Personal Finance – Page 25

Surviving a Bad Quarter Well

Posted on 1 July 2010 by David Merkel

To my readers: I am still in the process of blog repair.? I have heard from a few readers that I need larger type and more contrast.? I will fix that.? For now, use Ctrl-+ to expand the font.? I don’t want any of you going blind over me. 😉

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Onto tonight’s topic: asset allocation.? So, we had a bad quarter for equities.? Not that I can predict things, but I pulled in my horns progressively over the last nine months, culminating in buying a bunch of utilities at the last portfolio reshaping.? I own mostly energy, insurance, utilities, and consumer nondurables stocks, with a little tech thrown in for fun.? At present, median P/E is around 9, and P/B around 90%, with strong balance sheets, and around 17% of the portfolio in cash.? I missed roughly half of the carnage of the last quarter, and this week, I put some money to work, cash falling by 1%.

So, when are equities cheap?? Next question: cheap relative to what?? It’s difficult to say when equities are absolutely cheap, but here are some ideas on cheapness:

Stocks are absolutely cheap when they trade in aggregate at less than book value, or less than 8x trailing earnings.? Think of Buffett getting excited back in 1974.
Stocks are relatively cheap to Baa bonds when the earnings yield of stocks plus 3.9% is above the yield on Baa bonds.? But this at present depends on very high profit margins continuing, and sales not shrinking, neither of which are guaranteed.
When there is significant debt deflation going on, determining cheapness is tough.? Better to ignore the market as a whole, and focus on survivability/cheapness.? Aim at companies in necessary industries with relatively little debt, strong accounting practices, and cheap to earnings/book/sales.
I don’t have a good metric for when equities are cheap/dear to commodities.? Ideas welcome.

With respect to bonds, credit spreads are not wide enough to make me yell buy, as I did in November 2008 and March 2009.? Beyond that, the spread on GSE debt and guaranteed mortgages is thin.? TIPS look attractive, as few care about inflation.? The US dollar has been strong lately, largely due to weakness in the Euro.? I would be light on non-dollar bonds for now.

What we have been experiencing is creeping illiquidity, where the prior stimulus from the Fed and US Government has been declining.? There isn’t enough private demand growth to drive the economy, because we need to pay off or compromise on debts.? Also, the private sector looks at the growing debts of the government, and gets concerned.? How will the government deal with it?? Higher taxes, inflation, default?? No good scenarios there.

When an economy is overleveraged, there are no good solutions.? If sales fall, then corporations will fire more people, and idle more capacity in order to maintain profits near prior levels.? High quality bonds do well, but stocks do poorly, until enough debts are paid of or compromised, and the economy can work without the fear of mass insolvency again.

I have written before on a new approach to asset allocation.? Broadly, I am looking at a system that:

Considers the credit cycle first.? Great returns typically happen after credit spreads are wide, and are lousy after they are tight.
Considers the slopes of the Treasury nominal and TIPS curves.
Looks at the cash flow yield of all asset classes relative to history, relative to other asset class yields, etc.
Factors in safety provisions for each asset class.? Stocks need the most, then junk bonds, then investment grade.
Looks at the short-run and the long-haul returns of each asset class, attempting to analyze when the short run is way above or far below long-haul trends.

At present, I am still happy playing conservative, because I am less confident about debt deflation than most investors are now.? There will come a time to be much more bullish, but it will come after earnings decline, and firms have delevered still further.

How I Minimize Taxes on my Stock Investing

Posted on 14 May 201014 May 2010 by David Merkel

One thing that I do differently than most investors is the concept of rebalancing.? I buy and sell positions to maintain their weights in the portfolio, within a 20% band around the intended weight.? As I wrote about it at RealMoney:

The two smaller purchases were done for a different reason than the other trades. I already owned Petrobras (PBR:NYSE) and Dycom (DY:NYSE) , but both had been performing badly. Their weight had shrunk to be the smallest in my portfolio. After a review of their fundamentals, I did what I call a rebalancing trade.

When I interviewed fund managers, I would often ask how they would rebalance positions in response to market movements. Many of them would do nothing; others had no fixed strategy. However, three of them had really worked on refining their strategies, and to my surprise, their outcomes were similar — even though other aspects of their styles were different. One was value, one was growth, one was core, but they each had evidence that their approach improved their returns by a few percent per year. That caught my attention.

One cost of trading comes from whether a trade demands or supplies liquidity to the market. When a trader posts a limit order, he or she offers other market participants an option to exchange shares for liquidity at a known price. In offering liquidity, the trader hopes to get an execution at a favorable price.

The approach that the three managers use — and that I employ in my personal account — is as follows:

Define a series of fixed weights for the stocks in the portfolio.
Do a rebalancing trade when any position gets more than 20% away from its target weight. The 20% figure is arbitrary, but I think it strikes a balance between excessive trading and capturing reasonable trading profits by providing shares and liquidity to the market when it wants them.
Use this time as an opportunity to re-evaluate the thesis on the stock. If the thesis is no longer valid, exit the position and buy something that you like better.
If the rebalancing trade generates cash, invest the cash in the stocks that are the most below their target weights, to bring them up to target weight.
If the rebalancing trade requires cash, generate the cash from selling stocks that are the most above their target weights, to bring them down to target weight.

This discipline forces you to buy low and sell high and to re-evaluate your holdings after significant relative market movement. This method works best with companies that possess low total leverage relative to others in their industries. This helps avoid the problem of averaging down to a huge loss.

It also works best for diversified portfolios with 20 to 50 stocks, with reasonably even weights. In my portfolio, the weights range from 3% to 7%, with 33 companies altogether.

The incremental profits add up as companies and industries fall in and out of favor, and the rebalancing system buys low and sells high.

Now, one aspect of this that I did not write about at RealMoney is that it saves on taxes.? In a very volatile market, like we have had over the last three years, and that we had 2000-2004, there were a lot of opportunities to buy low.? Now for someone like me, who runs with 30+ positions, a sharp move down and up feels like this:

At the start of the move down, I have realized and unrealized capital gains.
As the move down proceeds, I have realized gains but no unrealized capital gains.? I have redeployed? money into defensive industries, or, at least stocks that are undervalued.
Further into the move down, I have no realized gains and and I have unrealized capital losses.? I am still redeploying money into defensive and cheap investments.
Still further into the move down, I have realized losses and and I have large unrealized capital losses.? At this point I should be moving into economically sensitive names, and add cyclicality.
I may have to do that twice, or even three times, but eventually a bottom comes.
As the move up begins, I have realized losses and unrealized capital losses.? As I sell stocks to reinvest in better companies, I sell stable names to buy cyclical ones.? As stocks hit my upper rebalancing points, I sell high tax cost lots, and hold onto the low tax cost lots.? My realized losses grow.
As the move up continues, I have realized losses and no unrealized capital losses.? I continue to sell high tax cost lots of companies that have hit my rebalancing points.
Further into the move up, I have no realized losses, and unrealized capital gains.? My rebalancing and other sales are now creating small gains.
Still further into the move up, I have realized gains and large unrealized capital gains.? I then look for my largest unrealized long-term capital gains in stocks that I would like to sell, and donate them to charity.? Fidelity Investments makes that very easy.? After the year end, I repeat that process.? The advantage is that I don’t get taxed on the capital gain, and I get a full tax deduction on the market value of stock donated.

I do almost all of my charitable giving via appreciated stock.? It works well.? Given the volatility of the markets, for those that have a diversified portfolio, and a dedicated reason to give to charity, it is a free lunch.? I marvel each? year at the ways that I eliminate capital gains, while still managing to make good money in stocks over the long haul.

Book Review: Who Can You Trust With Your Money?

Posted on 8 May 201012 February 2011 by David Merkel

The author of this book has been through the ringer.? As one who advised people to be careful in their investing, she found that her husband had been stealing from his investment clients.? Shades of Madoff and his sons.

She uses her ex-husband as an example of what to avoid in investment advisors, and adds in data from the Madoff scandal.? She then moves on to be more generic in what investors have to look for in order to avoid being cheated.

The book moves on to explain financial planning, and understand:

Certifications
Compensation and Fee Structures
Formal Communications
All the parties that affect pooled investments
How to choose an advisor
Red flags
How to employ an advisor
How to maintain the relationship
How to deal with minor and major failure in the advisor relationship.

She covers all of it.? It is very basic, and not flashy.? The juiciest part of the book is the troubles she had with her ex-husband.? The rest is all business, which isn’t bad, but it could have benefited from counterexamples to explain why this is the right way to do things.

Quibbles

The book has an exciting start, and it is all business after that.? That is not horrible, but could have been more done to motivate the important aspects of protecting investments through citing more case examples.

If you want to buy the book, you can buy it here:? Who Can You Trust With Your Money?: Get the Help You Need Now and Avoid Dishonest Advisors

Who would benefit from this book

Most average investors could benefit from the book.

Full disclosure: This book arrived in my mailbox; to the best of my knowledge, I never requested a copy.

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.

Book Review: Higher Returns from Safe Investments

Posted on 5 May 20105 May 2010 by David Merkel

This book gets a mixed review from me.? If I were reviewing it 14 months ago, when everything was in chaos, I would have given it a better review.? There are time to take credit risk, and times not to.? There are times to extend maturity, and times not to.? There are times to seek inflation protection, and times not to.? There are times to invest abroad, and times not to.

This book takes a view of income investing that is correct for average credit markets, for the most part.? But average credit markets rarely exist.? Few investors possess the fortitude to go through the nadir of the credit cycle, and ride it into the next cycle.

With high yield, he offers a simple stop-loss strategy.? Good.? But he should offer something similar on preferred stocks and dividend-paying common stocks, which are riskier than high yield bonds.

The chapter on writing covered calls is simplistic, but the truth is that most of us are simplistic with covered calls — we look for free yield, and often gain losses greater than the income received.

The book gives simple and reasonable descriptions of various bond types, and other income oriented assets.? In general, it understands the relative riskiness of all of them, with exceptions noted above.

The title is a great title, but I would have loved to have seen a different book that would have taught people to analyze yield spreads, and getting people to think when there is enough compensation for the risk involved, and when there is not.

If you want to buy the book, you can buy it here: Higher Returns from Safe Investments: Using Bonds, Stocks, and Options to Generate Lifetime Income

Who would benefit from this book

If you don’t understand income investments, this book could be useful to you, and the book is not long.? It is an easy read.? In general I don’t agree with the way the book is designed, but if you have a lot of self-discipline, the book will prove useful to you.

Full disclosure: I said I would review the book, and his publisher sent me a copy for free.

The Rules, Part XII

Posted on 30 April 201020 June 2017 by David Merkel

Growth in total factor outputs must equal the growth in payment to inputs.? The equity market cannot forever outgrow the real economy.

This is the “real economy rule,” and was listed first in my document, but i have not gotten to it until now.? It is very important to remember, because men are tempted to forget that financial markets depend on the real economy.? If the global economy grows at a 3% rate, well guess what?? In the long run, payments to the factors — wages, interest, rents, and profits will also grow at a 3% rate.? Maybe some of the factor payments will grow faster, slower, or even shrink, but you can’t get more out of the system than the system produces year by year.

The value of equity is the capitalized value of the profit stream.
The value of debt is the capitalized value of the interest stream.
The value of property, plant and equipment is the capitalized value of the rent stream.
The value of a slave/employee is the capitalized value of the wage stream.

Hmm, that last one doesn’t sound right.? We no longer capitalize people, as if one could legally own a person today.? Contracts for labor are short-term, and employees typically can leave at will.

But, there can be bubbles in property, debt and equity markets.? We just happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three.? Think of late 2006 — high values for residential and commercial real estate, low credit spreads, and high P/Es (relative to future profits).? Market participants expected far more growth than the overindebted economy could deliver.

Important here are the discount rates.? By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency.? It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining.? Similarly, it is one thing if stocks are rising because GDP is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record levels, as they are today.

Extreme profit margins invite competition.? Extreme profit margins tend not to last.

In many asset classes, investors were fooled.? Home buyers bought thinking the prices could only go up.? They ignored the high ratio of property value relative to what they would currently pay.? Commercial real estate investors bought at lower and lower debt service coverage ratios.? Collateralized debt investors accepted lower and lower interest spreads at higher and higher degrees of leverage.? With equity, investor assumed that growth in asset values in excess of growth in GDP would continue.? The stock market does grow faster than GDP, but the advantage is less than double GDP growth.

Thus after the long rally, with no appreciable growth in the economy, I would be careful about equities, and corporate debt as well.? Some yields are high relative to long run averages, but the risk is higher as well.

The main point is to remember that the real businesses behind the financial markets drive performance in the long haul, even if adjustments to the discount rate do it in the short run.? To be an excellent manager, focus on both factors — likely payments, and rate at which to discount.? But who can be so wise?

Don’t Buy Stocks on Margin, Unless you are an Expert

Posted on 17 April 2010 by David Merkel

Most academic economists are irrelevant, so we can ignore them.? The few that are relevant are worth noting.? They can write such that ordinary people can understand — think of Milton Friedman with his “Free to Choose.”? Such economists are viewed skeptically by the “profession” because they interact with the unwashed.

So it is with Ayres and Nalebuff.? I have rarely been impressed with what they write.? Like Freakonomics, they write about stuff that is sensational, and challenge the conventional wisdom.? Yo, the conventional wisdom is right most but not all of the time.? Anyone that focuses on where the conventional wisdom is wrong will commit a lot of errors in an effort to be novel.

Now, Abnormal Returns and Sentiment’s Edge have made their polite comments, but now it is time for my less polite comments. I have five main critiques of their paper, which stems from the lack of practical experience in the markets for these two professors.

1) History is an accident.? It is fortunate that they are analyzing the US, rather than nations whose markets got wiped out during a war.? It is not impossible that the US could face a similar crisis in its future.? Try the same analyses with Argentina or Peru.? Will it work?

2) Even in the US stocks don’t outperform bonds by that much.? My estimate of the equity premium is around 1%.? Yes, the economics profession says the equity premium is higher, but they use a wrong metric; they should use dollar-weighted returns, not time-weighted returns.? The estimate of 4% equity returns over margin rates, which are higher than bond yields, is hooey.

3) Average people aren’t capable of managing portfolios that are 100% equities, much less levered equities.? It is well known that people invested in equity funds tend to buy and sell at the wrong times.? It would be far worse with leveraged portfolios.

4) Leveraged ETFs tend to underperform over time, have you noticed?? This is a mathematical necessity.? Through options and swaps, which have larger bid-ask spreads, maintaining the leverage is at low cost is tough.? If the advantage over margin rates were true, there would be real advantages to leverage.

5) What if everyone did it?? The paper is a typical, “If you had done this in the past, you would have done a lot better.”? Duh, and I can do better versions of that than the authors.? Going back to point one, history is an accident, and cannot be relied on.? Point two, their math is wrong.? Point three, average people can’t implement it.? Point four, those who try to do this don’t do as well as you might expect.

The last point is that everyone can’t do this.? Can you imagine what would happen if everyone aged 25-41 suddenly invested into equity exposure equal to twice their assets?? Stock prices would shoot up, and would offer little future returns to holders.? Stocks aren’t magic, and over the very long haul, they tend to return what the GDP does plus a few percent.

Think of Alan Greenspan encouraging people to finance using ARMs at the worst time possible.? The authors here encourage young people to speculate on equities with leverage at a time when the market is somewhat overvalued.? If this were a good idea, you would have seen many people doing it already, and it is not a common practice.? Don’t listen to academics that have little practical experience for investment advice.

One final note: when I wrote at RealMoney, I took a contrarian view that for average investors, no one should be fully invested.? Even the great Ben Graham never exceeded 75% invested.? My view is that average people must limit their risks or they will not be able to sustain their investment plans.? A 50/50 or 60/40 balanced fund approach is best for the average person — they will never get scared enough to abandon it.

Leverage is for experts only, and I have never used leverage.? Only use leverage if you are more of an expert than me.? (I write this not out of pride, but out of my experience where so many have gotten burned by taking too much risk.)

Where to Invest, When Interest Rates are so Low

Posted on 17 March 2010 by David Merkel

Unlike most people who analyze investments, I think there are periods of time where domestic long-only investors may be consigned to low or even negative returns.? As investors, we are generally optimists; we don’t like can’t win situations like the Kobayashi Maru.

When money market funds offer near-zero yields, asset allocation becomes complicated.? Near the beginning of such a period, it might pay to take a lot of risk when credit spreads are wide.? But when they are more narrow, but wide by historic standards, the question is tough.

I start analyses like this the way I do the the piece Risks, not Risk.? I look at the individual risks and ask whether they are overpriced or underpriced.? Here is my current assessment:

Equities ? slightly undervalued at present, particularly high quality stocks.? (US and foreign)
Credit ? Investment grade credit and high yield are fairly valued at present.
Real Estate ? the future stream of mortgage payments that need to be made is high relative to the present value of properties.? There will be more defaults, both in commercial and residential.
Yield Curve ? Steep.? It is reasonable to lend long, so long as inflation does not take off.
Inflation ? Low, but future inflation is probably underestimated.
Foreign currency ? One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
Commodities ? the global economy is not running that hot now.? There will be pressures on resources in the future, but that seems to be a way off.
Volatility is underpriced ? most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

All that said, for retail investors, I am not crazy about the options at present.? I would leave more in money market funds than most would as a part of capital preservation.? I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates.

Beyond that, I would consider fixed income investments in the Canadian and Australian Dollars.? I am skittish about the US Dollar, Euro, Pound, Yen and Swiss Franc.? (The least of those worries is the US Dollar itself.)

We live in a world where risk is often not fairly rewarded at present, due to the liquidity trap that the major central banks have enter into.? My view here is to play it safe when conditions are not crazy bad, and take a lot of risk whe credit markets are in the tank.

As for now, I would hold high quality US stocks that pay dividends, US money market funds, and Canadian and Australian short term bond funds.? Commodities and companies that produce them should play a small role as well.

Equities ? somewhat overvalued at present.? (US and foreign)
Credit ? Investment grade credit is slightly overvalued, and high yield is overvalued.
Real Estate ? the future stream of mortgage payments that need to be made is high relative to the present value of properties.? There will be more defaults, both in commercial and residential.
Yield Curve ? Steep.? It is reasonable to lend long, so long as inflation does not take off.
Inflation ? Low, but future inflation is probably underestimated.
Foreign currency ? One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
Commodities ? the global economy is not running that hot now.? There will be pressures on resources in the future, but that seems to be a way off.
Volatility is underpriced ? most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

The Rules, Part I

Posted on 6 March 201019 June 2017 by David Merkel

Dear readers, I am now on Twitter — AlephBlog is my moniker if you want to follow me.

I have been somewhat reluctant to do this, but tonight’s post stems from a file on nonlinear dynamics on my computer that I developed between 1999 and 2003 for the most part.? Not so humbly, I called it “The Rules.”?? This is the first in a series of what will likely be long set of irregular posts about what I call “The Rules.”? Please understand that I don’t want to make grandiose claims here.? After all, as I once said to Cramer (yes, that one): “The rules work 70% of the time, the rules don’t work 25% of the time, and the opposite of the rules works 5% of the time.”

My best recent example of the rules not working was when the formulas of the quants were blowing up in August 2007.? There were too many quants following the same strategy, and they had overbid the stocks that their models loved, and oversold the ones that they hated.? For a while, the quant models were poison.? Every investment strategy has a limited carrying capacity, and those that exceed the strategy’s capacity are prone for a comeuppance.

Here is today’s rule: There is no net hedging in the market.? At the end of the day, the world is 100% net long with itself.? Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

There are many people, particularly dumb politicians, who think that derivatives are magic.? To them, derivatives create something out of nothing, and that something is strong enough to smash innocent companies/governments that have been behaving themselves, but have somehow found themselves caught in the crossfire.

First, if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.? You have the upper hand.? But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.? Even without derivatives, that is a tough place to be.

With derivatives, for every winner, there is a loser.? It is a zero-sum game.? Yes, as crises arise there are always those that look for a way to make money off of the crisis.? And there are some parties willing to risk that the crisis will not be so bad, at a price.? Derivatives don’t exist in a vacuum.? Same thing for shorting — there is a party that wins, and a party that loses.? So long as a hard locate is enforced, it is only a side bet that does not affect the company whose securities are being played with.

When there are troubles, it is because a company or government has overstretched its limits.? You can’t cheat an honest man (or country).? You can take advantage of countries and companies that have overreached on their balance sheets and cash flow statements.

Cash on the Sidelines, Market is Oversold/Overbought, Money is Moving into or out of…

Every bit of cash on the sidelines is matched by a short term debt obligation somewhere.? Now, that’s not totally neutral, as we learned in the money markets crises in the summers of 2007 and 2008.? If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.? It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.? CIT did die.? Mexico in 1994.? When you can’t roll over your short term debts, it gets really ugly, and fast.? Think of the way we messed up housing finance in the mid-2000s; one of the chief signs that we were in a bubble was that so much of it was being financed on floating rates, or contingent floating rates with short refinance dates.? Initially, that gave people a lot more buying power, at a price of higher unaffordable rates later.? “The phrase, “You can always refinance,” is a lie.? There is never a guarantee that financing will be available on terms that you will like.

This is also a good reason to go for debt that fully amortizes (i.e., when you get to the end of the loan, the payments haven’t risen, and the loan pays off in full).? I’ve never been crazy about the way commercial mortgage loans don’t fully amortize.? I know why it happened this way.? A) in the late ’80s and early ’90s, insurance companies were issuing GICs by the truckload, and needed higher yielding debt with a 5-year maturity.? Voila, 5-year mortgage loans with a balloon payment.? For the real estate developers, the loans were cheaper, but they had to trust that they could refinance — an assumption sorely tested in the early ’90s.? After the death of many S&Ls, a few insurers and developers, and the embarrassment of a more, borrowers and lenders became a little more circumspect.

But the loss of the S&Ls left a void in the market.? The Resolution Trust Company created some of the first Commercial Mortgage Backed Securities [CMBS], that Wall Street then imitated, filling in the void left by the S&Ls.? But to make the securitizations more bond-like, for easy sale the loans were 10-year maturities with a balloon payment at the end.? That way the deals would closer at the end of ten years.? Maybe some of the junk-grade certificates would be stuck at the end with a some ugly loans to work out, but surely the investment grade certificates would all pay off on time.

And that is a big assumption that we are going to be testing for the next five years.? Will developers be able to refinance or not?

This has gotten long, and have more to say, but I’m going to a wedding of a friend, and must cut this off.? Let me close by saying there is a corollary to the rule above, and it is this:

Long-dated assets should be financed by non-putable long-dated liabilities or equity.? Don’t cheat and finance shorter than the life of the assets involved.? There is never an assurance that you will be able to get financing on terms that you will like later.

What is Liquidity? (IV)

Posted on 6 February 20107 February 2010 by David Merkel

When I was a corporate bond manager, I often dealt in less liquid bonds.? Why?? They had more yield, I only bought those that my credit analysts liked, and I had a balance sheet that could hold them.? I had the option of holding those bonds, but not the obligation of holding those bonds.? As credit conditions improved in early 2003, to leave my successor with a simpler portfolio, I decided to lighten my holdings of bonds issued by a private bank.? I held 35% of the issue, and bought most of it near the height of the panic.

I told my secretary, “The phone will start ringing off the hook in 30 seconds.”? She gave me that usual sweet smile and said, “Okay, David.”? I offered a chunk of the bonds 0.2% below the last trade in spread terms, without guaranteeing the level.? To my surprise, I got a lot of bids rapidly, to the point where I said “whoa! there are too many that want these bonds.”? I recalibrated my levels and offered a “supply curve” of bonds, where I offered more the higher the price went.? I ended up selling 2/3rds of my holdings, and made significant gains for my client.? The final trade was 1/2% tighter than my initial proposed trade.

Having traded small and microcap stocks, and traded illiquid bonds, I am less afraid of illiquidity than many are.? Illiquidity is something that one can absorb, if he has a strong balance sheet and a patient disposition.

The great Peter Lynch would buy small cap stocks for Magellan, with strict orders on price.? Then he would let them sit, while they gained in value on average.? Marty Whitman buys in “safe and cheap” small cap stocks that are illiquid and holds them until their value is recognized.

If you have a strong balance sheet or patient investors, take advantage of it, and buy investments that are less liquid, where value may take a while to obtain.

But liquidity is not natural to all assets.? Most things in an average person’s life will not be liquid.? Your house and car are not liquid.? It will take a lot of effort to sell them and buy a different house and car.? So why should futures on property values be liquid, or residential mortgage-backed securities?

Well, debts that are very certain will always be liquid.? Debts that are less certain will be liquid during boom-phases, and illiquid during bust-phases.? In general, that is why AAA-rated asset-backed securities, which are usually “last loss” securities are fairly liquid, while lesser-rated securities trade rarely.

My point is that you can’t take illiquid assets and make them liquid.? Assets are liquid because they are short term, where one knows the cash flow to be received soon.

Are public stocks, like Exxon Mobil, liquid?? In one sense, yes.? During the day, when trading is in session, and there is
no news hitting the wire, then yes, quite liquid — one can get in and out of a position easily with little difference between the bid and ask.? But, when news hits, or from the closing price to the next day’s open, the price can move considerably.

Over a long period of time, the shares of two companies in identical businesses, one publicly traded, and one privately held, could deliver the same value over a long period of time.? The public company would have the ability to adjust its capital structure to buy in shares when they are cheap, and sell when they are dear, unlikely as that behavior is.? The public company would adjust its debt levels more frequently, while the private company would likely keep debt high and equity low, to keep taxes low.? The private company could act quietly and think longer term, subject to the constraints of their loan agreements.? The public company would have more bumps to its seeming value from news events, including earnings releases.

For the holder of shares in the public company, though liquidity is available, the value of the shares will vary.? For the public and private companies alike, liquidity for any large amount of the shares would be an event.? And, aside from successful maturity dates, the same would be true of large amounts of debt — there might be a public market available for small amounts of it, but just try to buy or sell a big amount, and pricing conditions are rarely favorable.? My example at the start of the post, where I sold 20% of the total issued amount for a favorable price, only happened because the willingness of investors to take risk increased dramatically since the last trade.? Yield greed had set in.

But that brings up the other definition of liquidity — what does it cost to enter/exit fixed commitments?? Tight credit spreads mean that corporations can (borrow) enter fixed commitments cheaply, and lenders, dearly.? The same applies to Fed policy — a wide Treasury curve means that it is expensive to borrow long, and cheap to borrow short — but borrowers want more security than to have a short maturity leash.

But when lenders are scared, they gravitate to short loans and high quality — cash equivalents lent to the Treasury.? If enough do that, short term yields get really low.? They can even go negative.

I remember arguing with a visiting professor at Wharton back in 1990 that negative interest rates were possible.? He told me I was nuts, people would sit on cash.? I replied, “what if you can’t keep the cash safe?”? Maybe I should have said, “What if it is inconvenient to transfer and guard several billion dollars in cash?? There are costs to that as well.”

In a liquidity trap like we are in, short-term money managers that must have US Treasury collateral must bid for it, no matter what.? They can’t move to cash.? Cash to them is very short-term debts of the most creditworthy entity that they know — their Government, the one that controls the Fed, sorta.

But the volume of lending, particularly to smaller business borrowers is light.? Is there really a lot of liquidity out there?? Or, is it being used primarily by the US Government and its affiliates while the economy is weak?? I think that is the case.

Liquidity is not magic; it can’t be created or destroyed — it just travels where it is needed.? During booms, liquidity appears abundant because of loose monetary policy and high willingness to take credit risk.? It seemingly disappears in the bust, as the marginal fixed income investor attempts to eliminate credit risk — liquidity then flows to the highest quality assets.

Liquidity is always around; it is only a question of where the marginal credit buyer has migrated.? In the current environment, it is short high-quality obligations that are still king, and lower-quality longer obligations that trail, though not as badly as last winter.

I am sure that I will write more on this topic, should I live so long.? My contentions are:

Securitization does not create liquidity, it only redirects it.
The Fed does not create liquidity, it only redirects it.
The Treasury does not create liquidity, it only redirects it.

Liquidity is a function of human action.? We all have to work and trade to survive.? Liquidity is where people are transacting at any given moment toward that end.? Structural changes in the economy, whether by the government or through private channels will shift where liquidity goes, but it will not change the amount of liquidity, unless the changes are so severe that the economy itself becomes much less productive.

R Bonds R Bad 4 U

Posted on 14 January 2010 by David Merkel

I have long been a fan of immediate annuities, particularly those that are inflation indexed, as retirement products for seniors.? Yet, they do not get bought by retirees.? Why?? Well, insurance products are sold, not bought, typically, and when the agent sells an immediate annuity, that is his last sale on that money.? They would rather sell a less suitable product that offers them another sale down the road.? And, people like having flexibility with and control over their investments, even if that leads to less money for them in the long run.? Annuitizing a portion of one’s lump sum lowers risk, and takes the place of investing in bonds in the asset allocation.

Most people like the reliability of their pensions, and Social Security, should it be paid, but do not seek the same thing when investing their private money.? One would think they would invest that money for growth if they had a strong stream of income elsewhere, but often that money is conservatively invested as well.

People get fooled by yield, and in an environment like this, more so.? People try to make their investments do more through targeting higher yields, while ignoring the possibility of capital losses.

Most people can budget, if pressed to do so.? Few can manage a lump sum of capital, and know what to invest it in, and how much to take from it per year.? Few have the discipline to buy an immediate annuity or limit their withdrawals to 4% of assets per year.

But where there is chaos and confusion, some in our government will seek to create a “solution.”? The ill-defined solution that sounds a bit like a Stable Value Fund is what is getting called “R Bonds.”? Here’s the idea: for those with 401(k)? or IRA balances, if they should retire, and not decide what to do with the money, the assets would get automatically get placed into a Retirement Bond, and for two years, the retiree would receive income.? They can opt out before that happens.? If after two years they still don’t decide, the income continues.? There is nothing mandatory about this program, should it come into existence; people who are asleep about their finances may find themselves trapped in it, at least for a time. [Note: there are scandalmongers alleging out-and-out theft being planned by the US Government.? From what I can see that is not true for anyone that keeps his wits about him.? All the proposals allow people to “opt out.”]

But let me go further.? Scrap the idea of “R bonds.”? Issue a limited number of Trills for retirees to use, or create a special variant of TIPS that pays until someone dies.? These are easy solutions that do not require a lot of changes to the legal codes, or changes in investment behavior.

Now, there is not just one proposal out there.? Let me give the two most comprehensive:

Increasing Annuitization in 401(k) Plans with Automatic Trial Income
Guaranteed Retirement Accounts Toward retirement income security — less desirable.? People should not be coerced into investments for retirement.? People should have a right to choose or not choose.

With interest rates so low on the short end, I don’t see how the returns could be that great from “R Bonds.”?? I would play for higher returns given the risk of inflation.? Today that would mean safe stuff that yields little, while waiting for a correction in the fixed income markets, and high quality common stocks with some yield.? And, annuitization at present?? I would wait for higher rates.

Other posts on the topic worthy of your consideration:

Now, all that said, there is a reason to be politically aware here.? Governments have in the past forced people to convert assets that were more valuable for those that were less valuable.? And, we have the example of Argentina doing it in the present with pension assets, and also when their currency blew up — most debtors faced a forced conversion to less valuable bonds.? With the pension nationalization, it was done in the name of protecting people’s pensions, but ended up benefiting the finances of the Argentine Government.

So, be aware.? R Bonds, as currently proposed, are a bad idea.? But there are worse ideas not yet proposed that might be proposed in the guise of protecting your future.? Let us work to make sure they never get implemented.