets desk continues to be sloppy on the upside.? Over the last four days, three times Fed funds finished over 5.25%, with the close yesterday at 5.4325%.? This is not what you would expect to see from a Fed that expects to loosen aggressively.
  4. The discount window finally got good demand last week.? With that strategy seeming to work, the FOMC has less pressure to cut the funds rate.? Might they cut the discount rate more than the funds rate?? Yes. because seeming success often breeds more of the same.
  5. Business conditions aren’t that bad nationally yet.? Real estate is a drag, and will get worse, but it is not an immediately obvious reason to loosen.
  6. A 25 basis point move validates the temporary policy move of the Fed, and does not change policy, beyond making the more semi-permanent.
  7. There are more hawks with votes on the FOMC now, and Bernanke is not pushing to get his way, the way that Greenspan did.

Beyond that, we have the language of the statement, where the FOMC will attempt to sound a balanced view between the risks of inflation and economic weakness.? After the announcement, I expect the stock market to fall back and then rally modestly.? Bonds won’t do much.

That’s my view, though I must state that this is not one of my more strongly held views.? I am still gathering data on the current Fed, because they are so new to their roles in loosening environment.

The Longer View, Part 4

The Longer View, Part 4

Posted on by David Merkel

In my continuing series where I try to look beyond the current furor of the markets, here are a number of interesting items I have run into on the web:

 

1) Asset Allocation

 

  • Many people who want to stress the importance of their asset allocation services will tell you that asset allocation is responsible for 90% of all returns, so ignore other issues.? An article on the web reminded me of this debate.? The correct answer to the question, as pointed out by this paper, is that asset allocation explains 90% of the variability of the returns of a given fund across time, but only explains only 40% of the variability of a fund versus other funds.? Security selection matters.
  • Two interesting papers on asset class correlation.? Main upshots: historical correlations are not fully reliable, because risky assets tend to trade similarly in a crisis.? Value tends to march to its own drummer more than other equity styles in a crisis.? The effects on correlation in crises vary by crisis; no two are alike.? Natural resources and globa bonds tend to be good diversifiers.
  • In bull markets, risky asset classes all tend to do well.? Vice-versa in the bear markets.? My reason for this correlation is that you have institutional asset buyers all focusing on asset classes that were previously under-recognized, and are now investing in them, which raises the correlation level, not because the economics have changed, but becuase the buyers have very similar objectives.
  • There are a few good states, but by and large, public pensions are a morass.? Most are underfunded, and rely on future taxation increases to support them.? When a public system realizes that it is behind, the temptation is to take more investment risk by purchasing alternative asset classes that might give higher returns.? This will end badly, as I have commented before… I suspect that some state pension plans are the dumping grounds for a lot of overpriced risk that Wall Street could not offload elsewhere.

 

2) Insurance

 

 

3) Investment Abuse of the Elderly

 

It’s all too common, I’m afraid.? Senior citizens get convinced to buy inappropriate investments.? Even the SEC is looking into it.? This applies to annuities as well, mainly deferred annuities, which I generally do not recommend, particularly for seniors.? The comment that a CEO doesn’t fully understand his own annuity products is telling.

 

Now fixed immediate annuities are another thing, and I recommend them highly as a bond substitute for those in retirement, particularly for seniors who are healthy.

 

The only real cure for these deceptive practices is to watch out for the seniors that you care for, and tell them to be skeptics, and to run all major investment decisions by you, or another trusted soul for a second opinion.

 

4) Accounting

 

  • I am against the elimination of the IFRS to GAAP reconciliation for foreign firms.? What is FASB’s main goal in life — to destroy comparability of financial statements?? We may lose more foreign firms listed in the US, which I won’t like, but a consistent accounting basis is critical for smaller investors.
  • Congress moves from one ditch to the other.? This time it’s sale of subprime loans.? Too many modifications, and sale treatment is at risk, so Congress tries to soften the blow for the housing market.? Let auditors be auditors, and if you want the accounting rules changed, then let Congress do the job of the FASB, so that they can be blamed for their incompetence at a complex task.
  • As I’ve said before, I don’t like SFAS 159.? It will lead to more distortions in financial statements, because managements will tend to err in favor of higher asset and lower liability values, where they have the freedom to set assumptions.

 

5) Volatility

 

  • Earn 40%/year from naked put selling?? Possible, but with a lot of tail risk.? I remember how a lot of naked put sellers got smashed back in October 1987.? That said, it looks like you can make up the loss with persistence, that is, until too many people do it.
  • Here’s an interesting graph of the various VIX phases over the past 20 years.? Interesting how the phases are multiyear in nature.? Makes me think higher implied volatility is coming.
  • I don’t think a VIX replicating ETF would be a good idea; I’m not sure it would work.? If we want to have a volatility ETF, maybe it would be better to use variance swaps or a fund that buys long delta-neutral straddles, and rebalances when the absolute value of delta gets too high.

 

That’s all for now.? More coming in the next part of this series.

Fifteen Notes on the State of the Markets

Fifteen Notes on the State of the Markets

Posted on by David Merkel

1)? Start with the pessimists:


2)? Move to the optimists:

3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at? “Splutter”).? I began toting up a list of notable losers, but it got too big.? One positive note, many of the large quant funds bounced back from their mid-August stress.

4)? When muni bonds get interesting, you know it’s a weird environment.? It starts with the fundamental mismatch of muni bonds.? Muni issuers want to lock in long term financing, but most investors want to invest shorter.? Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.? When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.? (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)? When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.? That didn’t last long, but munis are still a good deal here.

5) Large caps are outperforming small caps.? Foreign exposure that large caps have here is a plus.

6) Not all emerging markets are created equal.? Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)? Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)? I would be more concerned about the first group.

7) Are global banks cheap?? Yes on an earnings basis, probably not on a book basis.? We need to see some writedowns here before the group gets interesting.

8) I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.? This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.? What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.? Poring over the SFAS 159 disclosures will be required as well.

9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

10) Hedge funds do better if the managers went to schools that had high average SAT scores?? I would not have guessed that.? Many of the best investors I have known were clever people who went to average schools.

11) My but bond trading has changed.? When I was a corporates manager, hedge funds weren’t a factor in trading.? Now they are 30% of the market.? Wow.? Surprises me that volatility isn’t higher.

12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.? His call for outperformance of quality assets seems to be happening.? Now the question is whether the cost of capital is going up globally or not.? If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.“? Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

14) Morningstar moves into options research.? Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.? They make a good point that most people use options wrong, and get the short end of the stick.

15) Oil is amazing, but wheat is through the roof.? I’ve seen articles about bread prices rising.? Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

With that, I bid you good night.

Looking Beyond the US

Looking Beyond the US

Posted on by David Merkel

So, what’s happening in the global economy?? Let’s start with the weak dollar.? As Fed policy tilts toward loosening, the already weak dollar hits a 15-year low, and is less than 2% from an all time low.? The carry trade currencies, the yen and the Swiss franc, rallied the most during the dollar sell-off.? (Here’s a good summary article on the carry trade.)

It’s not that foreigners are fleeing the dollar (unlike this article), though Treasuries are getting less attractive, because the dollar-based investments must be bought by someone.? That doesn’t mean the exchange rates don’t shift down in the process, though, and exports seem to be improving because of the weaker dollar.? Also, the idea that China would try to ruin the US through selling all of their dollar-based reserves is unlikely, though not impossible.? China is too big of a holder to sell without driving the dollar down massively, which would force down the value of their remaining holdings, and harm their ability to export to the US.

Besides, what would they trade into?? The US has the largest, most diverse debt markets in the world.? One reas
on why the US is the world’s reserve currency, despite all of its flaws, is that there is no other economy with a currency capable of filling the role.? Perhaps this article should have been titled, “Why isn’t the dollar falling more?” because the dollar has been falling, yet there are some things good about the dollar, and the US economy.

China is bumping up against the boundaries of its economy’s current capacity.? With few additional young laborers, wage rates are rising.? Inflation is now at a 10-year high.? That’s leading the government to tighten monetary policy.? Beyond that, it is raising the prices of their exports, which slowly forces inflation into the US and other trading partners.

India is facing similar difficulties.? Wages are rising rapidly, amid rapid real growth, putting pressure on interest rates to rise.? In one sense, this is what you get for taking back US assets in exchange for selling goods and services to the US.? So long as your labor pool appears inexhaustible, you can avoid inflation at home, because you aren’t paying new workers much.? But when workers become more scarce, the absence of imported goods for those workers to buy means that there will be inflation.? Also, excess dollar reserves often produce excess credit, if the central bank allows the money supply to grow from the dollar reserves, which can lead to credit-induced inflation.

Final quick notes:

In summary, we are in a situation where the dollar is likely to remain weak.? If currency calm returns, the carry-trade currencies will do badly, but if volatility picks up, the opposite will happen.? (I can make a case either way.)? China and India are on fire, and the developed nations are largely on ice.? We are living in interesting times; in the long run, the development of the poorer areas of the world will be a big plus, particularly for US agriculture and resource extraction industries, but there will be bumps along the way.? Keep your positions flexible enough to be able to benefit from volatility; I sense we are entering a more volatile period.

My 9/11 Experience

My 9/11 Experience

Posted on by David Merkel

Six years ago, I was a neophyte (2 months) corporate bond manager, also doing mortgage bonds, and nominally Chief Investment Officer of a medium-sized life insurance company. I was leading our asset management team through a merger with another firm as well. On 9/11, I was going to have a meeting with my new bosses and the management of our one and only life insurance client.

I was running a little late, so I got to the office as the first tower fell. I talked with a few of my brokers, and concluded that nothing would be trading today. After the second tower fell, our offices were crowded from people in the insurance company watching the spectacle on CNBC. I told my staff to prepare a broad threat report, describing what parts of our portfolio would be harmed by the events; after that, they could go home and grieve. (Our KBW coverage died that day; he was a good fellow.) I went to the meeting, where we canceled our agenda, and I gave a brief threat report, and told them they would have full threat report every day at 4PM until the markets normalized. Aside from owning part of a mortgage on a building near the World Trade Center (One Liberty Plaza) which was rumored to be leaning (not true), the problems were pretty light; liquidity was adequate.

That evening I showed my family video clips from the Internet, and explained what had happened. We’re a pretty matter of fact bunch, so they took it in stride, and realized that the world had changed for the worse.
Because of the merger, the portfolio was relatively high quality. Good thing, too. The markets were closed for the whole week, and reopened the next week. Bond markets are networks, and so, they come back proportionally to the square of the nodes. After one week, the bond market was half functional. After two weeks, 80% functional. After three weeks, 100% functional. We started trading sooner than most, and offered liquidity in exchange for good deals. When our merger closed on 9/30, was began a massive down-in-credit trade, buying bonds in sectors most affected by the disaster. Our logic was that the terrorist event was a “one off” matter where the highjackers got really lucky, and that the odds of a second event were nil, now that the US was on alert.

When I went to a Chief investment Officer’s forum in October, there was a “closed door” meeting with “peer companies” to discuss problems and strategies. One of the early questions was how investment strategy had changed since 9/11. I was the odd man out. We were the only one in the room taking more risk. Everyone else was running up-in-credit trades, and avoiding affected sectors. Not only did I get a “you’re weird” look from the other participants, but I got the “you’re irresponsible” look as well. Not fun.

We continued the down-in-credit trade for another month until we had gone as far as we thought prudent. Then our client came to us and said that the ratings agency heard what we were doing, and told us to knock it off, or face a downgrade. We were done, so we agreed. By this time, it was mid-November. By December, a little more willingness to take risk took hold, and by the first quarter of 2002, there was a full-fledged scramble for yield. We sold into it, doing a massive up-in-credit trade that left the portfolio higher quality than it was prior to 9/11, and giving us room for the upset that would happen as Worldcom went down, and the corporate bond markets doing a double dip in late July and early October. We played the risk cycle very well.


There are four investment points here:

  • Don’t follow the crowds during panics.
  • Don’t follow the crowds during manias.
  • Know your limits. No matter how good an idea will work out eventually, don’t overplay it, because the market can be crazy longer than you can stay solvent.
  • After a panic event, analyze what has truly changed, and ask what things will be like when the next steady state comes, and how long it will likely take to get there.

It was not a consensus view at the time, but the idea that not much had changed permanently proved to be a valuable idea. Capitalist economies tend to be resilient, bending but not breaking. With that, guard your emotions, and try to be analytical toward investing, even when times are abnormal, and people think you are nuts.

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