Portfolio Management – Page 65

Sorted Weekly Tweets

Posted on 26 May 201226 May 2012 by David Merkel

Market Dynamics

Go Your Own Way: Correlation Breakdown in the Market http://t.co/3Zwpx3kB @japhychron hints at deterioration in US stocks as USD strengthens May 26, 2012
RE: To me it implies that conservative HY investors are running out of places to put money.? Yellow flag. http://t.co/eUSRq8dY May 25, 2012
Vanguard Closes High-Yield Fund ? ETF Alternatives http://t.co/bMmYUMTC Note: ETFs proposed take more credit risk than Vanguard fund does $$ May 24, 2012
Vanguard’s high yield fund was fairly conservative; they may feel strain in the size of their positions relative to t? http://t.co/lLJFeiYc May 24, 2012
RE: They were called the Americus Trusts, sponsored by the Americus Shareowner Service Corp., and they had Scores and? http://t.co/TPNPkL8T May 23, 2012
Wealthy Americans Turn to Trusts to Shield Assets http://t.co/2rKGuNWb Reasons: taxes, liability, avoid probate. Covetous world $$ May 23, 2012
You can say that again, momentum is addictive $$ RT @credittrader: lol – never learn – especially when momentum feels so good haha May 23, 2012
@credittrader I’m well. Fascinating that $JPM didn’t learn from the correlation crisis in 2005; tranche px/corr relationships shift $$ May 23, 2012
IG CDX diverges from S&P500; JPMorgan advocates mean reversion trade http://t.co/FIsOqhBN Long IG spreads vs HY spreads and equities $$ May 23, 2012
Kroll Sees Supplanting S&P in Rating Commercial Mortgage Bonds http://t.co/IrzfQ6cH Gratuitous trash talk on competitor S&P from Kroll $$ May 22, 2012
Treasuries in Longest Winning Streak Since ?98 on Europe http://t.co/EWJkiN5u Everyone knows that Treasury yields can only fall, right? $$ May 20, 2012

Eurozone

Merkel May Be Persuaded on Euro Debt-Sharing Compromise http://t.co/P3yQaN1K H/L misrepresents Merkel; does not seem likely politically May 25, 2012
Indeed, why not? RT @TimABRussell: ?http://t.co/831diM1O Why not just pick the best person for each position regardless of sex, race, etc? May 25, 2012
If a man will not respect his “wife” by marrying & staying with her, why should you expect him to respect women in mo? http://t.co/83lvXtu1 May 25, 2012
Stock Market Performance Versus Dollar http://t.co/mfrXyqvp Difficult for the US stock market to do well when the $$ is strengthening v Euro May 25, 2012
Slim Family Sees European Crisis as Good Time to Invest http://t.co/XZOgx3xX Buy when there is blood running in the streets $$ #slimchance May 25, 2012
Europe Girds for Greek Exit http://t.co/HMfsVt86 Two problems: Can’t kick Greece out & Greece can only leave Eurozone by leaving EU $$ May 24, 2012
Euro-Zone Economic Contraction Deepens http://t.co/b49VctDj Overindebted Eurozone muddles as politics/bureaucracy strangle growth $$ May 24, 2012
EU Chiefs Clash on Euro Bonds as Crisis Summit Bogs Down http://t.co/S1YnHrbM Fiscal Union requires political union; elephant in room $$ May 24, 2012
The Seeds of the EU?s Crisis Were Sown 60 Years Ago http://t.co/SsWQUvGa Overly ambitious EU goal of “ever closer union” leads 2 crisis $$ May 24, 2012
War-Gaming Greek Euro Exit Shows Hazards in 46-Hour Weekend http://t.co/WD7HSbMI Assumes Greek competence & they care about global mkts $$ May 23, 2012
A Greek Exit Could Make the Euro Area Stronger http://t.co/C7v2mDmM Concludes that a Greek exit would lead the rest 2 pull together $$ May 23, 2012
Campaign for Joint Euro Bonds Builds http://t.co/xXAvSU73 Will the core Eurozone countries give up resources to bail out the fringe? $$ May 23, 2012
Europe?s Prisoner?s Dilemma ? LTRO Needs to Continue for Years http://t.co/NldAsVL2 Until govt debt is gone from finl sector?s bal sht $$ May 23, 2012
Germany to Sell Interest-Free Bonds http://t.co/q7ewNqd2 It is good to be king. People give you their money, & they pay for the honor $$ May 22, 2012

US Politics / Economics

Even with a High Court win, Obamacare won’t work http://t.co/NKhyAe56 Failed ideas @ the states will not add up to a successful Federal plan May 26, 2012
USDA Is a Tough Collector When Mortgages Go Bad http://t.co/ZX24InYJ Definitely has different goals than most of the govt re mortgages May 26, 2012
Report: Negative Equity More Widespread Than Previously Thought http://t.co/UkQBpbGY Adds in value of second liens, 31%+ inverted $$ May 24, 2012
Let Mr. Reid look to his own spending extremism.? As for me, let the tax cuts expire, and automatic cuts happen.? Bet? http://t.co/cabthITQ May 22, 2012
Shale Glut Means $1-a-Gallon Savings at the Pump http://t.co/RHlFbT3L Liquefied Natgas would shave $1/gal over diesel for trucking $$ May 22, 2012

China

New Signs of Global Slowdown http://t.co/2o4kFRkD Weak Reports in U.S., Europe and China Suggest Economies Are Slipping in Sync $$ May 26, 2012
@researchpuzzler Pettis is among the best on China. @ritholtz and John Mauldin are good friends. Trends in China r very negative… $$ May 25, 2012
EM investing: check out the grid http://t.co/dIEGJeJC 3Qs How much electricity do they have? Future development? Probability of success? May 24, 2012
China flash PMIs point to contraction, again http://t.co/DZGf3ZZS The number for May is 48.7, compared to 49.3 in April. 7th decline. $$ May 24, 2012
China, North Korea ties hit rough weather http://t.co/r7TlDbux Kim Jong Un needs lessons showing honor2the Suzerain: Chinese Communist Party May 24, 2012
RE: @SoberLook I’ve heard that Chinese electricity consumption has flatlined.? Another straw in the wind. http://t.co/IqAHJCgo May 21, 2012

Companies

Facebook Investor Spending Month?s Salary Exposes Hype http://t.co/eGhCiHXq Please. Stox r risky. High expectation stox r veryrisky $$ $FB May 24, 2012
General Mills Unveils Restructuring, Job Cuts http://t.co/IUHltbai $GIS Budget-conscious US consumers push back against price increases May 23, 2012
Benihana Agrees to $296 Million Buyout http://t.co/YxJtfun3 Agreed 2b acquired by investment firm Angelo Gordon & Co. for about $296M $$ May 23, 2012
The Miracle on Wellington Street http://t.co/DUbSY81d Fairfax Financial Holdings’ tricky transaction for 6.6% of Odyssey Re -> legal trouble May 21, 2012
Barclays to Sell Entire $6.1 Billion BlackRock Investment http://t.co/notUgeFk Basel III rules make it uneconomic to hold as capital $$ May 21, 2012
Houghton Mifflin Harcourt Publishing Files for Bankruptcy http://t.co/heUuF3gj Bank debt -> New Equity, old Equity -> warrants for 5% $$ May 21, 2012

Financial Sector

JPMorgan Gave Risk Oversight to Museum Head Who Sat on AIG Board http://t.co/INr9ebI5 No banking experts on $JPM ‘s risk ctrl committee May 25, 2012
Goldman to JPMorgan Swap Trades Soar on Risks http://t.co/fvSPysAp A cheap-ish option on systemic risk rising. And not in the eurozone! $$ May 25, 2012
JPMorgan Copper ETF Plan Seen Creating Havoc by Merchant Groups http://t.co/zoJ0BfeM They oppose retail hoarding b/c it hurts them $$ May 24, 2012

Advice Regarding Life

I Wish I Had Known: Don?t Underestimate Compounding In EVERYTHING http://t.co/mIdFf5Dx People overrate their ability to change habits $$ May 26, 2012
Compound Experience, Not Just Interest http://t.co/n6CaWLN0 Early behavior influences later behavior, and the options that will be open 2u May 26, 2012

Berkshire Hathaway

Buffett Says Free News Unsustainable, May Add More Papers http://t.co/medRWMWm Strategy: Buy papers, end free distribution on Internet $$ May 25, 2012
Buffett?s Idiot Challenge Seized by Jain in Premium Hunt http://t.co/89qcKilo Misses how Jain blew it reinsuring life & LTC from Swiss Re May 23, 2012
Don’t get me wrong, Ajit Jain knows more about insurance than me; I’m saying he is not perfect; he does not know all insurance equally $$ May 23, 2012

High Frequency Trading

+1 That would work too RT @merrillmatter: @AlephBlog how about for all orders, one second minimum life May 24, 2012
Mutual Funds Promised Haven From Speedsters http://t.co/iCFFZXsU I proposed this HFT solution @ BaltimoreCFA 2 1 of those interviewed $$ May 24, 2012

Miscellaneous

The sex slavery stuff makes me sad/angry. I have daughters. $$ RT @moiracathleen: Brothels on Wheels http://t.co/COBuwJbS @leafjohnson May 25, 2012
How a bizarre legal case involving a mysterious billionaire could force 1.2M Canadians 2b married, against their will http://t.co/zv7QJBCz May 24, 2012
Veterans Face Ruin Awaiting Benefits as Wounded Swamp VA http://t.co/W0Ydcu3x Long sad tale: wounded vets not getting enuf disability pay May 24, 2012
Gold Boom Spreading Mercury as 15 Mln Miners Exposed http://t.co/f7oBSo26 Long fascinating article about mercury poisoning in Colombia $$ May 24, 2012
Rust-Belt Babushkas Live Alone as Fewer Remain to Marry http://t.co/ASbsIAMg % of US single person households up ~250% since 1940, 8%->27% May 23, 2012
Private Spacecraft Lifts Off Toward Space Station http://t.co/JlGRR2m0 The sustainable space age has begun, w/private $$ flying rockets May 23, 2012
Fitch Downgrades Japan http://t.co/rITu0126 Blasts the govt 4 taking a “leisurely” approach2solving country’s spiraling debt problems $$ May 23, 2012
Is the College Cave Age About to End? http://t.co/ispDBLTX Thinner slices of “deeper” knowledge produce less relevant research & teaching May 21, 2012
Getting America on a Diet That Works http://t.co/vooh1iNN What’s funny2me is how little agreement there is today on what works in diets $$ May 21, 2012
+1 Fatal Risk RT @ToddSullivan: AMAZING book…one of my favorites RT @alephblog: Please follow my friend @BoydRoddy, who is new to Twitter May 21, 2012
Please follow my friend @BoydRoddy, who is new to Twitter. $$ May 21, 2012
Read my review: ‘The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds’ by Maneet Ahuja via @alephblog http://t.co/kJf89aVT May 21, 2012

The Rules, Part XXXII

Posted on 25 May 201225 May 2012 by David Merkel

Dynamic hedging only has the potential of working on deep markets.

Arbitrage pricing can reveal proper prices in smaller less liquid markets if there are larger, more liquid markets to compare against.? The process cannot work in reverse, except by accident.

The recent case of JP Morgan’s hedging activities bring to light an observation that should be clear to all but isn’t.? Hedging only works when you are small relative to the markets in which you hedge.

Let’s consider tranched credit index default swaps.? We can create models where the prices of each tranche can be calculated given default frequency and severity.? But default is not a constant beast.? Defaults come in waves, and when incidence is high, so is severity of loss.? Vice-versa when incidence is low, leaving aside fraud.

We might have a good idea of where credit default should trade for a basket of corporate debtors “credits” so long as we look at the thing as a whole,? and don’t carve it up.? In general, a basket of borrowers is easier to predict than individual borrowers.

But the basket gets difficult when we split it up into first loss, second loss, third loss, etc. claims where different parties lose their capital at differing levels of total loss.? Yes, in theory, we can come up with prices.? We can even come up with hedge ratios? that show the theoretical tradeoff between tranches as losses increase or decrease, which might work, might, if you are a small player in that market.

Woe betide you, if you do anything too fancy, and you are big relative to the market.? Because you are big, you have affected the prices of the market.? Price relationships that were normal before you arrived have shifted and reflect your interests, which in the short-run makes your accounting look better.? As the bubble grows, those investing in the bubble look better.? But as the bubble expands, those that have invested in it find a wave of cash fighting against them, but it doesn’t matter, because momentum investors are still buying.

At the end, the large investor amid the bubble finds himself stranded.? The market knows his positions, and he can’t make trades to extricate himself, because the terms are onerous.

Look, I used to trade small-issue lesser-known bonds.? I only bought stuff that I knew would be money-good, i.e. pay off.? In that case, you have the option of speculating when spreads are wide, and selling when they get tight.? But if you do that with bonds that you don’t know whether they will likely pay in full, the ability to hedge is meaningless, because your hedge could break in a default.

And so it was for JP Morgan.? When you get too big relative to the market, it had better be when you are the buyer or seller of last resort, and you are catching the turn.? But in normal markets, bigs are pigs, and are likely to be slaughtered.

It doesn’t matter what your model says is the right tradeoff if you are too big relative to the market.? Your own actions have poisoned the signals that your models receive.

Amaranth fell into this same bucket, with a talented energy trader who understood how the market generally worked.? As his success grew, so did his size, and he didn’t realize that the size of the fund was distorting market prices.? At the end there was one unlikely scenario that was unhedged, and that was the scenario that occurred, and the results led to the collapse of the fund.

If Amaranth had been smaller they could have traded out of it.? At their size, they were “elephants in an elevator.”

Size matters, and for investment purposes, smaller is better.? And for the most part, less complex is better too.? Don’t demand liquidity from markets, or you will lose.? If liquidity comes to your door, and it seems to be a good deal, wave it in.

23,401 Auctions

Posted on 23 May 2012 by David Merkel

I’m fascinated at the degree of hatred for high frequency trading [HFT] among my fellow portfolio managers, particularly those that live in the Baltimore area.? I have my own techniques for dealing with them: discretionary reserve orders, and not trading much.? If you are a longer-term investor, the games that exist in buying and selling in the short-run don’t matter much.? In my opinion, HFT milks short-term traders the most.

But I have my own solution to high frequency trading: revamp all markets such that there is one auction per second in the trading day.? Auctions happen at the top of each second: 9:30:00.000000… 9:30:01.000000… … 16:00:00.000000.? Additionally, orders still standing at the start of any second may not be cancelled for the next second.

Auctions once per second.? Click, click, click, click…? 23,401 auctions per day offers more than enough flexibility to buyers and sellers.? No truly economic commerce would be hindered by such an arrangement.

Why would anyone argue with this?? It splits the difference, and brings order to markets where many are presently skeptical of the validity of the markets.

I’m open to other ideas here.? I toss this out as a way of making markets more transparent.? Transparency aids validity, which aids legitimacy, eventually.

High Profits

Posted on 23 May 2012 by David Merkel

Dr. Jeff Miller wrote an interesting question the other day:

“Why does a Shiller disciple care about profit margins?“

Now, I am not a disciple of Dr. Shiller, I disagree with him on many issues, Trills for an example.? When Shiller talks, odds are 50-50 that I agree, which makes him interesting to me, unlike Bernanke and Krugman who I almost always disagree with, and James Grant and Caroline Baum, who I almost always agree with.? Someone who agrees with me and disagrees with me equally is interesting, because he makes me think harder.

And with his cyclically-adjusted price-earnings [CAPE] ratio, I was a reluctant partial convert.? Consider this piece.

There are a couple ways to answer the question:

Most stocks are cheap on a forward P/E basis, less so on a trailing P/E basis, and still less so on a P/B or P/S basis.? The difference between P/E and P/S is profit margin — E/S.
Consider the critiques from Dr. John Hussman, who awaits the reset that will come if/when profit margins get competed down.
My answer: we should care about it a little, for the above reasons.? But labor is no longer scarce, which leads to higher profit margins for a time while wages are depressed.

My view is that profit margins will not revert to mean for many years, until the increase in capitalist labor is absorbed.? Until then economic results will be poor those that labor on the low end — you have got a lot of new competition.

As I wrote earlier:

A reason to consider the validity of the CAPE is twofold: it has a huge similarity to Tobin’s Q-ratio, which compares market capitalization to replacement cost.? It also has a similarity to Michael Alexander?s Price-to-Resources ratio, out of which the book makes a lot (link here for an example).? It?s a Price-to-Adjusted Book value ratio as I see it.

The CAPE has value as a proxy.? It mirrors overall market value pretty well, like other fundamental ratios.

But I don’t agree, at least in part because profit margins should remain high, until readily obtainable labor is less scarce.? Getting there could be a long time.? Profit margins could remain high for a long time as a result, leaving? markets in a limbo zone, where it treads water as underlying value builds.

So profit margins should remain high for now.? Once labor is scarce globally,? and companies must pay more to get more or better quality labor, then will profit margins come under stress.

Little Things are Important

Posted on 22 May 2012 by David Merkel

One of the problems with many politicians, journalists, financial analysts, economists, etc., is that they don’t think systematically.? Go back to late 2006, when I wrote my piece Wrecking Ball Looms for Big Housing Spec, which was regarding the coming subprime crisis.? (Note: my editor often retitled my pieces; my original title was more circumspect.)? Or read my piece in mid-2005 regarding the impending unwind of leverage and prices in residential real estate, Real Estate?s Top Looms.? Both of those are inside the wall at RealMoney.? Apologies if you can’t read them.

At the beginning of the crisis, most economists, including the present Fed Chairman, said that problems ere limited, because they only affected limited areas of the residential real estate market.? Now, part of that response reveals that the Fed and other regulators beneath them had not been doing their jobs, because it is well-known now that underwriting quality of all residential mortgage lending had deteriorated.

When an economic system is overleveraged, with leverage that is layered, such that a domino effect can occur, small failures can have disproportionate results.? It is almost like the economic system during the bull phase self-organizes for the largest possible failure.? (Note: self-organizing systems do not always optimize for the long term.? Think: what other ideas could that invalidate?)

An overlevered residential real estate system had the possibility of a self-reinforcing decline in prices, once prices started declining nationally.? Now we face a still-overlevered residential real estate sector with a lot of the market inverted, where people owe more than the house is worth, though pockets on the low end of prices show recovery in some areas of the US.

Little things are important.? Some people say, “How can Greece pose so much risk to the rest of Europe?? It’s economy is so small relative to the rest of Europe.? Well, that’s where the leverage comes in again.

Core Eurozone banks have lent to Greek entities, and those banks are not well-capitalized.? If Greece left the Eurozone, and repaid loans in depreciated New Drachma, it would lead to a crisis in confidence regarding loans made to Spain, Portugal, and Italy.? The exposure of core Eurozone banks is significant, to the point where it could cause a broader crisis.

Little things are important where the system has been optimized; where something near perfection is needed to insure the proper performance of the over-evolved system where many entities are playing for a slice of the cash flow, and most have over-borrowed, and overpaid.

The optimized scenario is akin to the dominoes being set up, and they are beautiful, but woe betide the one who knocks over a domino.? (Note: as a kid, I would build domino structures, but would leave out every tenth domino, in order to create something where if I made a mistake, only a little would fall down.? The last dominoes were added with the greatest care.)

There are some worries in the US over European exposure.? I don’t think that is likely, except with some of the biggest banks.? Maybe that could spill over, but I doubt it.? If it does spill over, it will prove that the biggest banks should be broken up.? My favored way is to regulate banks like insurers.? You can do business across state lines, but you are tightly regulated by your state.? Much better than what we have currently.

Survivable systems exist when adequate returns are earned without high leverage.? That may sound vague, but vague is often the best we can do in economics.

When debts are complex, aim for simplicity.? Complex systems tend to die.? Simple systems survive.? This is a rule of value investing, measure simplicity versus reward.? Complexity has a price; avoid it unless well compensated for it.

Book Review: The Alpha Masters

Posted on 21 May 201221 May 2012 by David Merkel

This book has just been released.? I got an early copy.? The book is interesting enough that I would like to do a Q&A with the author, and I have contacted the PR flack to do so.

To the review:

Would you like to understand the mindsets of a variety of successful hedge fund managers?? This book will give that to you, but there is a catch: you will also learn how these managers developed, and this is a big plus.

Most of the managers went through rigorous experiences that made them far more effective at evaluating risk and return potentials.?? Have you been through anything similar to that?? If not, you might read this very interesting set of accounts, but then realize that you don’t have the personality/skills necessary to replicate what they have done.? Don’t feel bad, most people don’t have that.

A large part of what makes hedge fund managers successful is their willingness to limit their activity to areas where they have genuine expertise.? They gain insight beyond most into areas where they are experts in discerning value.

This book does not give you a formula for how to make money; instead, it gives you lessons in the characters of those that have made a lot of money for themselves and their clients.? What are they like?

Among their many attributes, they are:

Driven/competitive — though I have known my share of failures in investing that have that attribute.
Lifelong learners, like Buffett and Munger — though I have known some really bright people who know a lot about investing/finance who add little to an investment process.
Opportunistic — they recognize what their best opportunities are, and pursue them to the exclusion of others.
Focused — they develop an edge, and try to be “best in class,” whether in mathematics of the markets, understanding the legal rights of different types of securities, understanding industry dynamics, accounting nuances, etc.
Patient — if opportunities are not promising, don’t do much.? It’s like being an intelligent underwriter — when your competitors are giving away the store, don’t write business, spend time sharpening your skills.? Study what could go wrong, and see if there is a way to take advantage of the situation.
Team-builders — They develop talented teams/cultures and motivate them to excellence.
Sensible — They know when to be doggedly persistent, and know when to admit defeat.

Now, no hedge fund manager has all of these, but the best have most of them.

Contents

The book covers nine managers/firms:

Ray Dalio — Bridgewater
Pierre LaGrange & Tim Wong — MAN Group / AHL
John Paulson — Paulson & Co.
Marc Lasry and Sonia Gardner — Avenue Capital Group
David Tepper — Appaloosa Management
William A. Ackman — Pershing Square Capital Management
Daniel Loeb — Third Point
James Chanos — Kynikos Associates LP
Boaz Weinstein, Saba Capital Management

About the Author

Her name is Maneet Ahuja, and is a producer for CNBC, specializing in covering hedge funds.? That’s how she gained the contacts in order to write the book.? Business Insider did a profile on her, and you can find it here.

Quibbles

The book needs something to tie it together and give it depth, otherwise the book is only “Meet these nine nifty hedge fund managers that I have gotten to know.”? That’s a serious deficiency; even a single chapter at the front or back would have enriched the book, making it more general and cohesive.

I also think there would have been better choices for those that wrote the foreword (Mohamed El-Erian) and the afterword (Myron Scholes).? The former is an accomplished investor, but is not an expert on hedge funds.? Myron Scholes is an accomplished academic, has worked for hedge funds, but is still not an expert on them.

Who would benefit from this book: If you want to learn about what type of people these nine hedge fund managers are, and read anecdotes about some of their best and worst trades, this would be a book you would enjoy.? If you want to, you can buy the book here: The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds.

Full disclosure: The book was sent to me out of the blue; did not ask for it.

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.

Don’t Become the Market

Posted on 17 May 201218 May 2012 by David Merkel

It was late 1993, and I knew that we could make a lot of money if I sold floating-rate Guaranteed Investment Contracts.? Let me quote an earlier piece:

My goal as an actuarial businessman was to make profits with modest risk for my ultimate owners, who were the mutual policyholders.? Once I faced a situation where there might be easy profits ? writing floating rate GICs.? So, I went to my models and tried to figure out how we could make money safely while our interest rates would shift every three months.? I came to the conclusion that there was no safe way to do so, and so I walked into the office of my boss and told him so.? He surprised me by supporting my thesis, and in his usual back-of-the-envelope way, explained to me in a few minutes why it had to be so.

A few weeks later, he informed me that an actuary from Goldman Sachs (yes), would be dropping by to tell about one of their new derivative contracts that would enable us to write floating rate GICs profitably.? The meeting day came, and I validated the expectations of my boss.? The year was 1993.? I asked the actuary from Goldman what happens if the yield curve inverts.? He answered honestly, ?This strategy blows up when the yield curve inverts.?? Score a small victory for me.? I gave myself points for avoiding trendy bad ideas.? Over the next twelve months, two major insurers and one investment bank would announce billion-dollar blowups from following that strategy.

After the blowups, I went back to the buyers of floating-rate GICs, and asked them if they would accept a lower spread over LIBOR.? The response was a firm ?no.?? So much for that market.

Those few players in that market had mispriced the risk.? Is it any surprise that they got a lot of volume?

Here’s another example:

Two years after that, I was at the Society of Actuaries annual meeting, where I met a well-known actuary who had worked inside the corporate actuarial area of the Equitable during the critical years.? I.e., he watched and analyzed the assets and the liabilities as they arose.? The conversation went something like this:

David: What was it like working inside the Equitable during that period of fast growth?

Corporate Actuary: It was amazing.? It took everything we could do to stay on top of it, and still we fell behind.

D: Didn?t you think that perhaps you were offering guaranteed rates that were too attractive?

C: We wondered about it, but with money coming in, everyone felt great about the growth.? We simply had to find ways to productively deploy all of the cash flow.

D: But wait.? Didn?t the investment department have a difficult time investing all of the proceeds?? With that much money coming in, the likelihood of making severe errors would be high.

C: Were you a bug on the wall at our meetings?? Yes, that is exactly what happened.? The money came in faster than we could invest it prudently.

D: Wow.? I thought that was what happened, but it amazes me to hear it confirmed.

They offered free options, and surprise, investors took them up on them.? They couldn?t make enough to fund the promises, and undertook a risky strategy in the late 80s that I called ?double or nothing.?? The strategy failed, and they almost went broke, except that AXA bought them, pumped in a little capital, and then the real estate market turned.

What?s my point here?? Twofold: one, rapid growth in financial institutions is rarely a good thing; it usually means that an error has been made.? Two, there is a barrier in many financial decisions, where responsible parties are loath to cry foul until it is way past obvious, because the cost of being wrong is high.

Long Term Capital Management became large relative to the markets that they “arbitraged.”? Anytime you can feel yourself moving the market, it is time to stop.

There was a correlation crisis in the CDO market in 2005.? For those with access to RealMoney, I wrote about it here.? Some quants with clever ideas, much like the current JPM fiasco, thought that they could hedge mezzanine against subordinated.? True when the trade is small, wrong when the trade is big.

Beyond that, we have the brain-dead example of AIG.? They dominated the market for AAA subprime mortgage insurance.? It was free money, until it wasn’t.? If you have a large share of a market where there are no barriers to entry, you should stop and ask why you are the only smart one.

The problem with becoming large relative to the market, is that you begin distorting the price signals of the market.? If you have a large long position and the price starts to fall, it is easy to justify purchases, because your internal model indicates that it is cheap.? But every model has weaknesses, consider the examples listed above.? Anytime you get a large fraction of the market’s volume, you should stop, and re-evaluate.? You’re probably doing something wrong.

Markets by their nature invite diversity, and do not admit anyone to dominate them except under abnormal circumstances.

So, if you find yourself growing large relative to your market, calm down, and re-evaluate your positions, before they get large enough to bite you.

Elderly Poor?

Posted on 17 May 2012 by David Merkel

There will be elderly poor.? Look at page 26 of this PDF.? I interpret those that don’t know or declined as being well below $50K in assets.? That means 60% of those reaching “retirement age” will have less than two years income stored up.

That said I feel more sorry for younger workers who have to pay high amounts into Social Security/Medicare, and they will not get out of program what they put in.? There’s a longish article here, excerpting from a recently released book on the topic.? In general, the older you are, the sweeter the deal was for those who received payments from Social Security, at least until 2026 when benefits will be cut by 25%, or taxes raised.

What this means is that in aggregate, Americans don’t save enough, particularly the Baby Boomers, of which I am one, but not a negligent one.

We are heading for elderly poverty/work for a large portion of Americans.? I suspect that many older people will continue to work, solving their problem but taking jobs from those who are younger.

This should be no surprise.? Incomes should be declining for lower skilled people in the US, because there are more people who can do that work abroad.? My advice to all readers is to make sure you cannot be obsoleted by foreigners.

One more note: don’t expect the asset markets to bail you out.? Returns to financial assets will do poorly as so many begin to sell them to pay for living expenses, whether directly as individuals, or indirectly as defined benefit plans pay retirement benefits.

This is on top of the problem that when high-quality long interest rates are so low, it is typically a bad time to try to make money in financial assets, because returns on risky assets are typically only 0-2% percent higher than the yield on long BBB/Baa debt over the long run.

All for now…

Skewed Incentives

Posted on 16 May 2012 by David Merkel

May is a tough month for me, because I have to submit reports for the nonprofits that I work with, and this year is worse, because I have a moderate injury that I need? to see a doctor about, but can’t until next week, because of the schedule.

But I do want to say a few things about the JP Morgan news.? First, JP Morgan should be broken up, whether state by state, or by Federal reserve district, with an investment bank spun off as well.

Second, after we have been through 2008, why do we care about a piddling $2Billion+ loss?? JP Morgan’s balance sheet can handle far more than that, and come back kicking.

Third, there are a lot of people who are mindlessly asking for the reinstatement of Glass-Stegall, without realizing that the repeal had little to do with the crisis.? Most of the losses at banks sprang from bad lending on residential mortgages, not trading.? Also, if regulators had been more fastidious about asset quality and leverage, it also might not have happened, but who dares to oppose a boom?

My point of view is that states are better at regulating financials than the federal government.? It is far harder to co-opt 50 regulators than one.

Decentralized government, where power is limited, is far harder to corrupt than centralized governments like India, China, Russia, Greece, etc.

Fourth, when a bank engages in a complex trade, and is a large portion of the market, it is asking for trouble.? Companies have problems when they become the market for financial promises.? Markets work well when there are a large number of players, with no one dominating.? Financial markets with a dominant player have a problem because it becomes difficult for the dominant player to discern the right price.? They don’t want to set it too low, because it makes their own financials look bad.? That skewed incentive can harm economic truth, and the company as well.

Being a monopolist or an oligopolist is not as easy as the textbooks would say, at least for long-term transactions.? When there is no free market to validate your pricing against, how does an oligopolist come up with an economic price?? It can’t do so.

We get on shaky ground when anyone becomes dominant in a market of promises.? Initially the accounting is flexible enough that losses do not occur on bad lending, but eventually the bad/negative net cash flows crush the firm.? This is why I never invest in novel financial companies.

Simple Stock Valuation

Posted on 12 May 201213 May 2012 by David Merkel

I appreciate Eddy Elfenbein.? He comes up with ideas that make me say, “Huh. Interesting.? Let’s test that.”? His recent article, World?s Simplest Stock Valuation Measure, put forth the idea that:

Growth Rate/2 + 8 = PE Ratio

Cool, reminds me of my 1993 formula for value investing:

Price per share < Tangible Book per share + 5 * EPS

Eddy’s idea is that you can buy a company that isn’t growing or shrinking earnings at a PE of 8, or alternatively, a E/P (earnings yield) of 12.5%.? In a weird environment like this, it means an earnings yield that is more than 9% over the long bond is a good purchase.? I like that idea, it offers a good reward for taking risk.

But as the growth rate rises, you can expand the PE multiple by half of the anticipated growth rate.? So, a company anticipated to grow at a 10% rate would warrant a PE multiple of 13, a 20% rate 18, etc.? I like his formula, because it is conservative.? It seeks growth at a reasonable price.? It will not overpay for high growth rates.

But now let’s test this statistically to see what validity it presently has.? I ran a regression on Current year expected PEs versus expected 3-5 year growth rates.? I excluded all companies with fewer than two analysts putting forth growth estimates.? Here were the results:

SUMMARY ?OUTPUT

Regression Statistics
Multiple R	0.15
R Square	0.0224
Adjusted R Square	0.0218
Standard Error	39.70
Observations	1,589

ANOVA
?	Df	SS	MS	F	Significance F
Regression	1	57,333	57,332.91	36.38	0.000000002
Residual	1,587	2,500,838	1,575.83
Total	1,588	2,558,170

?		Standard Error	t Stat	P-value	Lower 95%	Upper 95%	Eddy	T-test
Intercept	11.87	1.88	6.33	0.0000000003	8.19	15.55	8.00	2.06
eps_eg5	0.69	0.11	6.03	0.0000000020	0.47	0.91	0.50	1.66

Significant results statistically, but what a low R-squared.? Just shows us all how complex the market really is.? Look at this graph to see it as it is:

There really doesn?t seem to be much of a relationship.? But Eddy?s formula is conservative versus the estimates.? His formula invests in no-growth? companies ?at an earnings yield of 12.5%, the market does so at an earnings yield of 8.4%.? His formula increases the PE multiple at a 50% rate as earnings increases, but the market does so at a 69% rate.

Good for Eddy, and any that follow him.? His method builds in a margin of safety, which is a key to all good investing.

Before I close I would like to offer the 20 most mispriced companies, both positively and negatively.? Just be aware that the markets are complex, and this valuation method is simple, and most likely wrong? but it can provide a jumping-off point for due diligence.

Potential Buys

company	ticker	eps_eg5	PE
Seagate Technology PLC	STX	37.94	4.3
US Airways Group, Inc.	LCC	38.5	4.9
China Xiniya Fashion Ltd (ADR)	XNY	12	2.6
Exide Technologies	XIDE	15	3.4
HollyFrontier Corp	HFC	31.19	5.3
First Solar, Inc.	FSLR	20	4.2
Xerium Technologies, Inc.	XRM	20	4.3
YPF SA? (ADR)	YPF	13.69	3.9
Newmont Mining Corporation	NEM	54.68	9.6
Western Digital Corp.	WDC	20.84	5.1
Gulfport Energy Corporation	GPOR	48	9.1
Delta Air Lines, Inc.	DAL	17.25	4.9
KKR & Co. L.P.	KKR	22.43	5.7
Dana Holding Corporation	DAN	31.56	7.1
Perfect World Co., Ltd. (ADR)	PWRD	9.78	4
Marathon Petroleum Corp	MPC	25.16	6.3
Stoneridge, Inc.	SRI	35.2	7.8
GT Advanced Technologies Inc	GTAT	11	4.2
Telecom Argentina S.A. (ADR)	TEO	11.3	4.3
SUPERVALU INC.	SVU	11.1	4.3

Potential Sells

Company	Ticker	eps_eg5	PE
Rubicon Technology, Inc.	RBCN	15	125.6
NetSuite Inc.	N	34.79	204.1
Amazon.com, Inc.	AMZN	30.02	190.6
Clear Channel Outdoor Holdings	CCO	24.04	175.5
Servicesource International In	SREV	27	192.1
Wright Medical Group, Inc.	WMGI	9.43	117.1
Lamar Advertising Co	LAMR	4	96.8
Cogent Communications Group, I	CCOI	17	170.5
Shutterfly, Inc.	SFLY	18.75	182.6
Lattice Semiconductor	LSCC	11.5	165.3
Conceptus, Inc.	CPTS	17.5	201.6
Cepheid	CPHD	20	225
Black Diamond Inc	BDE	2.33	146.9
Quidel Corporation	QDEL	17.5	421.5
WebMD Health Corp.	WBMD	15	485.1
SL Green Realty Corp	SLG	-3.09	230.2
Diana Shipping Inc.	DSX	-16.62	11.4
Netflix, Inc.	NFLX	16.96	803.8
Citi Trends, Inc.	CTRN	10.67	942.7
Weatherford International Ltd	WFT	-30.72	11.4

That’s all for now.