Personal Finance – Page 28

Efficient Markets as a Limiting Concept; There are Conceptual Limits to Efficient Markets

Posted on 4 July 200916 October 2010 by David Merkel

I do and don’t believe in the efficient markets hypothesis [EMH].? I do believe in the adaptive markets hypothesis [AMH].?? The efficient markets hypothesis posits that:

Past price-related information can’t be used to obtain better-than-average returns. (weak form of the EMH — cuts against technicians)
Past and present public information can’t be used to obtain better-than-average returns. (semi-strong form of the EMH — cuts against fundamental analysis)
Public and private information can’t be used to obtain better-than-average returns. (strong form of the EMH — believed by few)

In practice, the academic community holds to the semi-strong? form, while the investment community holds to the weak form.? One thing is certain: the market is dominated by large institutions, and the market on the whole, less fees, cannot beat the returns of the market on the whole.

Part of the problem with the EMH is that with respect to the market as a whole, of course it is true.? The real question is whether any particular strategy covering a small portion of the assets of the market can consistently beat the returns of the market on the whole.? I believe the answer to that question is yes.

An implicit assumption of the EMH is that research costs are free.? They are not free.? Also, it implicitly assumes that a dominant number of investors understand what information drives the markets.? Both assumptions are not true — even in the most clever firms, there is information that is missed, and research costs are expensive, and not always rewarded.

But the effort to earn above-average returns forces the market closer to the EMH.? When the competition is tough, finding excess returns is hard.? This makes it a limiting concept.? We never get there, but effort to find above-average returns gets us closer to that ideal.? Conversely, when many decide to index, those who do not index have a better chance at earning above normal returns, because there is a large chunk of naive capital in the market seeking average returns with certainty.

I want average people to use index funds for many reasons:

It lowers their costs.
It is tax-efficient.
Most people aren’t very good at picking equity managers.? They go for the manager who is hot, in the style that is hot, rather than one that did better in the past, and is in a cold spell now.? They go for large fund groups that spread their research over large asset bases, diluting whatever skill they might have.?? The best managers are the smaller specialists running their own funds, and who eat their own cooking.? They are also inconvenient to use.
It improves conditions for the remaining active managers.

I also want them to buy-and-hold (dirty words) because they aren’t very good at market timing, and also have enough in safe assets to lower the downside of returns to a level that does not panic them.? Most people are bad at most investment decision-making.? Better to hand it off to those who don’t panic or get greedy, than to be a part of those who buy into tops or sell into bottoms.

On the AMH, quoting from another piece of mine of the topic:

The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it?s not worth the search costs any more.

And so it is for those of us who are active managers.? We have a twofold task:

Base our strategies in areas that are unlikely to be overfished for long — e.g., low valuation, positive momentum, and earnings quality.
Dip into areas that are temporarily out of favor, whether those are industries, countries, or odd risk factors.? (Odd risk factors: occasionally certain factors in the markets are poison, and even the slightest taint marks a security off-limits, even though those that are barely affected are fine.? My example would be Enron-like structures 2001-2002.? Few would buy the stocks or bonds of companies that had them, even though those structures were not large enough to impair the company, as they did with Enron.? We bought the bonds of a Dominion subsidiary with abandon, because we knew the covenants the bonds had would not kill Dominion, and we had extra value as a result.? What killed Enron benefited us, indirectly.)

To active managers then, I warn: watch how your main strategy goes in and out of favor.? It happens to all of us.? Add to your main strategy most when it is out of favor, and add to whatever alternative you have when your main strategy is running hot.

To average investors, then, I advise: if you adjust frequently, add to your winners and prune your losers.? If you adjust infrequntly (once a year or less), prune your winners and add to your losers.? In the short run, momentum persists, in the longer-term, it mean reverts.

Know yourself.? If you are prone to panic and fear with investments, better to hand the job off to someone competent who will be dispassionate.? If you have conquered those emotions, you can potentially do better yourself in investing.? But ask yourself what your sustainable competitive advantage is in investing.? If you don’t have one, better to index.

Unchangeable

Posted on 19 June 2009 by David Merkel

When people look at this crisis, they look for simple answers — they want to find one or two parties to blame, not many, a la my Blame Game series.? The economic system is an interconnected web, and it is not easy to change one part without affecting many others.? Intelligent ideas for change consider second order effects at minimum.? This piece, and any that follow under the same title, will attempt to point at things that are not easily done away with.? Some of these will be controversial, others not.

1) Derivatives.? What is a derivative?? A derivative is a contract where two parties agree to exchange cash flows according to some indexes or formulas.? There are some suggesting today that all derivatives must be standardized, and/or traded on exchanges.? That might make sense for common derivatives where there are large volumes, but many derivatives are “out in the tail.”? Not common, and standardization of what is not common is a fool’s errand.

To regulate derivatives fully is to say that certain types of contracts between private parties may not exist without the consent of the government.? Thinking about it that way, what becomes of free enterprise?? Granted, there are some contracts that cannot be considered enforcable, like that of a hit man, arson for hire, etc.? Those are matters that any healthy government would oppose.

What makes more sense is to bring the derivatives “on balance sheet.”? Let the effects of the notional value play out, showing owners what is happening, rather than hiding it.

2) Rating agencies — Moody’s, S&P, and Fitch deserve some blame for what happened, but the regulators needed the rating agencies.? They still do.? The rating agencies make imperfect estimates of relative credit quality for a wide munber of instruments, which then feed into the risk-based capital formulas of the regulators.? To rate such a wide number of instruments means that the issuers must pay for the rating, because there is no general interest for most ratings.

Yes, let more rating agencies compete, but they will find that the “issuer pays” model is more compelling than the “”buyer pays” model.? The concentrated interests of issuers in a rating trumps the diffuse interests of buyers.? Bond buyers need to learn to live with this, and employ buy-side analysts that don’t take the opinion of the rating agencies blindly.? What the analysts at the rating agencies write is often more valuable than the rating itself, though it doesn’t change capital charges.

Rating agencies make the most errors with new asset classes.? Better that the regulators do their jobs and prohibit immature? asset classes where the loss experience is ill-understood.

I don’t think that rating agencies are going away any time soon.? I do think that the government and regulators contemplated this, but concluded that the changes to the system would be too drastic. (Contrary opinions: one, two)

3) Yield-seeking — the desire to seek yield is near-universal.? As a bond manager, I found it rare that a manager would do a “reduce yield, improve quality or certainty” trade.? The pattern is even more pronounced with retail accounts.? They underestimate the value of the options that they are selling, and take a modicum of yield in exchage for lower certainty of return.

Can this be banned, as some are proposing with reverse convertibles?? I don’t think so, there are too many variables to nail down, and too many people in search for a yield higher than is reasonable.? Yield-hogging is an institutional sport, not only one for retail fans to grab.? As one of my old bosses used to say, “Yield can be added to any portfolio.”? How?

Offer protection on CDS
Lower the quality of your portfolio.
Buy all of the dirty credits that trade cheap to rating.
Buy securities from securitizations — they almost always trade cheap to rating.? (Ooh! CDOs!)
Sell a call option on the securities you hold.
Buy mortgage securities with a lot of prepayment or extension risk.
Accept the return in a higher inflation currency, assuming that their central bank will tighten.
Do a currency carry trade.
Lever up.
Extend the length of your portfolio.
Underwrite catastrophe risk through cat bonds.

Adding yield is easy.? The transparency of that addition of yield is another matter.? Reverse convertibles have been the hot issue recently since this article.? Here is a small sample of the articles that followed: (one, two, three).? Reverse convertibles, and other instruments like them give bond-like performance if things go average-to-well, and stock-like performance if things go badly.? The inducement for this is a high yield on the bond in the average-to-good scenario.

What to do?

I have three bits of advice for readers.? First, don’t buy any financial instruments tht you don’t understand well. This especially applies when the party selling them to you has options that they can exercise against you.? Wall Street excels at products that give with the right hand and take with the left, so beware structured products sold to retail investors.

Second, don’t buy any financial product that someone appears out of the blue and says, “Have I got a deal for you!”? Stop.? Take your time, ask for literature, maybe, but say that you need a month or more to think about it.? Haste is the enemy of good financial decision-making.? Instead, do your own research, and buy what you conclude that you need.? Consult trusted advisors in either case.

Third, don’t be a yield hog.? Yield is rarely free.? There are times to take risk and accept higher yields, but those are typically scary times.? At other times, make sure you understand the portfolio of risks that you accept, and that you are being adequately paid for those risks.? Better to have a ladder of high quality noncallable debt, and take some risk with equities than to take risk in a series of yieldy and illiquid bonds that you don’t understand so well.? At least you will be able to know what risks you have, and that is an aid to asset management.

Final Question

This article began as a discussion of things that are very hard to change in the current environment.? I thought of several here:

The continuing need for derivatives, and the impossibility of full standardization
The continuing need for rating agencies
Human nature makes us yield hogs.
Wall Street builds traps for investors off of that weakness.

What other things are very hard to change in the current environment?

Book Review: The Guru Investor

Posted on 17 June 200917 June 2009 by David Merkel

John Reese and I share something in common: we both once wrote for RealMoney.com.? Occasionally I would question him in? the CC about what he wrote, but I never got an answer back.? He was probably a busy man.

Well, now I get to review his book, and I have to say that I like it.? It won’t be one of my favorite investment books, but it embeds many good ideas that will be useful to average investors.? Here are some of the main advantages:

1) It points people toward strategies that are valuation-conscious.? Whether investing for growth or value, the best investors pay attention to valuation.

2) Valuation is not everything.? Earnings growth and price momentum also are valuable to follow.

3)? Quality of the balance sheet matters.

One of the things that I like to say to investors is find something that fits your character, your free time, and your time horizon.?? This book simplifies the strategies of ten clever investors.? Some require more time and effort, some less.? With ten good strategies to choose from, perhaps one will fit your situation well.

For the ten gurus, it describes them, their strategies, and how to implement them in a simplified way.? I knew a little about all of the gurus before reading the book, but I learned a little bit new about each one, except Buffett.? They made life choices that led them to their investment theories, and the book makes that connection.

Sell Discipline

The sell disciplines in the book are similar to mine — rebalancing, and adding stocks that the model likes better, and removing those that rank lower.? For fundamental investors, that’s a reasonable way of limiting risk, assuming that you review your thesis before adding new money.

Quibbles

1)? Earnings quality: leaving aside Piotorski, the rest of the gurus spend little time on earnings quality.? Particularly for value investors this component is critical for avoiding mistakes.

2)? What Reese puts forth is a simplified version of what most of these great investors do.? The actual process is more complex, and requires business judgment.? That said, his simplifed versions have done better than the market, in general.

3)? Performance calculations cut off in July 2008.? Now, he had to cut off somewhere, or he couldn’t publish.? Still, it would be interesting to know how the strategies did July 2008 through February 2009 — how did they do at risk control?

4) To be able to use this book effectively, you would need to have access to some reasonably sophisticated stock screening software.? The cheapest one that I know of would come from AAII, but you would also have to be an AAII member to buy it.? (If anyone knows a better one at a cheaper price, let me know.)

Who Would Benefit From this Book

This book would work best for people who want to follow valuation-conscious strategies, and not spend a ton of time at it, if they are willing to put in some time at the beginning setting up stock screens.

Summary

If after you have read this, you want to buy the book, you can buy it here — The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies.

Full disclosure: I get a small commission from Amazon on anything that gets bought after entering Amazon through my site.? Your price doesn’t go up, and Amazon is always happy to have additional sales, even at a lower gross margin.

Problems with Constant Compound Interest

Posted on 4 June 20094 June 2009 by David Merkel

This piece is an experiment.? I’m not exactly sure how this will turn out by the time I am done, so if at the end you think I blew it, please break it to me gently.

People in general don’t get compound interest, or exponential processes generally.? It is not as if they are pessimistic, they are not numerate? enough to apply the rule of 72.? (Rule of 72: For interest rates between 3 and 24%, the time it takes to double the money is approximately 72 divided by the interest rate, expressed as a whole number.)

But there is a greater problem, and it applies to the bright as well as the dull.? People don’t understand the limitations of compound interest.

Let me begin with a story: I started my career at Pacific Standard Life, a little life insurer based in Davis, California.? The universal life policieswere crediting 11-12% interest, and annuities were in the 9-10% region.? It was fueled by junk bonds.? One of my first projects was to set the factors that would give us GAAP reserves for the universal life products.? To do this, I was told to project UL account values ahead at 11-12% interest for the life of the policies.

That rate of interest doubles policy account values every six or so years.? What economic environment would it imply to sustain such a rate of interest?

High inflation, or
High opportunities, because there is little competition.

The former was a possibility, the latter not.? As it was, inflation was receding, and 1986 was the nadir for the 80s.

People buying policies would see these tremendous returns illustrated, and would buy, because they saw an easy retirement in sight.? Alas, constant compound growth rarely happens in economics.? Policyholders ended up very disappointed; Pacific Standard went insolvent in 1989, and the rump was sold off to The Hartford.

Where do we often see constant compound growth modeled in finance?

Asset allocation models, including simple illustrations done by financial planners
Life insurance sales and accounting
Defined benefit pension accounting
Long-dated debt obligations
Simple stock price models, like the Gordon Model, and all of its dividend discount model cousins.
Social finance systems, like public pensions and healthcare.

There are likely many more.? Whenever we talk about long-dated financial obligations, whether assets or liabilities, we need something simple to aid us in decision-making, because the more variables that we toss in, the harder it is for us to make reasonable comparisons.? We need to reduce calculations to single variables of yield, present values, or future retirement incomes.? Our frail minds need simple answers to aid us.

I’m not being a pure critic here, because I need simple answers also.? Knowing the yield of a long debt obligation has some value, though if that yield is high, one should ask what the is likelihood of realizing the value of? the debt.? Similarly, it would be useful to know how likely it is that one would receive a certain income in retirement.

I’m going to hit the publish button now, and pick this up in a day or so.? Until then.

“Just Gimme the Answer, Will Ya?”

Posted on 3 June 2009 by David Merkel

Half of my career, I have worked for bosses who were actuaries, and half not.? Half of my career, I worked for bosses that were intellectually curious, and half not.? There was a strong, but not perfect correlation between the two — most actuaries are intellectually curious, but there are a few that aren’t.

Those that know me well, know that I am a pragmatic idealist.? I have strong beliefs, but I also have a strong desire to solve the problem.? Where I run into difficulty is where the problem is ill-constructed, and does not admit a good answer.? Any answer would be subject to numerous qualifications and explanations.? Perhaps I can give some examples:

“What’s my illiquid structured finance bond worth?”

Oh my.? Whether residential mortgage, commercial mortgage, or asset-backed, that depends a lot upon future loss activity across the whole financial sector.? Typically I only get this question when the bond is worth little, but the entity thinks it is worth a lot, but can’t get a bid anywhere near that.? Often they have been misled by third-party pricing services doing a facile job in exchange for a fee.

“How will this equity portfolio behave versus the market?”

Ugh. Beta is unstable, and estimates often lead to erroneous conclusions.? More detailed modeling can come up with a reasonable answer, but also state that the correct beta is a weak tendency, and is swamped by other effects.

“This investment will eventually come back, right?”

No.? Most will, but not all will.? Some do go to zero, or something really close.? Mean-reversion exists in the markets, and over long time periods it is strong on average, but in specific over short horizons it does not work.

“What’s the interest rate sensitivity of this illiquid structured finance bond?”

Often there is not a good model of prepayment/extension risk.? Or, the model exists, but the security in question is dominated by credit risk.? Will that tranche pay off or not?? In such a situation, the wrong question is being asked, because interest rate risk is not the main risk.

“What’s the right spread to Treasuries for this illiquid bond?”

Sorry, but the answer will be regime-dependent, and will vary by the liquidity of the era.? During times of high liquidity, it will trade near liquid bonds of similar risk.? In times of low liquidity, it will trade far behind its liquid cousins.

What’s the right yield tradeoff between bonds of different credit quality classes?

Again, it varies.? Even across a whole cycle, there is no right answer.? Personally, I would try to estimate the likelihood, subjectively, that we would enter the other side of the cycle within the life of the asset in question.? There are boom valuations, and bust valuations, and scarce little time in-between.

“Just Gimme the Answer, Will Ya?!? I need an Answer!”

Yeah, I got it.? I’m a practical man also, but I try to understand where I can go wrong.? Process is as important as the result.? For many investors, institutional as well as retail, they don’t understand the broader environment that we are in, and they think there are these long term averages that don’t vary that much.? Just invest, and you will make good money over a 2-5 year period.

Sorry, but life is more variable than that.? Investment processes are a function of human processes.? Where humans play a game of follow-the-leader for a long time, with positive results, the cycle will be long, and the unwind severe.? Truth is, the real economy grows at a 1-3%/year rate in inflation adjusted terms, with a lot of noise, absent rampant socialism, or war on our home soil.? The result over the long term should not be much more than 2% more than bond returns, with moderate risk.

You mean there are no answers?

No, there are answers, but there are confidence bands around the answers, and the answers are subject to the overall well-being of the financial economy.? We are playing a complex game here, because the boom-bust cycle is less than predictable on average.? Thus the advantage goes to those that play with excess margin, particularly when things are running hot, and they? pull back.? It is a tough discipline to maintain, but it yields results over the long term.

I will say it this way: focus on where we are in the risk cycle, and? it will aid you in where to invest.?? As Buffett says, “Be greedy when others are fearful, and fearful when others are greedy.”

I encourage caution.? Ask what can go wrong.? Consider what a prolonged downturn in the economy would do.? If the answer is “little,” then be a man and take real risks.

Be skeptical, but don’t be paralyzed in decision-making.? Look to the long-run as a weak tendency, and realize that over many years and with moderate certainty, the trend will revert on average, buit not necessarily for individual investments.

So what should I do?

Keep a reserve fund of safe assets.
Be skeptical of short, intermediate, and long-term results, but for different reasons.
Resist trends during normal times, but during times of extreme movement, let it run.
Always consider what could go wrong.? WHat is the upside and the downside, and the likelihood of each.

There is no single formula or answer for all investment problems, but a conservative attitude, and a reasonable analysis of where we are in the risk cycle will help.

The First Priority of Risk Control

Posted on 30 May 2009 by David Merkel

In early 1994, after the Fed’s first rate hike in what would be annus horribilis for the bond market, I was behind in my quota for selling Guaranteed Investment Contracts [GICs] at Provident Mutual.? Worse, my liabilities were running off faster than my assets.? My bosses gently nudged me about sales, and I told them that spreads were not justifying sales at present.? They let me be; they did not want to compromise underwriting in order to get sales.

But as my cash position got worse, and went negative, I eventually got a call from the Treasurer, one of the few people at Provident Mutual who could have worked at AIG and thrived.

“What are you doing?”

“What do you mean?”

“We are into the banks [DM — borrowing money] because your GIC separate account is forcing us to borrow money!? What are you going to do about it?!”

“I’ll sell some GICs, and soon.”

“You better, or the CEO will hear of it.”

“You got it.”

After that, I reviewed my options, and looked for the cheapest way to raise cash.? The stable value industry at that time had yield illusion when the yield curve was steep.? GICs the would mature half in one year and half in five years were considered the equivalent of a three year GIC, even though the 1-5 had a forty basis point advantage in funding over the 3.

So, I called up a new client in Boston that I had been cultivating, and offered him a “special.”? A 1-5 GIC at 40 bps over the 3-yr GIC rate.

“That’s one special rate.”

“It is a special rate.”

“How much can you do?”

Thinking of the amount of debt I was in, I said “Six Million.”

“Sweeten it by another basis point, and we are done.”

I replied, “Done.”

My present problem solved, as the investment actuary, I looked at the situation, and with the mortgage market falling apart, and rates being forced up, I drew the conclusion that we were in a self-reinforcing situation where interest rates were going to rise.? I began to sell GICs with abandon, telling the investment department not to hedge my sales, and not to stretch for yield.? I sold my entire year’s quota in the next six months, and the investment department upgraded the credit quality of the portfolio as rates rose.? By the time Confederation announced its insolvency, I had almost finished my year.? Good thing, given that the Confederation insolvency would kill of my line of business two ways: 1) charges from the guaranty funds.? 2) Provident Mutual’s credit rating was now too low to sell GICs.? I ended up closing the line of business two years later.

Now, as a note to risk managers, it is probably a bad idea to give control of hedging policy over to the line of business actuary, even though it worked out for the pension division of Provident Mutual.? We were special, not because of me, but because we stayed in close touch with the investment department, and hired actuaries that understood investments, which was rare at that time.

So, out of the horrible year 1994, we came out of it better off, while many were licking their wounds, and three of our competitors had blown up.? That wouldn’t keep the business from being eliminated two years later, but it did protect the interests of our dividend receiving policyholders.

The First Priority of Risk Control

This brings me to the main idea of this piece.? What is the first priority of risk control?? It is to make sure that the company/individual in question is never forced to take action at an adverse moment.? Consider all of the financial companies that are being forced to dilute common sharholders in order to survive.? Consider the universities that entered into illiquid investment programs with the promise of earning higher returns.? Many of them are choking on a lack of liquidity at present, as the fall in the markets has driven:

the endowment down
giving is down
willingness of parents to send children to expensive universities is down
what’s worse, illiquid investments have suffered worse than liquid investments.? Very tough to sell in the secondary markets — akin to consorting with guys who wear “panky rangs,” as they say down south.? (Loan sharks.)

The first priority of the risk manager is to make sure that there is never a call on cash (or any other resource) that he can’t meet on favorable terms.? It means running at a lower ROE, and having more surplus assets to cushion the company.? It also means doing stress-testing beyond what is imaginable to most of your peers.? My interest rate scenarios for cash flow testing went up 9%, and went all the way down to zero.? We made sure that we could survive.? If you can’t survive, you can’t play for the next round, no matter how good the last few rounds were.

David Swensen is a bright guy, as are many of his peers in similarly tough situations.? Yes, they enjoyed the boom as the leverage built up, but now what do you do when faced with demands for liquidity, and precious little liquid assets to deliver?? You estimate the duration of the crisis, and if it is longer than your liquid assets can finance, you sell some of your best illiquid assets now, and play for time.? If the duration is shorter, sell liquid assets.

Most life insurance companies that died in the 90s died from a liquidity mismatch.? Liquid liabilities, and illiquid assets.? Works great in a bull cycle, and lousy in a bear cycle.? That is true for any institution, though, so if you manage risk, be careful of the illiquidity of your assets.? Even owning a home that requires two incomes to pay the mortgage is not a risk worth taking.

Ask yourself, for your firm, and for your household, are there any conceivable situations where you will not be able to meet your obligations on favorable terms?? If not, you are placing those that you care for at risk.? Take action now to reduce that risk while you still can.

Don’t Confuse Stupidity with a Bear Market

Posted on 22 May 2009 by David Merkel

“So when are we coming out with a tasset fund?”

“A tactical asset allocation fund?” I replied. “Mmm, it’s worth a thought, but you know what it takes to add a new product.? How much demand would there be for this?”

“Are you kidding? In a bear market, people still want to make money.? We need someone smart who can decide when to be in the market and when to take shelter in cash.”

“If it were only that easy,” I replied, “Tell me, who is so reliably brilliant at market timing, and willing to trade for anything other than his own account?”

“You got me there, Dr. Merkel, but we really need a product like this.? It would sell like crazy.”? (Note: they called me Doctor there regularly.? I did not encourage it; I am not a Ph. D.)

“No doubt.? I will consider it, and get back to you.”

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I had that conversation back in 1994 with one of the better pension representatives of Provident Mutual.? As one of the actuaries there, I quickly realized that I had to boil any investment ideas down into very simple terms for the field force.? The best explanations were rich and simple, like a fairy tale, one of Aesop’s fables, or one of the parables of Jesus Christ.? That is a challenge — one worthy of the best investment minds.

The thing is, there is a constant war between two views of the market:

Buy and Hold — Bull Market
Trade, trade, trade — Bear Market

I don’t think either view has permanent validity.? Of course in a bull market the buy and holders will crow; they are making money.? And in a bear market, those with less exposure to the market will crow.? Big deal.? Those that are accidentally correct boast while their strategy is in favor.

So, when I read this NY Times article about diversification, I yawn.? After a bear market, you decide to reduce equity exposure?? That’s just fear expressing itself in stupidity.? Even worse is this WSJ article, where the author is giving into his fears, and reducing equity exposure.

My point here is a simple one.? Don’t confuse brilliance with a bull market.? Don’t confuse stupidity with a bear market.

Very few people are good traders, such that they can manuever the pulses of the market.? For those that understand how the market works in the long run and on average, the best thing to do is to ride bear markets out.? Own the best companies you can find, and adjust your asset allocation such that you can survive something worse than a bad recession.? Many people over-own stocks, implicitly trusting in the naive view that they always outperform bonds.? Stocks do outperform bonds, but by much less than advertised, say 1-2%/year.

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When I look at the risk cycle now, I am inclined to reduce risk, and add to safe investments.? That said, I might wait a while to see if the positive momentum persists.? I am gratified by the rally in lower-rated corporate bonds, but think that the risk there is growing.? I am presently inclined to do an “up in quality” trade, sacrificing yield for safety.? There.? That is the way to go now.? Reduce risk, and take the loss in yield.

So What’s a Year Worth?

Posted on 14 May 2009 by David Merkel

When I heard the announcement on Tuesday about Social Security and Medicare, I emoted something between a grin and a grimace, and said, “A pity that I have been right on this.”? I’ve always felt that Social Security and Medicare? have had optimistic economic assumptions.? It does not surprise me that the year that Social Security revenues are exceeded by expenses has moved in by one year, from 2017 to 2016.? Medicare, we are already exceeding revenues in 2008 and now.

Many focus on when the trust funds will run out — now 2017 for Medicare, and 2037 for Social Security.? Consider this, the trust funds are invested in nonmarketable US Treasury Notes.? That’s safe, right?? Safe, yes, as safe as the US government.? They will pay with the dollars that they print via their stepchild, the Fed.

This is my advice to all who read me.? Given that these social insurance programs invest only in US government debt, on an accounting basis, it makes sense to unify their balance sheets with that of the US government.? Once we unify the balance sheets, it is easy to realize that the negative consequences will come when expenses exceed revenues, not when the funds go to zero. When expenses exceed revenues, the US government will either need to tax or borrow more in order to make ends meet.? The US Government bonds held are a convenient accounting fiction to show that the taxes paid have been spent for other purposes.? There are no “Trust Funds,” only nonmarketable bit of US debt, that will get repaid through higher taxes, or further borrowings.? China and OPEC, ready to fund US retirements in style? 😉

As for the economic assumptions that Social Security uses, I think they are still optimistic.? One thing I have learned about cash flow modeling is that though the averages matter, the early years matter the most.? There is more time for their results to compound with interest.

We could have two more bad years (flat/down GDP on average), and then face the total system revenue breakeven in 2013.? Even if their assumptions prove correct, total system breakeven will come in 2014-2015.

And the markets will react ahead of that, because it will be so well known.? The need for tax revenues will be significant, and more so as we proceed into the 2020s.? This will lead to the need for solutions — with Medicare, much sooner than Social Security.

Medicare

Possible solutions (and their liabilities):

Nationalize the healthcare system and Medicare goes away.? (Medicare is solved, at the expense of creating a bigger problem.? Other cultures may fit nationalized healthcare, but American will chafe at it.)
Create a second parallel healthcare reimursement system that only serves Medicare clients with limited services to those that are terminally ill.? Ease the pain, but nothing radical and expensive.? (I like this one, so it can’t be a good idea.)
Raise taxes.? (lower the reasons to employ labor)
Raise eligibility ages, and quickly. (Listen to the screams.)
Lower reimbursement rates. (Also won’t work because fewer doctors will do Medicare medicine… and quality drops as well.)
Mandate that doctors must take Medicare clients at Medicare rates.? (Nasty.? But once rights of contract get violated in one place, they get violated in others.)
Eliminate plan D, the drug prescription benefit.? It’s young and too complicated, so just kill it.
Means-test eligibility for reimbursement.? (It would lose political legitimacy.)
Terminate the system, such that children born after 1/1/2010 don’t pay in, and would not receive benefits. (Doesn’t really solve the funding problem, unless mixed with some of the above.)

Social Security

Possible solutions (and their liabilities):

Means-test eligibility for reimbursement.? (It would lose political legitimacy.)
Raise taxes.? (lower the reasons to employ labor)
Raise eligibility ages, and quickly. (Listen to the screams.)
Lower benefit payments. (More screams.)
Remove the cost of living adjustments, and inflate the currency.? (At least this rates the problem back to the Baby Boomers, who would get hurt the worst over this… a generation that failed to save and produce enough kids.)
Terminate the system, such that children born after 1/1/2010 don’t pay in, and would not receive benefits. (Doesn’t really solve the funding problem, unless mixed with someof the above.)

“I’ll Gladly Pay You Tuesday for a Hamburger Today.”

The nature of the US government, the lower Federal governments, many of its corporations, and some of its people has been to promise/borrow today, and pay it off later, because tomorrow will be, much, much, better than today.? With the the debt overhang and the looming pension crises, we are beginning to see that much American prosperity was a debt-fueled illusion.? We are presently in stage 1 of dealing with the grief of this shattered illusion — denial.

If the Federal Social Insurance schemes (Social Security, Medicare, Veterans Pensions, Old Federal Employee Pensions) and most State Pensions and Elderly Medical Care are going to pay off, taxes will have to be raised significantly.? That will be one nasty political fight, which might result in the death of certain sacrosanct laws governing the inviolability of pension promises to state employees, and perhaps Federal employees.? Also note, you can raise tax rates, but if it harms the economy, you will get less taxes.

The Federal Government will try to borrow its way out of the problem, until foreign creditors finally rebel, realizing they are throwing good money after bad.? After that, taxes will have to be raised, or promises abandoned/reduced.

For underfunded private defined benefit and retiree healthcare plans, they will likely be terminated, and lesser benefits paid.? All three of the legs of the modern retirement tripod (social insurance, savings, and pensions) are under threat as the era of debt deflation progresses.

Now, realize that though I talk about the US, most of the rest of the developed world is in worse shape as the demographic crisis affects pensions and elderly healthcare globally — they had even fewer kids than in the US, which is close to replacement rate, and so the ratio of workers to those supported will fall even more than in the US, setting up many nasty political fights — all the more nasty, because the governments are much more heavily involved already.? Don’t even think about China, which will come to regret the one child policy that led to so many abortions, and so many beautiful Chinese girls coming to the US to be adopted.

So What’s a Year Worth?

A year can teach us a lot.? 2008 showed us the limitations of our economy.? Future years will show us the limitations of the power of our governments.? Conditions for prosperity can be created, but prosperity can never created by governments.? That is up to the culture of those governed.

This has gotten a bit long, so I will do a follow-up piece within a few days.? Here are a few good articles to consider:

One Dozen Notes on our Current Situation in the Markets

Posted on 8 May 20098 May 2009 by David Merkel

I’m leaving for two days.? I might be able to post while I’m gone, but connectivity is never guaranteed, particularly in southwestern Pennsylvania.? (Sometimes I call it “the land that time forgot.”) Apologies to those that live there — Pittsburgh is the capital city of Appalachia.

Here are a few thoughts of mine:

1) Many have been critical of Buffett after a poor showing in 2008.? Much as I have criticized Buffett in the past, I do not do so here. The mistake that many make in analyzing Berky is forgetting that it is first an insurance company, second an industrial conglomerate, and last an investment vehicle for Warren Buffett for stocks, bonds, derivatives, etc. With most of his investments, he owns the whole company, so you can’t tell how Buffett’s investing is doing through looking at the prices of the public holdings, but by reading Berky’s financial statements. By that standard, 2008 was not a banner year for Berky — book value went down — but it was hardly a disaster. Buffett remains an intelligent businessman who deserves the praise that he receives.

From The Investor’s Consigliere, he agrees with me.? Berky is more like a special private equity shop than like a mutual fund.

2) I’m past my limit for cash for my broad market portfolio.? I have sold bit-by-bit as the market has risen.? I’m planning on buying more of my losers, or finding a few new names to throw in.? Will the current “bull market” evaporate?? There are some sentiment measures that say so.? Also, when cyclicals lead, I get skeptical.

3) As correlations rise, so does equity market risk.? Are we facing crash-like risks now?? I don’t think so, but I can’t rule it out.? My opinion would change if I knew that major foreign investors were willing to “bite the bullet” and recognize the losses that they will experience from investing in Treasuries.

4) My initial opinion of Ben Bernanke, which I repudiated, may be correct.? My initial opinion was that he would be a disaster.? Now that the transcripts of the 2003 Fed meetings are out, he was among the most aggressive in loosening policy, which was the key blunder leading into our current crisis.? It also explains the novel policies adopted by the Fed over the last 18 months.

5) Investors are geting too excited about a recovery in residential housing.? Such a recovery is not possible while 20%+ of all residential properties are under water.? Foreclosures happen because of properties under water where a random glitch hits (death, disaster, disability, divorce, debt spike (recast or reset), and disemployment).

6) I have long had GM and Ford as “zero shorts.”? Sell them short, and you won’t have to pay anything back.? Though Ford is prospering for now, GM is declining rapidly.? In bankruptcy the common is a zonk.? With dilution, the common will almost be a zonk.

7) I worry over our government’s involvement in the markets.? First, I am concerned over contract law.? The bankruptcy code in the US strikes a very good balance between the needs of creditors and debtors.? I worry when the government tampers with that.? I fear that the Obama administration does not grasp that if they attempt to change certain regulations, it will have a disproportionate effect on the economy.

8) I have almost always liked TIPS.? Do I like them now?? Of course, particularly if they are long-dated.

9) Much as I do not trust it, we have had a significant rally in leveraged loans and junk bonds.

10) Did major banks support subprime lenders?? Of course many did.? No surprise here.

11) The EMH exists in a dynamic tension with its opposite.?? Because many, like me, are willing to hunt out inefficiencies, the inefficiencies often get quite small.? So it is that those that come into investing with no hint that the EMH exists think it is ridiculous.? Coming from a household where the EMH had been stomped on for many years (thanks, Mom) made me ill-disposed to believe it, and not just because we subscribed to Value Line.

12) He who pays the piper calls the tune.? To the degree that the government gets involved in business, it will intrude into lesser details that should only be the province of shareholders.? What this says to management teams is “don’t let the government in in the first place,” which should be pretty obvious.? Major shareholders with secondary interests are often painful.? With the government, that secondary interest is regulation, which makes them a painful shareholder.

With that, I bid all of you adieu for a time.? May the Lord watch over you.

Choose Two: Principal Protection, Liquidity, and Above-Market Returns

Posted on 5 May 2009 by David Merkel

Two pieces worth reading today from Eleanor Laise at the Wall Street Journal, which go along with what I have been writing in my Unstable Value Funds series:

I just want to make the short, simple point that an investor can only get two of the following three items (at best):

Principal Protection
Liquidity
Above-Market Returns

Perhaps I am a bit of a pessimist, but as a wide number of products came into existence attempting to offer all three back in the 90s, I would ask questions like, “But what happens if you have losses on assets and redemption requests at book at the same time?”? An answer would come back on the order of, “You worry too much.? We’re making money.”

True, as parties are willing to take more and more risk, you can get all three for a time.? But over a full market cycle, it can’t be done.? And, by a full market cycle, I mean a period of time long enough to include a major debt deflation, like the 30s and now.

So, be aware of withdrawal provisions on your investments, both the formal ones listed in the prospectus or its equivalent, and the informal ones where ability to withdraw is suspended as a matter of fairness to all clients, and/or protecting a business at a financial firm (though risking lawsuits in the process).

Also, try to understand what underlies the shares in any pooled investment vehicle that you own.? If the underlying does not have a liquid secondary market, the shares of the pool won’t be liquid under all conditions.? If the value of the assets vary considerably over time, stability of principal won’t be possible under all conditions.

So, be aware.? Though there are laws and courts, you are your own first and best defender when it comes to any investments.