I am a skeptic on leveraged ETFs in one way.? My view is that the more levered they get, the less likely they are to replicate the behavior of their index, however levered.
To get high amounts of leverage, they must rely on futures, options, swaps, and options on swaps, and the higher the amount of leverage they attempt to replicate, the greater the amount of slippage they will experience versus their multiplied index.? There is also slippage from rolling futures from month to month.
Here’s my challenge, and I may do this myself, or, though I encourage others to do it.? Add the performance of the bullish and bearish funds of an index together, for a given amount of leverage.? If there is no friction or fees, they should do as well as T-bills.? My guess is the higher the leverage the lower the aggregate returns.
Let the games begin.? Does anyone want to run this analysis before I do it, say, six months from now?
This review will be short, because my view of How to be the Family CFO, is mixed.? Let me start by saying that I preferred the book Easy Money, by Liz Pulliam Weston, because it had more concrete? advice than did Family CFO, by Kim Snider.
Also, I did not feel that I was being “marketed to” in Easy Money, but I did in Family CFO, particularly toward the end of the book, where the dividend-oriented Snider Investment Method (R), is discussed.? What put me off was the promotional nature of the writing, and the lack of detail, particularly any information on capital gains and losses from the strategy.? Definitely not Global Investment Performance Standards-compliant.? Also, the strategy would be undiversified, in my opinion, by being overexposed to income factors.
Now, there is one major positive to the book, a place in which it is superior to Easy Money.? It motivates the “why” of getting your financial life in order, while Easy Money is better with the “how.”? What I admire about the author is that after failure, she grew up, and learned to be a serious adult about planning for the future, and using money wisely.
Most of my readers I expect are good at handling their money, but perhaps you have family or friends with self-inflicted money troubles.? If they lack motivation, you could get them a copy of Family CFO (with my caveats).? If they have motivation but lack knowledge, you could give them Easy Money.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? If you wanted to get it anyway, it is good for both of us…
I’m taking a brief break from “all crisis, all the time” writing.? I’m backlogged on book reviews, and it is time to write some.
When I get a book on asset allocation, I suck in my gut and say, “Oh no, not another book that falls into the common traps of only relying on past history, and doesn’t consider structural factors….”? I was surprised this time, and I have a book on asset allocation that I can wholeheartedly endorse.
Messrs. Swedroe and Kizer have distinguished between asset classes in sophisticated ways.? With annuities they classify immediate annuities as good, variable annuities as bad, and equity indexed annuities as ugly.? I could not have said it better.
They identify real traps for the retail investor: avoiding the structured product that Wall Street tries to feed retail investors.? They always find new ways to cheat you, encouraging you to sell options that seem cheap, but are quite valuable.
They also describe areas of the asset markets that are less correlated with domestic stocks and bonds — Real Estate, TIPS, Stable Value (I would note the over a long period stable value and bonds do equally well), Commodities, International Stocks, and Immediate Annuities.
Assets that are hybrid between equity and debt tend not to offer much diversification to a balanced core portfolio, so junk bonds, convertible bonds, and preferred stock do not offer much of a diversification advantage.? Similarly, Private Equity is highly correlated with public equity returns over a intermediate-to-long time horizon.? (I would note that any of those assets classes may present relative valuation advantages at certain points in time, and that expert managers can add value, if you can find them.? As for now, high yield is attractive, and there is value in busted convertibles trading for their fixed income value only.)
Hedge funds are difficult to consider as an asset class.? Their is much variability across hedge fund types, and within each type of hedge fund.? There are a lot of difficulties with survivorship bias in analyzing the effectiveness of hedge funds as a group.
The book has several strengths:
How do the costs of an asset class affect performance? (e.g. Variable Annuities)
How do taxes affect performance? (e.g. covered calls)
How does complexity affect performance? (e.g. Structured products)
How do personal factors like age and risk averseness affect what products might work well?
How does inflation affect performance?
Now, this is only indirectly a book on asset allocation.? It is not going to give you a set of procedures to tell you how to analyze your personal situation, the relative attractiveness of various classes at present, and the macroeconomic environment, and calculate a reasonable asset allocation for yourself, your DB plan, or endowment.? But it will give you the necessary building blocks to see how each alternative asset class fits into an overall asset allocation.
PS — Remember, I don’t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra.? Such a deal if you wanted to get it anyway…
Before I try to explain what a Depression is, let me explain what a bubble is.? A bubble is a self-reinforcing boom in the price of an asset class, typically caused by cheap financing,? with the term of liabilities usually shorter than the lifespan of the asset class.
But, before I go any further, consider what I wrote in this vintage CC post:
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems:
1) Lack of data on private transactions.
2) Lack of divisional data in corporations with multiple divisions.
3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc.
4) Lack of data on corporations as they get dissolved or merged into other operations.
5) Survivorship bias.
6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided?
This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified.
To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well.
Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue.
It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.
none
Bubbles are primarily financing phenomena.? The financing is cheap, and often reprices or requires refinancing before the lifespan of the asset.? What’s the life span of an asset?? Usually quite long:
Stocks: forever
Preferred stocks: maturity date, if there is one.
Bonds: maturity date, unless there is an extension provision.
Private equity: forever — one must look to the underlying business, rather than when the sponsor thinks he can make an exit.
Real Estate: practically forever, with maintenance.
Commodities: storage life — look to the underlying, because you can’t tell what financing will be like at the expiry of futures.
Financing terms are typically not locked in for a long amount of time, and if they are, they are more expensive than financing short via short maturity or floating rate debt.? The temptation is to choose short-dated financing, in order to make more profits due to the cheap rates, and momentum in asset prices.
But was this always so?? Let’s go back through history:
2003-2006: Housing bubble, Investment Bank bubble, Hedge fund bubble.? There was a tendency for more homeowners to finance short.? Investment banks rely on short dated “repo” finance.? Hedge funds typically finance short through their brokers.
1998-2000: Tech/Internet bubble.? Where’s the financing?? Vendor terms were typically short.? Those who took equity in place of rent, wages, goods or services typically did so without long dated financing to make up for the loss of cash flow.? Also, equity capital was very easy to obtain for speculative ventures.
1998: Emerging Asia/Russia/LTCM.? LTCM financed through brokers, which is short-dated.? Emerging markets usually can’t float a lot of long term debt, particularly not in their own currencies.? Debts in US Dollars, or other hard currencies are as bad as floating rate debt,? because in a crisis, it is costly to source hard currencies.
1994: Residential mortgages/Mexico: Mexico financed using Cetes (t-bills paying interest in dollars).? Mortgages?? As the Fed funds rates screamed higher, leveraged players were forced to bolt.? Self-reinforcing negative cycle ensues.
I could add in the early 80s, 1984, 1987, and 1989, where rising short rates cratered LDC debt, Continental Illinois, the bond and stock markets, and banks and commerical real estate, respectively. That’s how the Fed bursts bubbles by raising short rates.? Consider this piece from the CC:
One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:
2000 — Nasdaq
1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
1994 — Mortgages/Mexico
1989 — Banks/Commercial Real Estate
1987 — Stock Market
1984 — Continental Illinois
Early ’80s — LDC debt crisis
So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.
But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.
Position: None
Bubbles end when the costs of financing are too high to continue to prop up the inflated value of the assets.? Then a negative self-reinforcing cycle ensues, in which many things are tried in order to reflate the assets, but none succeed, because financing terms change.? Yield spreads widen dramatically, and often financing cannot be obtained at all.? If a bubble is a type of “boom phase,” then its demise is a type of bust phase.
Often a bubble becomes a dominant part of economic activity for an economy, so the “bust phase” may involve the Central bank loosening rates to aid the economy as a whole.? As I have explained before, the Fed loosening monetary policy only stimulates parts of the economy that can absorb more debt.? Those parts with high yield spreads because of the bust do not get any benefit.
But what if there are few or no areas of the economy that can absorb more debt, including the financial sector?? That is a depression.? At such a point, conventional monetary policy of lowering the central rate (in the US, the Fed funds rate) will do nothing.? It is like providing electrical shocks to a dead person, or trying to wake someone who is in a coma. In short: A depression is the negative self-reinforcing cycle that follows a economy-wide bubble.
Because of the importance of residential and commercial real estate to the economy as a whole, and our financial system in particular, the busts there are so big, that the second-order effects on the financial system eliminate financing for almost everyone.
We face a challenge as great, or greater than that at the Great Depression, because the level of debt is higher, and our government has a much higher debt load as a fraction of GDP than back in 1929.? It is harder today for the Federal government to absorb private sector debts, because we are closer to the 150% of GDP ratio of government debts relative to GDP, which is where foreigners typically stop financing governments. (We are at 80-90% of GDP now.)
We also have hidden liabilities through entitlement programs that are not reflected in the overall debt levels.? If I reflected those, the Debt to GDP ratio would be somewhere in the 6-7x GDP area. (With Government Debt to GDP in the 4x region.)
We are in uncharted waters, held together only because the US Dollar is the global reserve currency, and there is nothing that can replace it for now.? In the short run, as carry trades collapse, there is additional demand for Yen and US Dollar obligations, particularly T-bills.
But eventually this will pass, and foreign creditors will find something that is a better store of value than US Dollars.? The proper investment actions here depend on what Government policy will be.? Will they inflate away? the problem?? Raise taxes dramatically?? Default internally?? Externally?? Both?
I don’t see a good way out, and that may mean that a good asset allocation contains both inflation sensitive and deflation sensitive assets.? One asset that has a little of both would be long-dated TIPS — with deflation, you get your money back, and inflation drives additional accretion of the bond’s principal.? But maybe gold and long nominal T-bonds is better.? Hard for me to say.? We are in uncharted waters, and most strategies do badly there.
Last note: if you invest in stocks, emphasize the ability to self-finance.? Don’t buy companies that will need to raise capital for the next three years.
Have we survived the demise of Fannie and Freddie, Ambac and MBIA? It seems that way, but I would not be certain. These credits were crammed into stable value funds. How do you feel about life insurers? The stock prices of those that issue GICs have fallen significantly. Credit spreads have widened significantly.
Should you worry here?? My view is yes.? Any significant negative impact on the GSEs, Financial Guarantors or Life Insurers could affect the solvency of stable value funds to the tune of one year’s worth of interest.
This is similar to the way that I view money market funds.? It is possible that they could lose a year’s worth of interest.? Beyond that, I don’t see likely losses, unless the stable value fund had an unusual investment policy.
I have not done well in the markets for the last six weeks.? Here is why:
Overweight in Life Insurers.? Yes, they are in better shape than the banks, but that only means they got hit later, not that they would not get hit.
Too much economic sensitivity.? I felt that global demand would hold up better than US demand, but that only means they got hit later, not that they would not get hit.
I suspect that hedge funds have been blowing out my positions.
I’ve ben talking about stock survivability lately.? What does that mean?
Low levels of short-term debt.? Few major debt maturities coming in the next three years.
Low levels of total debt relative to tangible capital.
Still earning money and producing free cash flow, even in a tough environment.
If a company is cyclical, it has slack assets, particularly cash equivalents.? High current and quick ratios.
If not a financial, trading at a historically low price to sales ratio.? If a financial, trading at a historically low price to book ratio.
Good accounting quality and corporate governance.
A leader in their industry.? It would be difficult to lose them.
With a little work on my side, I came up with 80+ names to consider, that I think fit the above criteria, mainly:
AAPL ABX ADBE ADP AFG AHL ALL APA AXS BBOX BHE BHI BHP BWA CAS CB CF CHV CINF CLF CMI CRH CSL CTSH EBAY ENH FCX FDS FSR GD GPC GWW HANS HAR HCC HMN HON IBM ITW LNT LOW MHP MMM MRO MSFT MTW NKE NOC NOV NUE NVDA ODP OKE ORCL OXY PC PEP PL PRE PTP RE RHHBY RIO ROC ROCK RTN SHLM SIGI SYK T TEX TMO TRV TYC UTR VCLK WAG WBC WDC WRB Y ZMH
This is a portfolio that I think will do well even in tough environments.? I will be buying some of them on Monday, and let you know what I did.
When I write, I don’t always know what will be popular, and what won’t.? Personally, I thought my article Rethinking Insurable Interest was the more innovative of my two articles last night, but Blame Game made the splash.? Well, perhaps no surprise, the crisis has the attention of all of us.? I just have broader interests; I want to write about a wide number of things.
My readers took me up on my request, and gave me more targets to blame.? Let me expand on them:
21) The Rating Agencies — that was a popular choice.? Yes, the rating agencies messed up.? They always do.? Their job is an impossible one.? Should they be proactive or reactive?? Should they rate over the cycle, or be instantaneous?? Should they care about systemic risk issues?
Where they did err?? They competed for business, leading underwriting standards lower in structured finance.? They overrated the financial guarantors, who were their major clients.? Away from that, they made mistakes, but every firm offereing opinions makes mistakes.? I make mistakes regularly here.
22) Matt give me another party to blame, and I will let him speak for himself: I have one more to add – the Office of the Comptroller of the Currency. Not only did they fail to regulate the national banks, they also stone-walled State and local governments from bringing suit (claiming jurisdiction, but never following up on claims).
Add to that the divided regulatory structures that encouraged regulatory arbitrage.? That encouraged diminished underwriting standards.
23) Investment banks.? They asked the SEC to waive their leverage limts, and now none of the big guys are left as standalone publicly traded institutions.? They made a lot for a while, and then lost more.
24) Then there were the carry traders who have now gotten carried out on their shields. There were too many players trying to clip uncertain interest spreads, from hedge funds to Japanese housewives?
25) House flippers — whenever investors get to be more than 10% of a real estate market, beware.? Sad, but I heard an ad on the radio for buying residential real estate in order to rent it out.? It is not time for that yet.
26) The quants — they enabled models that gave a false sense of security.? They did not take into account decreased lending standards, and assumed that housing prices would continue to go up, albeit slowly.
They also assumed that various classes of risky business would be less correlated, but when hedge funds and fund-of-funds take many risks, returns become correlated because of investoors enter ing and exiting sectors.
27) The tax havens and hedge funds.? Hedge funds are weak holding structures for assets.? In a crisis they can be sellers, because they want to lower leverage.
28) Mainstream financial media — CNBC, etc.? They were relentless cheerleaders for the bull markets in stock and housing.? This isn’t a compliment, but financial radio makes CNBC sound cautious.? FInancial radio seems to be a home for hucksters.
And, that’s all for now.? If you have more parties to blame, feel free to respond.? One final note on my point 16, diversification, from the prior post: many quants did us wrong by focusing on correlations stemming from only boom periods.? There are many problems with correlation statistics in finance, but the big problem is that correlations are not stable even during boom times, much less between booms and busts.? In a bust, all risky assets become highly correlated with each other, invalidating ideas of risk control through diversification.
My view of diversification is holding safe assets and risky assets.? High quality short-term debt does wonders to reduce the volatility of results.? Other hedges are less certain.? Nothing beats cash, even when money market funds are open to question.
Unlike many, I have long felt that money market funds possess credit risk.? Does that mean that I don’t own money market funds?? I have a lot of money in money market funds, but I review the holdings of my funds to make sure that there are no “yield hogs” in the funds that might imply unreasonable risk.? I don’t go for the treasury only funds — I am willing to take ordinary high quality risk, so long as the managers aren’t doing anything to weird with structured products, ABCP, etc.
Money market funds break the buck when the market value of the instruments drops below 99.5% of par.? That rarely happens, though in this environment it is a risk, if a fund hasn’t availed itself of the cheap insurance offered by the US Treasury.
The real risk comes when a fund “breaks the buck” and allows withdrawals at par for a time, leading to a “run on the fund.”? My proposal says this: When a fund “breaks the buck,” it announces a credit event.? It tells shareholders that they have lost money, and to protect the interests of all shareholders, all shareholders will suffer a small capital loss.
Whatever the fairly calculated NAV is when a capital loss is announced, the new NAV would be 100.25, and the number of shares reduced to the level that supports that NAV.? If the value of the assets has been accurately calculated, and there are withdrawals, the premium to NAV should rise, not fall, for the remaining shareholders.
No one will like the concept of a credit event in money market funds.? That said, the idea would have many salutary effects on money market funds:
It would eliminate runs on the funds.
It would get people used to the idea that there is some risk in money market funds, though limited.
It would eliminate the need for the government to intervene and insure money market funds.
It would allow some money market funds to take more risk, and offer more return.
The cost would be minimal, most of the time losses would be 1-2%, which would be paid for through interest in less than a year.
Now, my main application was money market funds, but there are two other areas to consider.? Area one: short-term income funds.? Here is my poster child.? Under my proposal, instead of freezing redemptions, units are eliminated for the capital losses to the degree that it is not in the interests of anyone to liquidate assets.? A run on the fund would increase the NAV relative to the price.
Here’s area two: stable value funds.? I’ve written about this before, but stable value funds possess more levers to continue operating, even when the NAV drops below 99.5% of par.? Stable Value funds don’t typically reveal the NAV, and when the NAV is lower than the price, they lower the credited rate relative to the earnings rate in order to bring the two back into balance.
But what if a Stable Value fund is in a deep hole?? What if the credited rate is nearing zero, and investors are fleeing, worsening the problem?? My view is that at some threshold for NAVs the Stable Value funds have to announce a credit event and reduce units.? That value might be 96-97% of par, with a revaluation of units around 101-102% of par.? Even if there is no fleeing, the excess would be amortized into the credited rate over time.
On the negative side, this could lead money market funds, short-term income funds, and stable value funds to be more aggressive.? That said, it would encourage invest to analyze these funds that are not riskless, because they could undergo devaluations.
For those who hold pseudo-cash through money market funds, short-term income funds, or stable value funds, you need to be aware that they are not riskless, and that in their present form they may deliver capital losses, and more so if withdrawals are not limited.? My proposal provides an orderly way for recognizing and dealing with those losses in a way that does not require the government to step in with guarantees.
We’re talking stimulus, right?? And we trust the American People, right?? Why not just send each American household $2,300 for each man, woman, and child there?? Let them decide how the $700 billion stimulus should be used.? What, you say, it should diminsh debt?? But our dear government is doing nothing of the kind.? They are borrowing massively from China and OPEC.
What’s that, you say?? That doesn’t help the banks?? Well, why help the banks unless it helps the people?? So why not help the people directly, and maybe it will help the banks.? You believe in the free market, which means individual choice, right?
Sigh.? Our government believes nothing like this.? They intervene to protect their patrons, the financial institutions, while dissing the taxpayers, and that is how it goes.
Much as the government wants to eliminate stress in the lending markets, I don’t think they are succeeding.? The little bounce still leaves the indicator below Thursday’s close.
One reader brought up the timing mismatch in this indicator, because I have a 2-year Treasury versus a 90-day commercial paper series.? I use the 2-year Treasury, because it is very sensitive to changes in expectations for short-term interest rates.? I suppose I could use 3-month T-bills to match, but this indicator arose out of comparing two different series that change in opposite directions when the economy strengthens or weakens.
Part 2
Now for my article Now We?re Talking Volatility.? Okay, so we had three 4% moves in a five business day period, well, now you have four of them.? Now how do the statistics look?
Oddly, after four 4% events in five days the average return is lower than that for three 4% days.? Most of the history here comes from the Great Depression, and we are dealing with the “Law of Small Numbers” here, so I am not inclined to offer definitive analysis here.? I will give you my guess, though.? Extreme volatility often begets an opportunity for profit, but also sometimes begets significant future losses.? I lean toward the profit side here in the short run, but I also realize that the actions of the US Government might not be the best for the markets, even if the markets have interpreted it positively in the short run.
I would be neutral-to-positive on the US equity market here.? The presidential cycle is a positive, as is the current market volatility.? Given the difficulties with financials, I can’t get very positive, though.? Play defense, wherever you are.
