Personal Finance – Page 21

Enduring Ponzi

Posted on 2 July 20113 July 2011 by David Merkel

Why did Madoff’s Ponzi scheme last so long?

He didn’t take that much from it.? If the gross exposure was $60 billion, he took only 1/2% of it — $300 million.
The growth rate was high enough to attract investors but slow enough to not exhaust cash rapidly.
The SEC was clueless, with little expertise in quantitative investing, and little basic auditing knowledge where one traces every transaction back to the source, which would have revealed Madoff in an instant.? There were no assets in the accounts.
He had a reputable business that produced significant profits, and was viewed by many as an industry leader.? Many Europeans, among others, thought he was front-running, and Madoff implicitly encouraged that idea while explicitly denying it.? The idea of “front-running” was a honey pot to distract regulators from the idea that a Ponzi scheme was going on.
The marketing club.? You are the lucky one who is invited to partake of the gravy train.? Don’t question, just enjoy, and refer friends, maybe we will consider them.
Feeder funds that were looking for looking for a high-ish return and a low standard deviation found Madoff irresistible.
“Pus luck.”? There were many times where the scheme almost died, but new cash flows bailed them out.? The term, “pus luck” was unique to my block where I grew up in Brookfield, Wisconsin, and described a situation of undeserved luck.? A brother of my friend, and a friend of my brother always seemed to get the lucky break at unusual moments.? We called it “pus luck,” perhaps in an effort to denigrate his skill in unlikely situations.
Madoff did not encourage a marketing frenzy.? He tried to keep it low-key.? That kept it below the radar, and allowed it to be marketed to a wide number of people who would not fall for a hard sale.

And so it was for Madoff, skating through unlikely situations where others would have easily died, until it got too big, as all Ponzis do.

We know when it ended, but have no idea on when it started, ’60s, ’70s, ’80s, ’90s…? We really don’t know.?? Madoff has revealed a lot, but he has never given a date earlier than 1992.? His associate, DiPascali, suggested it may have started in the late ’80s.? There is some evidence that it may have gone all the way back to the ’60s.

I find DiPascali’s words to be more reasonable than Madoff’s.? The late ’80s were more desperate than the early ’90s.? If you could survive ’87 and ’89, you could likely survive ’92.

Recoveries?

When the Ponzi was revealed, few thought there would be any significant recoveries. But now, net losers from the Madoff Ponzi may get back over 50% of their money.? Why?

The Picower family gave in, and released their profits from the Madoff scheme.
Many large financial companies played small roles in the scheme, and they will all probably pay something to make the lawsuits go away.
Some net losers were involved in money laundering and are unlikely to pop their heads above water to make a claim on their ill-gotten funds.? More for the rest.

In one sense, the slowness of the Madoff Ponzi allowed for a less wasteful class of investors to be bilked.? Including Madoff, these were not the sorts of people that were big spenders as a fraction of their income.? Many investors were buy and hold with Bernie, and indeed, he encouraged that.

So the endgame may not be as bad as expected.? Many will get a large portion of their net investment back.? There will still be regrets, but they will be much reduced.? Good for them.

Got Cash?

Posted on 29 June 2011 by David Merkel

Ecclesiastes 10:19 (NKJV)

A feast is made for laughter, And wine makes merry; But money answers everything.

There has been a small flurry of posts off of James Montier’s piece on the virtues of cash.? I wrote a piece like it recently (not as comprehensive, but possessing brevity): Chasing Your Tail Risk.

Like gold, cash is special because it doesn’t do anything.? Even money market funds do nothing, or almost nothing.? It just sits there, waiting.? It waits for the day when the Fed is forced to raise rates because inflation is running faster, even though the economy is still underemployed.? It waits for the day when bond yields rise and stock prices fall, where there are good opportunities to use the cash.

Having cash on hand allowed my church to buy a building cheaply in March 2009, and allowed me to help rescue a friends business, as well as buy some cheap stocks.? The same was true for me in October 2002, when I fully deployed my cash into stocks.

Cash is flexibility.

Cash says, “I don’t know.”

Cash says, “I don’t care.”

Cash says, “I’m ready.”

When opportunities are numerous, I am more than willing to part with my cash.? But when yields are low, and valuations are high if profit margins mean-revert, I would rather have more of a cash buffer.

For my account, and client accounts, I did buy some stock last week.? If the weakness had persisted, I would have bought more.

I still have an above average amount of cash (for me).? I am waiting for opportunities to get better before I deploy it.

Evaluating Six Investing Mistakes To Avoid

Posted on 25 June 2011 by David Merkel

I read this article today, and he invited comments.? Here are my comments (his words are in italic):

While no investment approach is successful all of the time, here are six common investing mistakes to avoid:

Inability to take a loss and move on.

This is a good point, subject to what I will mention later.? If you learn new data about a company, such that you conclude it is worth far less than your original estimates, yes, it is likely you should sell.

But often when investors sell after a disappointment, they sell too cheaply.? Bounces often come after disappointments.? The key question is to estimate the new value, and calculate a new implied return, and compare that against the implied returns of alternative stocks.? Are you holding the stocks with the best set of likely returns?

Not selling winners.

The stock may have been a winner, but that doesn?t mean it can?t win more.? Don?t look through the rear-view mirror.? Look through the windshield.? What is your estimate of value NOW?? It may be a lot more valuable than when you first purchased it.? If uncertain, sell a little bit of it ? it helps psychologically to do that, because taking a gain will make you more comfortable about the remainder of the position.

But if the stock is one of your leading ideas, even after a run-up, why sell any of it?? Again, rank the idea against the alternatives that you might reinvest in, and choose the idea that gives you the best likely returns, adjusted for risk.

In my opinion, too many people trim winners that have more to run.? Be bloodless, and evaluate the future prospects of the company versus those of alternatives.

Not setting price targets.

Fixed price targets are foolish.? Price targets should be dynamic, and shift with the estimated value of the firm.? Further, evaluate companies against alternative investments.? Only sell the stock of a company when you have a company significantly better in terms of implied returns to replace it with.

Trying to time the market.

I agree that it is difficult to time the market.? That doesn?t mean that it is not worth trying to do it on an intermediate-term basis.? Follow the credit cycle in the corporate bond market, and you will have a good idea of where stocks are likely to go.? When corporate lending falls apart, so do stocks.? Also, momentum tends to persist, so be more aggressive when stocks are above their 200-day moving average, and less aggressive when below the average.

Worrying too much about taxes.

In general, I agree.? Taxes are a secondary concern, particularly for those who use stocks for charitable giving.? Donating appreciated stock is a home-run strategy for those with long-term capital gains.

Not paying attention to your investments.

This is true.? If you can?t evaluate you own investments, you should get a professional to do so.? By professional, I mean someone trained to understand how investing works, because few truly get how it works.? They should at least hold a CFA Charter, and hopefully show some competence beyond that to show that they have transcended the training of one with a CFA Charter.

My main points to you are these:

Don?t look through the rearview mirror.? Look through the windshield, and pick the stocks that offer the best returns now.
Only buy a new stock when its implied returns are better than most stocks in your portfolio.
Only sell a stock in order to fund a new stock with better implied returns.
Good investing is a lot of work.? If you can?t do it, get a professional to do it for you.
Consider taxes to the degree that it makes sense, and donate appreciated stock when you can.

The author?s six investing errors have a modest amount of merit, but the intelligent investor is dynamic, and adjusts to changing market conditions.? Your assets should be managed by those who are similarly dynamic, if you can?t do it yourself.

I read this article today, and he invited comments. Here are my comments (his words are in italic):

While no investment approach is successful all of the time, here are six common investing mistakes to avoid:

Inability to take a loss and move on.

This is a good point, subject to what I will mention later. If you learn new data about a company, such that you conclude it is worth far less than your original estimates, yes, it is likely you should sell.

But often when investors sell after a disappointment, they sell too cheaply. Bounces often come after disappointments. The key question is to estimate the new value, and calculate a new implied return, and compare that against the implied returns of alternative stocks. Are you holding the stocks with the best set of likely returns?

Not selling winners.

The stock may have been a winner, but that doesn?t mean it can?t win more. Don?t look through the rear-view mirror. Look through the windshield. What is your estimate of value NOW? It may be a lot more valuable than when you first purchased it. If uncertain, sell a little bit of it ? it helps psychologically to do that, because taking a gain will make you more comfortable about the remainder of the position.

But if the stock is one of your leading ideas, even after a run-up, why sell any of it? Again, rank the idea against the alternatives that you might reinvest in, and choose the idea that gives you the best likely returns, adjusted for risk.

In my opinion, too many people trim winners that have more to run. Be bloodless, and evaluate the future prospects of the company versus those of alternatives.

Not setting price targets.

Fixed price targets are foolish. Price targets should be dynamic, and shift with the estimated value of the firm. Further, evaluate companies against alternative investments. Only sell the stock of a company when you have a company significantly better in terms of implied returns to replace it with.

Trying to time the market.

I agree that it is difficult to time the market. That doesn?t mean that it is not worth trying to do it on an intermediate-term basis. Follow the credit cycle in the corporate bond market, and you will have a good idea of where stocks are likely to go. When corporate lending falls apart, so do stocks. Also, momentum tends to persist, so be more aggressive when stocks are above their 200-day moving average, and less aggressive when below the average.

Worrying too much about taxes.

In general, I agree. Taxes are a secondary concern, particularly for those who use stocks for charitable giving. Donating appreciated stock is a home-run strategy for those with long-term capital gains.

Not paying attention to your investments.

This is true. If you can?t evaluate you own investments, you should get a professional to do so. By professional, I mean someone trained to understand how investing works, because few truly get how it works. They should at least hold a CFA Charter, and hopefully show some competence beyond that to show that they have transcended the training of one with a CFA Charter.

My main points to you are these:

1. Don?t look through the rearview mirror. Look through the windshield, and pick the stocks that offer the best returns now.

2. Only buy a new stock when its implied returns are better than most stocks in your portfolio.

3. Only sell a stock in order to fund a new stock with better implied returns.

4. Good investing is a lot of work. If you can?t do it, get a professional to do it for you.

5. Consider taxes to the degree that it makes sense, and donate appreciated stock when you can.

The author?s six investing errors have a modest amount of merit, but the intelligent investor is dynamic, and adjusts to changing market conditions. Your assets should be managed by those who are similarly dynamic, if you can?t do it yourself.

The War Against Savers

Posted on 24 June 2011 by David Merkel

Today, Charles Rotblut, CFA who is the AAII Journal Editor wrote:

Federal Reserve Chairman Ben Bernanke continues to be the enemy of savers. Yesterday, the Boston Red Sox fan reiterated his belief that interest rates should be kept at rock-bottom levels for an extended period of time. He views this as necessary in order to keep the economy growing.

When you run an investment group that is largely composed of retirees and near-retirees, it is reasonable to call Bernanke the enemy of savers, because he is the enemy of savers.? When one can’t earn anything over one year without risk, something is wrong.? Better that the economy grow more slowly, than that savers not get their due for not consuming.

Saving deserves a return.? Let the Fed raise the Fed funds rate by 1%, and they will see that there is no harm to the banks, and little harm to the economy.? Once you have 1% slope between twos and tens you have more than enough oomph to make the economy move.? What, does the AARP have to bring a age discrimination lawsuit against the Federal Reserve to make this happen?? The Fed is discriminating against the elderly.

But now consider another issue — money market funds.? I consider them to be superior to banks because their asset-liability mismatch is so small, and they have generated small losses relative to banks and other depositary institutions.

Prime money market funds in the US have been investing 50% of their assets in the Commercial Paper [CP] of Core Eurozone Banks.? Well guess what?? If the Greeks and other fringe members of the Eurozone default, and the core governments don’t bail the situation out, those holding? CP of core Eurozone banks may take a loss.? And this is at a time where French and German Banks are facing liquidity issues.? Take time to review your money market funds.

The problems of the US and China are significant, but the problems of the Eurozone are pressing.?? The endgame there will arrive more rapidly because the underlying structure is unstable.? One currency can’t serve multiple cultures.? Also, there should have been an Eurozone exit plan designed in from the beginning.? It was hubris to think it would never need that level of adjustment.

It seems like the ECB is becoming a repository of euro-fringe debt, and perhaps the IMF as well.? After all, it doesn’t cost the ECB anything to absorb those debts, but it indirectly spreads the risk to the euro-core nations if there is ever a default or unfavorable restructuring.? A central bank can’t go broke, but it can impose problems on those that use the currency if defending the central bank exacerbates other problems in the economy.? (E.g., printing money to cover over bad debts absorbed by the bank, while inflation rolls on.)

On a slightly different level, I’m not sure that the banking regulators in the US or Europe really got the main lesson from the crisis.? Risk management is liquidity management.? I still think that banks rely too much on short liabilities to finance illiquid, longer assets.? One advantage of mark-to-market accounting is that it can reveal those mismatches to investors, or perhaps, to regulators.?? Extra capital can help, but it is usually not enough when there is a run on short-term liquidity, particularly because capital is the excess of assets over liabilities.? If there are not enough liquid assets to meet the redemption of liquid liabilities, the result is insolvency.

“But that’s a liquidity problem, not a solvency problem — just give it time and the market will normalize, the assets are worth more than the liabilities anyway.”? But at such a time, no one wants to buy the longer, less liquid, lower quality assets.? If the bank could raise liquidity, it would.? It can’t, so it is not only illiquid, but insolvent.? It’s always cheaper to issue liquid liabilities, because those are attractive to savers and investors, but they a poison in a crisis.

My fear here is that there may be another call on liquidity that forces the Fed or the ECB to backstop banks.? Not sure what would cause it; it’s always hard to pick which straw will break the camel’s back.

Thus I say be cautious at present; have some safe assets available in case we have a panic that emanates out of Europe, and has second-order effects on the US.

Learning to Like Lumpiness

Posted on 11 June 201114 June 2011 by David Merkel

Simplistic financial plans assume a smooth return that the client will earn.? Why?? No nefarious reason, but planners don’t know the future, so they either:

1) Assume an average rate as a baseline for calculations, or

2) Display the average, median, or some? percentiles from a series of randomly estimated possible futures.

But life isn’t that way.? Markets are lumpy.? High and low returns happen more frequently than average returns.? What’s worse, returns tend to streak over years and decades.? So much for the Efficient Markets Hypothesis.

So what to do?? Better to be like the great moral philosopher Linus van Pelt, who carried a candle at night, and his sister Lucy asked him why he was doing so.? Linus replied, “It is better to light a single candle than to curse the darkness.”? After Linus left, Lucy mused for a moment, and shouted, “YOU STUPID DARKNESS!”

Volatility is a fact of life, and even the volatility is volatile, with regions of seeming stability, and regions of extreme booms and busts.

My “single candle” is simple — it is an adjustment of expectations, which involves reasoning that when things have been horrible, after some amount of time, it is time to take risk again, before it is perfectly obvious to do so.? Same thing when things are great, it may be time to take risk off the table.? I would add that delay in doing so is not a failure — lumpiness means that trends run further than would be reasonable.? But when the momentum wanes it is time to change.

I’ve been in the situation multiple times, but it is really difficult to get permabulls or permabears to recognize that something has shifted.? I wrote about this a number of times in my series “The Education of a Corporate Bond Manager.”? I was constantly fighting those who were hanging onto the old trend too long.

And at another firm, I could not convince my boss to go long once the nadir of the credit crisis had passed.? He expected more trouble to come, while I looked at the bond market and found an absence of distressed credits.

The lesson of both cases is that opportunities to earn total returns or preserve capital are lumpy.? If the market is longing for safety now, it will likely do so for a while, and the same is true for bull markets.

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

Many retirees say “I just need a certain reliable income of X%/year. Please get that for me.”? We may as well tell these people to buy a CD or annuity, except that Fed policy makes the rates inadequate for their needs.? And yes, this is a deliberate policy of the Fed, picking on the elderly and the conservative in order to fund marginal lending that might? result in some tiny increment of growth.

It is far better to ask three questions:

1) Where are we now in the credit risk cycle? Rising, Peak, Falling, or Trough?

2) Where are yields on high-grade corporate bonds now?

3) Can you afford to spread your yield needs over five years?

Bond investors need to realize that most returns of the bond market are earned at three times: first, after the nadir of the credit cycle, credit-sensitive bonds soar.? Second, during deflationary times, buying long-dated Treasuries.? Third, when inflation is running, rolling over short-dated fixed income claims.? Beyond that, one can clip bond coupons during abnormal times of stability.

By asking the above first two questions, we can ascertain whether it is a favorable time to take risk or not, and what sort of risks to take.? The last question is more of a reasonableness check on the client.? If he has to have the return every year without fail, tell him to seek it at a bank or insurer, and see if he is pleased with the results.

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

But now take it one step further.? When will our stupid economists and politicians get it through their heads that lumpy economic growth is normal, and even that it is desirable that growth is not smooth?? Effort to produce a smooth economy led to a debt build-up, which ultimately sabotaged growth.? Far better to let small recessions do their work, and leave the Fed funds rate high until marginal investments are repriced, with the attendant bankruptcies.

The US economy grew more rapidly when there were no efforts at stimulus.? Yes, there were severe recessions, but the booms thereafter more than made up for it.? Though it would hurt a lot in the short-run, far better to end the deficits of the US government, and the pitiful efforts of the Fed, giving greater certainty to the private sector, that businessmen could make long-term decisions without worries that taxes, regulations, or interest rates might change dramatically.

Like it or lump it, some say.? Why choose?? Learn to like the lumpiness of the asset markets and the economy in general, and many things will go more easily for you.

Book Review: Debunkery

Posted on 23 May 2011 by David Merkel

Ken Fisher and Lara Hoffmans write well.? This book is accurate (with a few quibbles), and succinct.? I know these topics well; it took me less than three hours to read it.

There are many half-truths that travel around Wall Street.? There are still more that come from salesmen.? There are those that your investing friends will teach you.

Some come from the idea that the economy affects the markets in the short-run, or that good or bad policy will drive the market higher or lower.

Markets are far less predictable than we imagine.? They abhor simple rules.? Indeed the “rules” created in one cycle may be pure poison in the next one.

Also, absent war on your home soil, pestilence, plague and rampant socialism on a greater level than what Western Europe has seen, equity markets are pretty resilient.? Fisher’s native optimism has served him well in his lifetime.? There are few pessimistic millionaires.

That leads his asset allocation advice to be more geared to stocks, and more than the norm to foreign stocks.? (Which is good so long as the rule of law is maintained.)

In general, Fisher has written a very good book here.? The points are made briefly in an average of four pages each.? For those that want a quick introduction to the many fallacies on Wall Street, this book will do an excellent job.? After that, you can look to other books to fill in the details.

Quibbles

In Chapter 15, he mistakes immediate annuities for fixed annuities.? Immediate annuities are annuities that are paying out now.? Fixed annuities are those that pay interest, whether they are immediate or deferred (not paying out now).

In Chapter 16, he talks about Equity Indexed Annuities.? He misses several things:

1) Growth is more typically guaranteed at 2-3%, not 6%.

2) He misses Asian design contracts, which offer higher participation in exchange for having the option pay out on average returns over a year.? People don’t get what they are giving up there, but it looks better to them.

3) The surrender charges are higher and longer than they are for other deferred annuity designs.

There are other details that I think he mangles, but in his main thrust he is correct in both chapters to steer people away from any annuity aside from immediate annuities for those who need income.? Anything the insurance company can do with annuities, you can do, and cheaper.

But if Mr. Fisher wants to write about life insurance products more, maybe he would like to get a life actuary on staff, or at least someone with the LOMA credential.

Aside from that, Mr. Fisher should read “This Time is Different” by Reinhart and Rogoff.? Government deficit levels are not a thing of indifference, though they will affect stocks less than long bonds.

My penultimate quibble is that many common sayings are true within limits.? The limits imply broader models that might be discovered by multivariate regression.? There is little of that in the book.

Finally, the rule should be sell in April, buy in October.? More at my blog, I have an article to write.

Who would benefit from this book:

Ordinary people who don’t have a lot of time to consider each issue would benefit from this book.? They get a broad amount of protection from a single book.? The lessons come quickly, and immunize investors against a lot of investing mistakes.

If you want to, you can buy it here: Debunkery: Learn It, Do It, and Profit from It-Seeing Through Wall Street’s Money-Killing Myths.

Full disclosure: I asked the publisher for this book, and they sent it to me.? I read and review ~80% of the books sent to me, but I never promise a review, or a? favorable review.

If you enter Amazon through my site, and you buy anything, 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.

Impossible Dream Project, Part 1

Posted on 21 May 201122 May 2011 by David Merkel

When I start a hard project, I take out a blank piece of paper, and I write out the question, or desired goal, and start writing down what I know about the question.? The question that has been posed to me by many investors (in many different ways) boils down to: how can I be out of the markets when markets offer less potential return, and in when they offer more potential return?? Other names for this: Tactical Asset Allocation, or Market Timing.

This question comes while the markets are regarded by many but not all to be high.? Since I am trying to manage as business that had as its initial concept managing long-only stock portfolios, this perception creates a headwind.

So what did I think of as factors as I approached this?? The first thing that came to mind was the credit cycle.? Recall my stylized version of the credit/equity cycle from last time:

After a washout, valuations are low and momentum is lousy.? People/Institutions are scared to death of equities and any instruments with credit exposure.? Only rebalancers and deep value players are buying here.? There might even be some sales from leveraged players forced by regulators, margin desks, or ?Risk control? desks.? Liquidity is at a premium.
But eventually momentum flattens, and yield spreads for the survivors begin to tighten.? Equities may have rallied some, but the move is widely disbelieved.? This is usually a good time to buy; even if you do get faked out, and momentum takes another leg down, valuation levels are pretty good, so the net isn?t far below you.
Slowly, but persistently the equity market rallies.? Momentum is strong.? The credit markets are quicker, with spreads tightening to normal-ish levels.? Bit-by-bit valuations rise until the markets are fairly valued.
Momentum remains strong.? Credit spreads are tight. Valuations are high, and most value-type players have reduced their exposures.? Liquidity is cheap, and only rebalancers are selling. ?(This is where we are now.)
The market continues to rise, but before the peak, momentum flattens, and the market meanders.? Credit spreads remain tight, but are edgy, and maybe a little volatile.? This is usually a good time to sell.? Remember, tops are often a process.
Cash flow proves insufficient to cover the debt at some institution or set of institutions, and defaults ensue.? Some think that the problem is an isolated one, but search begins for where there is additional weakness.? Credit spreads widen, momentum is lousy, and valuations fall to normal-ish levels.
The true size of the crisis is revealed, defaults mount, valuations are low, credit spreads are high.? A few institutions and investors fail who you wouldn?t have expected.? Momentum is lousy.? We are back to part 1 of the cycle.? Remember, bottoms are often an event.

The transition from phase 5 to phase 6 is the key, as is recognizing when we are in phase 1/7.? What metrics could be useful?

Credit spreads, implied volatility, actual volatility
Direction of credit spreads
Earnings yields or P/E, and variations thereon.
Earnings yields less yields on Baa bonds
Momentum of prices, and variations thereon.
Momentum of earnings, and variations thereon.

I did a variety of experiments using the same data set as before, melding the Moody?s Bond yields with Robert Shiller?s S&P 500 data.? Before the experiments started, my expectation was that the final result would be a combination of a valuation factor and a momentum factor, with other factors playing lesser roles.? I wasn?t disappointed.

Preliminaries

Since 1871, the price of the S&P 500 has risen at a rate of 5.17% annualized.? This doesn?t include dividends, which would add another 3.61%, which sums to an 8.78% annualized total return.? Yes, dividends have added that much in the past.? Now consider how earnings have done over the same period:

Earnings grow at a 4.87% annualized rate, very similar to the rate of price increase, but over 130 years, it results in a rise in the P/E of 45% in terms of the trend.? Interest rates are lower now, so that may explain it.

The logarithmic graphs accentuate the panic and euphoria as it was felt at the time.? Distances up and down measure percentage changes.? Doing the graphs in multiples of two makes it easy to see each series as it doubles.

The two graphs look very similar ? makes one remember Peter Lynch?s comment ?Earnings drive the market.?? It would be tempting to create an indicator out of the amount above or below the trend line, but no one could see the trend line in the past, and a series of shorter trendlines would likely prove deceptive.? Mean reversion tends to play at longer periods.

Regarding Double Factor Quintile Analysis (as I do it)

Doing an analysis of quintiles using two factors creates a five-by-five grid.? More often than not, the two factors are somewhat correlated.? The easy way is see is which diagonal is more populated:

Northwest to Southeast (negative)
Southwest to Northeast (positive)

Because individual cells are statistically insignificant, creating larger groups can help solidify the aggregate effects.? Adding more cells to off-diagonal groups can lead to statistically significant groups that help tell a story of what is going on.

Averages along the horizontal and vertical are useful for telling how an individual factor performs, but what is more valuable is when we see performance improve diagonally, because it shows how the two factors interact.

On to the Factors ? Bonds

Horizontal factor: Yield on Baa bonds ? Hypothesis: When yields are high, stock valuations tend to be low.

Vertical factor: spread of Baa bond yields over Aaa bond yields ? Hypothesis: When spreads are high, stock valuations tend to be low.

The variable being analyzed is the return of the S&P 500 over the next month, including dividends.? This is the same for all the analyses that follow.

Analysis: This was surprising.? Neither seemed to have a significant impact.? Spread had no discernible impact on returns, and the Baa yield effect was nonlinear, almost like a smile ? highest and lowest do best , with the middle doing less well.

The diagonal effects are weird, the market does the best when yields and spreads are high or when yields and spreads are low.? When there are high spreads and low yields (like now), or low spreads and high yields, the market doesn?t do so well.? That may be the market?s way of saying that we like normal-ish bond markets, and that we don?t like times when Treasury yields are too low or too high.

I take that conclusion with a grain of salt, but it seems more reasonable than my initial hypotheses.? I don?t think I would manage money off that conclusion.

Earnings Momentum

Horizontal factor: Percentage that earnings are over/under their 10-month moving average ? Hypothesis: The faster earnings rise, the faster the market rises.

Vertical factor: Percentage that earnings have risen over the last 10 months ? Hypothesis: The faster earnings rise, the faster the market rises.

Analysis: These variables are highly correlated, so the NW-SE diagonal is packed.? But leaving aside that the market doesn?t do too well in the first quintile of either, these variables don?t discriminate too well.? Being in the fifth quintile for both measures may be a good sign for performance, but I would not put too much confidence in that.? Of my five ?groups? the difference from best to worst is small.

Price Momentum

Horizontal factor: Percentage that stock prices are over/under their 10-month moving average ? Hypothesis: The faster prices rise, the faster the market will rise.

Vertical factor: Percentage that stock prices have risen over the last 10 months ? Hypothesis: The faster prices rise, the faster the market will rise.

Analysis: These variables are highly correlated, so the NW-SE diagonal is packed.? But that leaving aside, both of these variables discriminate well, and they seem to work well together.? Strong price momentum tends to produce strong markets in the short run.

CAPE10 and CAPE Tri-5

Horizontal factor: Dr. Shiller?s Cyclically Adjusted P/E (Ten year average earnings divided by price) Hypothesis: The higher the CAPE10 earnings yield, the faster the market will rise.

Vertical factor: My Cyclically Adjusted P/E (Five year trailing triangular average earnings divided by price) Hypothesis: The higher the CAPE Tri-5 earnings yield, the faster the market will rise.

Analysis: These variables are highly correlated, so the NW-SE diagonal is packed.? But that leaving aside, both of these variables discriminate well, but the CAPE10 is better.? CAPE Tri-5 was an effort to put more weight on present earnings, with progressively less weight until we are five years in the past, as a kind of compromise between CAPE10 and current P/E.? Current P/E should work well, but doesn?t.? CAPE10 gives a lot more weight to the past, implicitly assuming mean-reversion.? Much as I was not crazy about CAPE10 in the past, I think it is a keeper.? But what it implies is that average people who look at the current P/E for guidance on the market are looking at a measure that is influenced too heavily by near-term expectations for a long term asset.

CAPE10 and CAPE10 Risk Premium

Horizontal factor: Dr. Shiller?s Cyclically Adjusted P/E (Ten year average earnings divided by price) less the Baa bond yield.? Hypothesis: The higher the CAPE10 risk premium over bonds, the faster the market will rise.

Vertical factor: Dr. Shiller?s Cyclically Adjusted P/E (Ten year average earnings divided by price) Hypothesis: The higher the CAPE10 earnings yield, the faster the market will rise.

Analysis: These variables are highly correlated, so the NW-SE diagonal is packed.? But that leaving aside, CAPE10 discriminates well, while the risk premium variable displays a smile as it did in the bond test.? The market has done best when Baa yields have been high or low.

That said, the risk premium factor shows that the largest gains tend to come in the southwest quadrant: low equity valuations and high Baa bond yields, which is a perfect set-up for mean reversion.? It?s a pity that we are in the opposite quadrant now.

Valuation Plus Momentum ? The Impossible Dream?

Horizontal factor: Percentage that stock prices are over/under their 10-month moving average ? Hypothesis: The faster prices rise, the faster the market will rise.

Vertical factor: Dr. Shiller?s Cyclically Adjusted P/E (Ten year average earnings divided by price) Hypothesis: The higher the CAPE10 earnings yield, the faster the market will rise.

Analysis: These two factors are slightly negatively correlated.? Thus, NW-SE are triangles, while SW-NE are squares, unlike the other analyses.? But for practical purposes, they are uncorrelated, which is shown by the relatively even count of cells in the five-by-five grid.

In general, returns get better heading Southeast.? The best expected market returns come from cheap valuations and strong momentum.? Second best is high valuations and strong momentum.

Now, I didn?t do this for the others, but how volatile are the returns by quintile?? The standard deviation of returns is highest for cheap valuations and negative momentum.? For the most part, volatility drops as the market heads northeast, though once you are out of the ?L? that makes up the bottom and left of the grid, it doesn?t improve much.? Credit market volatility is highest in the ?L.?? It also highlights the uncertainty that happens when valuations are low, regardless of momentum.

Transition Probabilities

	Momentum	Valuation
Down 4	0.03%
Down 3	0.07%
Down 2	1.87%
Down 1	17.59%	5.93%
Same	61.58%	88.08%
Up 1	16.71%	5.99%
Up 2	2.02%
Up 3	0.07%
Up 4	0.05%

But one might ask, when in a given cell, how likely is it to shift to another cell the next month?? Valuation moves a lot less than Momentum ? Valuation never moves by more than one quintile in a month, and the odds of moving up or down one quintile are around 6%.? 96% of the time Momentum moves one quintile or stays the same.? It only moves three or four quintiles 0.22% of the time.? That?s about once every 37 years or so.

Statistically, there is a slight correlation in the movements of valuation and momentum.? When momentum is positive for a while, valuations get higher, and when momentum is negative for a while, valuations get lower.? But this effect is so small that it is not statistically significant, as seen in the table below.

This portrays graphically how jumps between cells happen.? Pity I could not create thicker lines for higher occurrences.? Note how the big momentum jumps happen in the cheap valuation quintile.

So What?s It All Worth?

It?s potentially worth a lot.? Look at this return graph:

The logarithmic scale makes it look small, but the strategy trounces the stock market over the last 130 years.? Wait, strategy, what strategy?

First and second quartiles for stock momentum: own bonds.

Fourth and fifth quartiles for stock momentum: own stocks.

Third quartile for stock momentum: own stocks, unless in the first quartile for valuation (expensive) own bonds.

Here are the stats:

	Bonds	Stocks	Strategy
Return	4.67%	8.78%	10.79%
Std. Dev.	4.30%	14.50%	9.39%

That is two percent over stocks with more than five percent less volatility.? Quite a performance.? Now ask me, what are the limitations?

Limitations

1)? Some of these strategies were known already, and may indicate data-mining.? Yes, CAPE10 came from Shiller, and the ten month moving average of prices came from Mebane Faber.?? But no one put them together before, at least, no one that I know of.

2) This is just a backtest; you wedged this result. I used the ideas of two bright guys, Faber, and Shiller ? I did not use any sort of advanced technique ? quintiles are ancient.? My ability to finagle matters was constrained.?? All that said, all illustrated returns deserve distrust ? there are too many ways to make the results come out in a way favorable for the investment advisor.

I made two passes on the data.? One to find the momentum indicator, and one for valuation.? Aside from that, I did little to ?optimize? the strategy.

3) Transaction costs would eat up some of the returns.? So would taxes.

Final notes

1) Though I think it could be applied more broadly than to just the S&P 500, valuation-based investors can do better by:

buying once momentum flattens after a bust
waiting for momentum to flatten after a rally
being willing to exit the market even when valuations look good if momentum heads south
enter if momentum is strong, even if valuation doesn?t seem compelling.

2) If this is such a great strategy, why would I reveal it?? One thing I learned as a professional bond and equity investor is that few people and firms are willing to change their ways.? Value investors will not do this.? Trend-followers will not pay attention to valuation.? Tactical asset allocators will find it thin gruel.? So, I?m not concerned about a large amount of money in the market doing this.

3) For clients that want a tactical approach that enters and exits the stock market, this is how I will do it.? But will I use it for my account?? Maybe a little.? But I?ve been good industry and stock picker over time, and I don?t care about volatility so much.? Buffett said something to the effect of ?I?d rather have a bumpy 15% than a smooth 12%.?? I agree, so, though I might hedge my taxable account on occasion, I will likely remain long only, trying to scoop up bargains when momentum is negative; it has worked in the past for me.? That?s where I have gotten some of my biggest winners.? And if I won?t likely use it, that may be the greatest reason for not worrying about publishing this.

4) If I were to augment this, I would add in something on bond yields; there is something significant going on there, but I?m not sure how I would use it.

AAII Baltimore Meeting

Posted on 14 May 201115 May 2011 by David Merkel

I was an amateur investor before I was a professional investor, and so long ago I joined AAII.? My mom was a member, and eventually I bought a life membership.? I still send them money once a year to keep my stock screener fresh.

The last time that I attended an AAII local function was in Philadelphia 15 years ago when John Neff came to speak, and there were 1000+ people there.? Well, today there were 32 people to listen to the Chief Economist of a major asset manager in Baltimore.? Of the listeners, I think I was the second youngest in the room.? I estimated the average age of the listeners to be in the high 60s.? Very few women.

I found myself disagreeing more than agreeing with the economist.? It was a very “Wall Street” “Consensus” view.?? Things are getting better, ignore the negative data. Equity valuations are reasonable.? So long as real GDP has positive momentum, everything will be okay.

But what really gored the listeners was the idea that inflation was under control.? These people might be well-off, but they said food and energy prices have risen distinctly, and “core” inflation does not reflect their situation.? The speaker repeatedly made excuses for why inflation was temporarily high in both areas.? “Bad harvests,” “Speculation on energy through ETFs,”? etc.

He placed a lot of stock in the idea that reducing position limits for ETFs at the futures exchanges would bring down energy prices (a result of Dodd-Frank).? I’m still thinking about that one — if it happens, the large ETFs would have to replace front month positions with later positions, and maybe with swaps, where counterparties would hedge with futures.? On net, it might lessen backwardation, and lead to better management of the ETFs because they don’t ride the front month, but forcing the ETFs off the exchange seems dumb — it will just lead to another level of intermediation and expense.

The speaker did not get the idea that the replacement cost for a barrel of oil has risen significantly (also true for ounces of gold and other commodities).? He also felt a few simple “actuarial tweaks” would get Medicare on track.? Those “tweaks” are benefit decreases by another name, and if you listen to the loony left on the topic, they howl at every one — raising ages, means-testing, limiting benefits, etc.? Reasonable ideas all, but they will be roundly opposed.

Another concern of the listeners was the lack of safe opportunities to earn income.? As an economist, he was able to beg off, saying that he wasn’t a bond expert, but that he personally liked dividend-paying common stocks.? Again, a consensus opinion, and one that I have some sympathy for now, but dividend paying common stocks are a lot more risky in the short run than the long run.? If you went back five years ago, banks would made up a decent chunk of such a portfolio — guess what happened?? There might be another sector in the future that runs into dividend stress as a result of economic change.

He added that holding bonds to maturity would be an important strategy in the future as interest rates rise.? I found this to be ridiculous.? If rates rise, and your bonds are under par, it can be advantageous to sell bonds at a loss and reinvest in more promising bonds at higher yields, or even move to money markets, should monetary policy ever normalize.

Another concern of the listeners was the sustainability of government policy, and the speaker agreed in principle, but showed a dated graph from the CBO that showed that the problem was tractable.? He felt that deficits needed to be dealt with soon, but that loose monetary policy should continue.? Reduce the borrowing from the future fiscally, but continue it monetarily.

I found the talk unsatisfying, and afterward, I ended up having a dispute with him over mark-to-market accounting — shallow people think that it was a significant cause of the crisis, rather than MTM accounting revealing liquidity and cashflow mismatches.? Those with (expensive) long-dated, noncallable funding did not suffer during the crisis.? Only speculators with short-dated funding holding illiquid assets suffered, and they should suffer, because they relied on the idea that financing will always be available on favorable terms, and that is a profitable idea in the short-run, but deadly in the long-run.? My own ideas for bank reform would cause banks investing in assets that they can’t value to fund them with equity, or debt that lasts past the maturity of the asset.? No borrowing short and lending long — that is what leads to liquidity crises.

Quality of Investor Education

I haven’t gone to AAII local meetings for the most part because of speaker quality.? I am reconsidering that idea because I had a good talk with the vice-chair after the meeting.? He said it would be valuable to perhaps have meetings where the group could share ideas, because often speakers don’t leave any practical ideas behind.? I’m wondering what good I could do for local investors. (The same way I try to do so here — this is pro bono, even if I earn a little off of ads and book reviews.)

I am also wondering if it would be smart to have a joint Baltimore CFA Society- Baltimore AAII meeting where we could have panels attempting to understand and develop financial solutions for those frustrated by the current market environment.? My heart goes out to the average investor.? That’s a main reason I write this blog — to give something back.? The solutions aren’t easy, but unless you try, you’ll miss 100% of the shots you don’t take, as Gretzky would say.

Inflation Speculation

Posted on 13 May 2011 by David Merkel

When currencies do not serve as a long-term store of value, economic actors search for ways to preserve future purchasing power, which often mean purchasing commodities. But most commodities are not cheaply storable over long periods, so actors get forced into the few that do: gold, silver, etc. There is a problem here, stemming from dumb money. When dumb money shows up for purchase of generic “commodities” distortions follow: backwardation, large storage demand, and warped market incentives.

Eventually overproduction catches up, but the volatility when it breaks can be huge and self-reinforcing, with c0unterparties raising margin to protect themselves.? Extreme volatility causes exchanges to raise margin requirements substantially, which reveals which side of the trade is inadequately financed, which typically is the side that was winning, which leads to a reversal in price action.? The dumb money is revealed.

Now after a washout, the dumb money often assumes that powerful entrenched interests colluded against them to deny them their long-deserved free ride to prosperity through speculation.? The exchanges are in cahoots with the other side.? Well, no, the exchanges have two interests, which are solvency and transaction volume, which drives their profits.? Solvency is a more primary goal for an exchange, because the second goal can’t exist without it, and exchanges are not thickly capitalized.

Many different types of financial systems are subject to these risks.? Think of AIG: they were rendered insolvent by rising margin requirements as their creditworthiness was downgraded, largely because the rating agencies concluded they were going to lose a lot of money off of their many bets on subprime residential credit.? Think of all of the mortgage REITs that got killed as repo haircuts rose on all manner of mortgage-backed securities at the time that values for the securities were depressed.? Alternatively, think of Buffett, who entered into derivative trades where he received money and bore the risk, but his agreements limited the margin that he would have to post.

Commodity-linked exchange traded products serve four functions:

Allow sponsoring financial institutions to get cheap financing through exchange traded notes.
Allow sponsoring financial institutions to inexpensively hedge their commodity risks.
Allow commodity producers to have cheap financing of their inventories via backwardation.? (And indirectly allow more clever speculators to earn extra profits from gaming the rolling of futures contracts.)
Allow retail speculators who cannot access the futures market to make or lose money.? Scratch? that, that should probably read “lose money in aggregate.”

Wall Street does not exist to do small investors/speculators a favor.? It exists to make money off of the issuance of securities, and their trading in secondary markets.

As Buffett put it, “What the wise man does in the beginning, the fool does in the end.”? Yes, there is monetary debasement going on.? We should expect gold, crude oil, and other commodity prices to rise to reflect that.? But rises can overshoot, particularly in smaller markets like gasoline and silver.

So in answer to the question, “Which came first ? the margin call or the commodities mayhem?” my answer is simple: The cause of the bust is found in the boom, not in the bust.? The boom happened because of loose monetary policy, which led many people to adjust their risk posture up, whether in commodity speculation, or in high yield debts.? (Oh wait, there are ETFs for that now too.)? Eventually self-reinforcing booms have self-reinforcing busts.? The elites think they can tame this, but they can’t, because you can’t change human nature, which means you can’t change the boom-bust cycle.

James Grant, at a recent meeting of the Baltimore CFA Society said that we had exchanged a “gold standard” for “Ph. D. economist standard.”? And indeed, the value of our currency is manipulated by that intellectual monoculture at the Fed, who pass Einstein’s test of insanity: doing the same thing over and over again and expecting different results.? I say that because the Fed thinks that it can produce prosperity by reducing interest rates.? All that their policy does is produce an asset bubble, or price inflation in goods and services.

The Fed drove us into this liquidity trap through increasing application of an easy money policy.? It will take different ideas and different people, and a lot of pain to get us out, because the Fed is blinded by their bankrupt theories.

Book Review: How To Smell a Rat

Posted on 11 May 2011 by David Merkel

I have written reviews on two Madoff books, No one Would Listen, and The Club No One Wanted To Join.? In the latter of those book reviews, I argued that the Madoff fraud was detectable in advance, which offended one who was defrauded by Madoff.? Ken Fisher lays the blame at her door; she should have been able to see it coming.

Look, I sympathize with her loss, but there are basic rules that are common sense for any investment where discretion is given to a money manager.? I am such a money manager, but I consider it a benefit to me and my clients that I have no ability to touch their funds.? The third-party custodian takes care of that.

Imagine playing a game — before we enter the game, both teams want to know that the umpires will be neutral.? So it is in investment management — we need neutral custodians to assure fairness between investment advisors and clients.

Ken Fisher manages ten thousand times more money than I do.? But he is aware of the many ways that people get skinned by fraudsters.? The leading way is to get investors to give the investment advisor both discretion and custody over the assets.? That opens the door for unscrupulous advisors to misappropriate assets.

This is critical.? Don’t entrust your assets to an advisor without a neutral third party providing custody.? This is more than normal — it should be expected.

There are four other lesser signs of fraud:

Returns are too good to be true — volatility that is too low, or returns that are too high.
Not being able to understand what is going on as the money is invested.
Being blinded by the trappings of wealth.
Trusting the opinions of others, rather than doing your own due diligence.

You have to understand that there are no magic bullets, and those who have great past returns should be willing to undergo extra due diligence, because great returns are rare, and need extra due diligence to prove that they are valid.

Beyond that, don’t be greedy or credulous.? Ignore wealth, and do your own due diligence — the book provides a good outline for doing so.? And unless you are so wealthy that you hire someone else? to hire your asset managers, don’t hire any manager whose processes you don’t understand.

These are basic rules that all investors should heed.? Enough said.

Quibbles

None.

Who would benefit from this book:

Most average investors would benefit from this book, because they are the ones who get targeted for fraud — not that all of them will be defrauded, but all of them need the warning, so that they can be prepared against those who defraud.? I wish I had read this when I was 25.

If you want to, you can buy it here:?How to Smell a Rat: The Five Signs of Financial Fraud (Fisher Investments Series).

Full disclosure: I asked the publisher for this book, and they sent it to me.? I read and review ~80% of the books sent to me, but I never promise a review, or a? favorable review.