Quantitative Methods – Page 14

The Education of an Investment Risk Manager, Part III

Posted on 30 March 201331 March 2013 by David Merkel

There’s kind of a rule of thumb in Asset-Liability management, that you match liquidity over the next 12 months, and match interest rate sensitivity overall.? I would do more than that, creating my own randomized interest rate models, as well as a new way of creating structured randomness in simulation models.? For a brief period of time, I had one of the best multivariate randomness programs out there, eliminating the problem of correlations in higher dimensions common with Hammersly points.? (My work was not theoretical, but intuitive… once I saw how the randomness was created, I figured out how to de-correlate the higher dimensions (since it was based on prime numbers, create more number than you need, and use a higher prime number to select observations.)

Anyway, when I brought my full-interest rate curve scenarios to the investment department in 1994, they said to me, “These are the first realistic interest rate scenarios we have ever seen.? Did you constrain them?”? I told them “No, just weak mean reversion.? Noise dominates in the short run, mean reversion dominates in the long run.”

As a result, for the lines of business over which I had oversight, we measured our interest rate mismatch in terms of days, weeks, and months, but never years.? Please ignore this incident where things drifted, but worked out exceptionally well (really, that should be a part of this series).? We published a document to show everyone how well we managed interest rate risk in Provident Mutual’s pension division.? We used scenarios far beyond what was required to show how well we did our work.? The regulators never complained.

At that point in time, the ability to integrate residential mortgage-backed securities into cash flow analyses was rudimentary at best.? But I found ways to make it work, most of the time.? That said, I remember joking with the MBS manager in late 1993, and saying there was a new term for a well-protected PAC bond.? He asked, “What is it?”? I replied, “Cash.”? He sarcastically said, “Oh, you are so funny.”?? That said, I pointed out to the investment department that some of their bonds that they thought would last another four years would disappear in 2-3 months.

Then there was the floating rate guaranteed investment contract project that I eventually killed because it was impossible.? You can’t argue with expectations that are unrealistic.? Even better, I beat the Goldman Sachs representative.

In running the GIC desk at Provident Mutual, I had to review a lot of strategies because making money on short-term bonds/loans was difficult, and difficult the degree that I doubted as to whether we were in a good business.? On the bright side, I protected the firm until the day that we? could not write any more? GICs, because our credit quality was too low.? That was the fault of the less entrepreneurial part of the company, so I couldn’t so much about it, except close my operations down.? I asked the senior management team to provide a guarantee to my GICs, but they refused.

As such, I shut the line of business down.? With clients that were unreasonable over credit quality, and management unwilling to extend credit protection to GICs, the battle over GICs was ended, and I sent the line into runoff.

Five years later, as we were now part of the same firm I stood at the estate of John Dwight, with a young woman that I had sold the last GIC of Provident Mutual to, I said, “The end of the GIC business of Provident Mutual.”? We talked, she smiled, but it was part of the end of an era, because GICs were a minority of the assets in Stable Value funds.

If nothing else, this helps to highlight the impermanence of all that is done in financial firms.? I know this in my own life, but I am sure that it is true for most people in finance.

The Education of an Investment Risk Manager, Part II

Posted on 30 March 20131 April 2013 by David Merkel

When I worked for Pacific Standard, which had the dubious distinction of being the largest life insurance insolvency of the 1980s, I had few investment-related tasks.? Investments were handled by the overly aggressive parent company Southmark, which gave little attention to risk.

But I knew things weren’t going well, and so I interviewed widely, finally landing two job offers with Midland National and AIG.?? I chose the spot with AIG, because they led me to believe I would work on the international side.? When I arrived, lo, I had a job on the domestic side.? As far as the job went, had I known I would be placed on the domestic side, I would have rather gone to Midland National.? They thought I had real leadership potential — whether true or not, that’s what I was told, and I would not have minded living in South Dakota, or nearby.? As it was, there were many good things that happen to me as a result of living in-between Wilmington, Delaware, and Philadelphia, living on the PA side of the line for reasons of adoption and homeschooling.

When I got to AIG, there was one main thing that involved my risk management skills.? AIG parent wanted growth in GAAP earnings.? They wanted to see a 15% ROE, which few in the life industry were attaining.? In order to do that, they entered into reinsurance treaties (before I arrived).? These would lever up the balance sheets of the subsidiary companies, without incurring debt.? Most of them passed risk to the reinsurers, one did not.

So, when I was called into an examination by the Delaware State Insurance Department auditor over the one treaty that did not pass risk, he said to me, “You know this treaty does not pass risk.”? I replied, “Under ordinary circumstances, I would agree, but the reinsurer has taken a significant loss from this treaty.”? He said, “What do you mean?”? I replied that when Congress passed the DAC tax, the reinsurer suffered the loss — they paid up front, and we pay over time, with zero interest.

He looked at me and said that reinsurance treaties did not exist to cover tax policy, and that the treaty was a sham.? I just shrugged.? I was not the creator of the treaty, and would not have done it if I had been at AIG two years earlier.

But the there were the two larger treaties that passed risk with a vengeance to a large reinsurer [LR] who is no longer a reinsurer (if anyone wrote treaties like these, he might not be a reinsurer anymore either).? In one sense, the treaties were structured like the trading requirements in CDOs.? If you must trade:

Get more income
Don’t give up rating
Don’t extend maturity
And a few more smaller things.

I was not there when the treaties were created.? Had I been there, I would have paid a lot more attention to them, and instructed the investment department to set up segregated portfolios, which was not done.? As it was, bonds that underlay the treaty were casually sold as if free to do so.

Now I arrive on the scene.? After reading the treaties, and looking at the data, I conclude that the treaties have been abused on our side.? I suggested to LR that I go through the history, and reallocate bonds that would have fulfilled the treaties strictures, an re-work the accounting so that the terms of the treaty would be fulfilled.? Initially LR agreed to this.

The treaty passed all investment risk to the reinsurer, so defaults would hit them.? What was worse, the liabilities underlying the treaty were structured settlements.? (Structured settlements result from a court case where someone is injured.? The defendant offers to buy from a reputable life insurer an annuity that will make the requisite payments.? Low bid wins, and if the plaintiff is badly injured, the cost goes down for payments that terminate at death.? That’s where most of the bad estimates com in.)? In those days, structured settlements were a “winner’s curse.”? If you won, it was because you mis-bid.? AIG Domestic Life Companies regularly overbid for their business (as did most of the industry).? LR did not do enough due diligence to see the underwriting errors.

I did a mortality study to estimate how badly we needed to increase reserves, and lo, it was more than $100 million, all of which would flow to LR.? LR decided to sue.? After I had gone on to Provident Mutual, AIG settled with LR.? Our missteps with the assets made the case tough, and the reinsurance treaty was rescinded.? That should have been enough to jolt AIG’s earnings for a quarter, but it did not.? Funny that, and it always left me a little suspicious of AIG.? (And LR.)

Before I left AIG, I had clipped the wings of the underwriters of the structured settlements so that they could not write on cases for the most severely disabled.? I also shut down a tiny line of variable annuities that was losing money left and right to an outsourcer who had a sweet contract from a prior management team, but upon leaving AIG I did not feel that great, because I had not built anything — most of my time had been spent trying to limit losses from prior bad underwriting and planning.? It wasn’t fun, and I loved my next company more because I got to build.

PS – a prior note on AIG.

A Few Notes from the Berkshire Hathaway 10K

Posted on 5 March 2013 by David Merkel

Letting the document speak, here are a few notes, starting with with the most significant part of the risk factors:

Investments are unusually concentrated and fair values are subject to loss in value.

We concentrate a high percentage of our investments in equity securities in a low number of companies and diversify our investment portfolios far less than is conventional in the insurance industry. A significant decline in the fair values of our larger investments may produce a material decline in our consolidated shareholders? equity and our consolidated book value per share. Under certain circumstances, significant declines in the fair values of these investments may require the recognition of other than-temporary impairment losses.

A large percentage of our investments are held in our insurance companies and a decrease in the fair values of our investments could produce a large decline in statutory surplus. Our large statutory surplus serves as a competitive advantage, and a material decline could have a material adverse affect our ability to write new insurance business thus affecting our future underwriting profitability.

Buffett does very well, but I know of no other insurer that invests so much in equities funded by insurance liabilities.? There is a real risk that if the markets fall hard, a la 1929-32, 1973-4, 2007-8. that BRK would be hard-pressed, particularly if there were some significant disaster like Katrina or Sandy, or set of disasters like 2004 or 2011.

And a note on the accounting change that Buffett mentioned in his letter, but did not decide to describe:

Underwriting expenses incurred in 2012 increased $586 million (21.1%) compared with 2011. The increase was primarily the result of a change in U.S. GAAP concerning deferred policy acquisition costs (?DPAC?). DPAC represents the underwriting costs that are eligible to be capitalized and expensed as premiums are earned over the policy period. Upon adoption of the new accounting standard as of January 1, 2012, GEICO ceased deferring a large portion of its advertising costs. The new accounting standard was adopted on a prospective basis and as a result, DPAC recorded as of December 31, 2011 was amortized to expense over the remainder of the related policy periods in 2012. Policy acquisition costs related to policies written and renewed after December 31, 2011 are being deferred at lower levels than in the past. The new accounting standard for DPAC does not impact the cash basis periodic underwriting costs or our assessment of GEICO?s underwriting performance. However, the new accounting standard accelerates the timing of when certain underwriting costs are recognized in earnings. We estimate that GEICO?s underwriting expenses in 2012 would have been about $410 million less had we computed DPAC under the prior accounting standard and that, as a result, GEICO?s expense ratio (the ratio of underwriting expenses to premiums earned) in 2012 would have been less than in 2011.

The point is that BRK’s underwriting result would have been very good without the accounting change.? The accounting change was a good thing, though.? Companies trying to inflate profits look for every marketing expense that they can deem an “investment.”? All of those costs would be spread over the life of the policies, rather expensed in the current year.? The new accounting standard limits what costs can be expensed to those that are truly marginal to the business produced.

Final note: They lost money on annuity reinsurance and retro at Berkshire Hathaway Reinsurance Group [Pp 34-36].? Retro sprang from new claims.? On annuities:

The annuity business generated underwriting losses of $178 million in 2012, $118 million in 2011 and $114 million in 2010. Annuity underwriting losses reflect the periodic discount accretion of the discounted liabilities established for such contracts as well as adjustments for mortality experience.

I am not sure I would want to reinsure annuities; I’m not sure that it is possible to insure long term investment guarantees, no matter how truncated.

Full disclosure: long BRK/B

On Equity Valuations

Posted on 26 February 201328 February 2013 by David Merkel

From a reader:

I only recently stumbled upon your blog, but I’m hooked. ?I can’t thank you enough for taking the time to share your financial insight, experience and wisdom.

I’m a new entrant to the financial services industry (3 weeks on the job) and feeling ill-equipped without a finance degree. I’m struggling with the application of equity valuation. I’ve read several DCF valuation books and can recite all the valuation ratios, but I still have trouble looking at a companies financial statements and using them to make a judgement on a companies stock price.

Do you have any book recommendations?for mastering fundamental equity valuation??

Any help would be greatly appreciated.?

Any book by Aswath Damodaran on valuation, or Michael Mauboussin’s book on Expectations Investing will give you the theoretically correct view on how to value any sort of company.? Also, this book by James Valentine is very useful.

But I want to make your life easier.? Typically, by industry there is one simple metric that drives valuation at any point in time.? That typically gears off of the maturity of the industry, and its need for additional capital.? For those that are math nerds, there is the true model, but us lesser mortals can’t run it.? But each industry faces constraints that others don’t, and so the true model in a given industry becomes simpler to a first approximation: focus on price-to-sales, price-to-book, price-to-earnings, or the PEG ratio, among other ideas.

These simpler valuation measures focus on what is tough to do.? Can we sell more?? Can we increase our profit margin?? Can we grow our business more rapidly?

This is why sell side analysts in a given industry do not use the full valuation models listed above, but use a partial version of them, as is appropriate to their industry.

It’s useful to know the overarching model, as the above books will give you. But practically, every industry is valued differently, because each one faces different constraints, and that drives their valuations.

My Theory of Asset Pricing

Posted on 23 February 201324 February 2013 by David Merkel

From a reader on last night’s piece:

David, can you expand on this – ” I would revise the concept of the cost of capital to make it credit-centric.? All the efforts to calculate the cost of equity capital from equity market correlations are bogus.? They don?t make any economic sense.? In most cases, the cost of equity should not exceed the yield on an average CCC bond.”

All valuation classes teach the equity market correlation method so it would be interesting to hear your views.

Equity exists in many forms.? In securitizations, equity is the tranche that takes the first loss and controls the deal.? In a mutual insurer/bank/thrift, etc.,? the book equity is held by the dividend-receiving policyholders.? The real equity is held by management, who actually control the place, because the dividend-receiving policyholders will not vote them out.? In a credit tenant lease, there is the guy that owns the property, and typically he puts up a teensy amount of equity, because there is a “credit tenant,” one that has an investment grade rating, and the mortgage is secured by:

the property
the senior unsecured credit of the “credit tenant,” whose lease payments pay the mortgage, and go directly to the lender, and
the equity owner.

In practice, the first two offer real security, and the third is a joke, sort of.? The thing is, if commercial property values inflate, there is a *lot* of leverage the the CTL structure for the owner of the equity.? And, if things go badly, most equity owners own the property though a thinly capitalized subsidiary.? Can’t squeeze blood from a stone.? “Heads, I win. Tails, you lose.”

Then there are more normal examples, like public and private equity.? The ownership is clear, though control varies considerably, considering the stakes that control investors have.

Contingent Claims Theory

Leaving aside options on equity, the equity of an investment is the most volatile investment that funds the assets of an economic entity.? The equity of an entity controls the entity, and possesses a valuable option — the option to abandon it all, and hand the company over to the next most junior investor.

Option valuation can tell us a lot about about the cost of capital.? The put option inherent in any debt can be measured, giving the following observations:

The more of the company that is financed with debt, the greater the risk of owning the equity (the default option is near the money), and the higher the cost of equity is.
The more volatile the economic results of the company, the higher the probability of bankruptcy, and the higher the cost of equity will be.
The underlying volatility of a company’s assets radiates out through it liabilities, with liability volatility increasing as liability claims become more junior.

In essence, thinking like a securitization, where you have many, many levels of debt, and as debt gets more junior, its yield rises as its economic prospects become more volatile.? Equity is not debt, but it is the juniormost claim on the assets and cash flow of the firm, even while it has control, which includes the option to adjust the capital structure.? (Had to add that, because it is important, but not strictly relevant to my argument.)

Holding the equity is holding control, with a complex option to adjust the capital structure, including the possibility of giving up control under bad conditions, or selling out under good conditions.? But now consider options on the equity — those options also imply a cost of equity capital:

The more volatile the at-the money option is, the higher the cost of equity.? (And the higher will be bond spreads…)
Another way to think about it is how expensive it is to set a floor under and equity investment.? Volatile companies have higher insurance premiums for their stocks.? That implies a higher cost of capital.
Using options, we can create pseudo-bonds, where we can lock in a certain range of returns.
A capital structure hedge fund can trade corporate debt and CDS [Credit Default Swaps] against equity options — they all price off of the volatility of corporate assets in the short run.
For any capital structure, the return on the assets can be modeled over a variety of credit scenarios.? Those returns can translate into returns for the various liability classes — e.g. trade claims, bank debt, senior unsecured debt, junior bonds, preferred stock, equity, and given the current prices for each class, the yields and yield spreads can be calculated, as well as the probability and severity of loss.

Summary

Cost of equity is a function of the overall volatility of the value of corporate assets, and the degree of leverage the firm employs.? This is how the cost of equity should be calculated.? Using a method like this, I believe the estimated cost of equity would be lower than what MPT models would produce, and the equity would display significant optionality, having very low returns under stress and very high returns under the best scenarios.

If we calculate the cost of equity like this, it will be an enhancement to DCF, and not require the bogus assumptions of MPT, because:

Risk is risk of monetary loss, not correlation to an index
Beta is not a stable parameter; correlation coefficients are not stable either.
This fits with the way that actuaries would price complex credit insurance policies, if they thought hard enough about it.
This fits with contingent claims theory, which legally describes the claim structures for competing classes of liabilities.

This is my theory of asset/liability/equity pricing in broad. Comments are welcomed.

The Education of a Mortgage Bond Manager, Part IX

Posted on 13 February 2013 by David Merkel

The Negative Convexity Project

Me: We can’t buy the majority of Residential Mortgage Backed Securities [RMBS] anymore.

Boss: What! That is a staple asset class of ours.? There’s nothing illegal about life companies owning RMBS.

Me: nothing illegal, yes, but because of new cash flow testing rules which our client is subject to, the negative convexity of RMBS will force our client to put up more risk-based capital than they would otherwise have to.? Most RMBS will require so much additional capital that the additional yield is uneconomic, and that assumes we get the yield when we want it, ignoring prepayment and extension risks.

Boss: I can’t believe that we can’t buy any RMBS… are there any exceptions?

Me: There are a few.? You know about the odd RMBS classes that have positive convexity, but little yield?

Boss: Yes, Yes… but why would we want to buy that?? Our client needs yield!

Me: I know that.? Would that they could do something other than need yield to sell yield.? There is one type of RMBS that still fits, and it is the NAS bond [Non-accelerating security], last cash flow structure.? Also, some of the credit-sensitive RMBS bonds rated less than AAA don’t affect the convexity issue, but we might not want to buy them, because the additional yield per unit risk is not compelling.

Boss: So what do we do?

Me: Buy NAS bonds when they are attractive, and buy CMBS that is attractive, after that look to corporates that our analysts like.

Boss: You are right, but I hate to lose a staple asset class.

=–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==–=-=-=-==-=-=–=-=-=-=-=-=-=

What I wrote there took longer than a single conversation, and involved contact with the client as well.? The client was very conservative with capital, because they levered up more than most life insurers.? The results of detailed cash flow testing would affect large annuity writers like my client, and negative convexity would make them put up more capital, constraining the amount of business they could write.

Wait: negative convexity simply means your bond portfolio hates interest rate volatility — it does better when things are calm.? That is certainly true with residential mortgages, where people refinance easily when rates fall, and in that era, no one faced falling property prices.

It took some effort, but I made my case to the client and my boss, and we stopped buying most RMBS.? As an aside, it made asset-liability management tighter.

Alternative Investments

I was not totally hidebound with respect to derivatives.? I bought our first asset-swapped convertibles, and synthetic corporates.? If the risks associated with getting additional yield were small, I would take those risks.? In both cases, they converted other asset into straight corporate debt (plus counterparty risk).

But I wouldn’t do anything.? I grew to hate CDOs, as I saw how perverse the structure was. I remember one weird CMBS deal structure that added a note that combined the AAA, BBB & BB CMBS of the deal.? What a nice yield, but the riskiness was greater than my models would allow for the incremental yield.

Finally, for this piece, the “piece of work” broker that I have previously described pitched me a private placement debt deal for a power producer affiliated with his firm.? After hearing the initial spiel, I said, “Okay, soft-circle me for $25 million, subject to due diligence; send me all of the hard data via email and paper.”

My request should not have obligated me to buy the deal.? Indeed, when I got the hard data, and began estimating the counterparty risks, I thought the deal was a loser, so I contacted the “piece of work,” and said, “Sorry, but we are dropping out of the deal — it just doesn’t offer enough value for the yield.”? After some arguing, he eventually said, “Look, stay in the deal, and I promise you that I will get you out at par at minimum on deal day.? Okay?”

Sigh, even though he was number eight with us, he served an important firm that could potentially do a lot for us, so I agreed.? The day of the deal came, and indeed, he got us out at a teensy premium (I would have accepted par, maybe even a slight scrape).? The deal did horribly, at least initially, though I have no idea of what the eventual credit result was.

As my boss who taught me bonds would say, “On Wall Street, if you want a friend, get a dog.”? There are some honorable people on Wall Street, but the economics of Wall Street often leads to suboptimal results for clients, and indeed, the salesmen may be sweet enough, but they live to distribute paper; they don’t live to be your friend in any true sense.? Professional duty to company trumps friendship.

Expensive High Yield – II

Posted on 19 January 201320 January 2013 by David Merkel

Near this time in 2012, I wrote a piece called “Expensive High Yield.”? In it I argued that higher quality high yield bonds were overvalued, but that CCCs might still have some play.

Here was my conclusion:

Whether I look at the Merrill High Yield Master 2, BBs, or Bs, junk bonds look expensive.? CCCs look a little cheap.? The yields on the High Yield Master 2 look about 0.8% expensive in terms of yield (that?s the residual in the above graph).? I will be lightening credit bond/loan positions in the near term.? Of course this is just my opinion, so do your own due diligence.

And, please realize that movements in the stock market may swamp my observations.? If the stock market runs, high yield can run further? but there will be an eventual snap-back.?? The bond market is bigger than the stock market, eventually the stock market reacts to bond market realities.

So what happened?? The stock market ran, and all corporate bonds tightened, Investment Grade and Junk.? Yield seeking continued, as people look for ways to earn 4% without undue risk.

But tonight I want to take a slightly different approach than last year, daisy-chaining the overvaluations in the corporate bond market.? I’m using the same data as last time — the indexes are the Merrill Lynch Corporate Yield Indexes as published at FRED of the St. Louis Fed.

The baseline for corporates are the few large AAA issuers.? The first check is whether AAAs are overvalued versus history.? Here are my regression results:

Okay, what this shows is that the concept of spread over Treasuries even at the AAA level is not valid.? The odds that the true coefficient versus the 5-year Treasury is one is minuscule.

This says that spreads on AAA bonds should widen when Treasury rates are low.? It also indicates that the simple model expects AAA yields to be 0.30% higher than they are now.

Perhaps that stems from the actions of the Fed, which they are now perhaps beginning to regret.? There are real costs when you force people to take more risk to get income.

My next step is to consider BBB bond yields as a function of five-year Treasury yields, and the Merrill Lynch AAA bond index yield.

The current environment shows a great deal of desire for yield.? BBB bonds are 0.87% lower than they should be relative to history.? If I used what the earlier model said the AAA yield would be? this would look worse by maybe 0.50%.

Perhaps that reflects the effects of QE as well, but with more vigor, as higher yields get competed down more.

That brings me to the next link in the chain, where I compare Merrill High-Yield Master II versus their BBB index.

Now, relative to where BBB bonds are currently priced, junk bonds are fairly priced versus history.

I would still argue the BBBs are too tight versus history, which means the same for the High-Yield Master.

That brings me to look at the yields on the CCCs.? I played this on two ways.? First, like the way with the high yield master:

In this case, it looks like CCC bonds are still relatively cheap to BBBs.? Let’s try a slightly different specification, because CCC bonds have equity-like aspects far more than BBB bonds.

So why not add in the high yield master?

It doesn’t have much effect on the ultimate result.? CCC bonds still look relatively cheap.? Do I trust this result?? No.

All that said, all of this points to a kind of exponential effect with respect to yields on various bonds with credit ratings.? Bond categories are highly correlated to those that are near them, but often negatively correlated to those a step or two beyond, when regressors are considered as a group.

Summary

All of the corporate bond market is expensive relative to history, perhaps excluding CCC bonds.? That doesn’t mean it can’t get more expensive, particularly if stocks continue to move upward.?? But this won’t last for more than two years; the signs of speculation are here, and that should make us cautious.

As a result, I am investing my bond strategy cautiously now.? What little yield I get comes from emerging market sovereigns.? Credit risk from corporates is small.

Sorted Weekly Tweets

Posted on 19 January 2013 by David Merkel

Central Banking

Records Show Fed Wavering in 2007 http://on.wsj.com/SgLPoG 4 all of their vaunted intelligence, the Fed was worried, but clueless in 2007 $$
Three Stages of Fed Grief: Key Quotes From 2007 http://t.co/X4ygwdqU Slowly realized the economy they overlevered was getting worse $$ Jan 18, 2013
Fed Concerned About Overheated Markets Amid Record Bond-Buying http://t.co/wDckfD77 The sourcerer’s apprentices note there is a problem $$ Jan 17, 2013
Paul Moreno: Gold, Greenbacks and Inflation: A History and a Warning http://t.co/75M1jNRo Ppl forget the degree the Fed has debased $$ Jan 17, 2013
Once you turn base money into short-term debt, can you go back? http://t.co/pG3gxBwA @interfluidity ideas getting deserved attention $$ Jan 16, 2013
First Shots Are Fired in Global ‘Currency War’ http://t.co/y6GJi0V5 Japan leads “race 2 the bottom.” Who will b first 2 stop sterilizing? $$ Jan 16, 2013
Currency Moves? & Central Bank Bravado http://t.co/zt7BI1As Posit that the yen is falling due to war risks & Japan biz risks in China $$ Jan 16, 2013
Abe Rocket-Start Lowers Sony Risk With Market Fuel http://t.co/J4cLgQKJ Loose monetary has spillover benefits 2 indebted corporations $$ Jan 16, 2013
I’ll grant this: the government always has some role in money, even commodity money like a gold standard… http://t.co/QtVI3oeC Jan 12, 2013

Rest of the World

Pressure Rises on China to Scrap One-Child Policy http://t.co/iDfZ0Ssl No better way 2 have a demographic crisis; change long overdue $$ Jan 18, 2013
Default Alarm Rings as Trust Loans Jump Sevenfold http://t.co/2tr1vFnq China is so messed up that it makes the Eurozone look good $$ Jan 17, 2013
Singapore Curbs Industrial Property Sales to Avert Bubble http://t.co/vZQhsdya Increases bid-ask spread; can’t fight fundamentals $$ Jan 17, 2013
Mongolia?s Erdenes TT Halts Coal Exports to Biggest Buyer China http://t.co/hoTHAxxZ Probably either gross malfeasance or bribery $$ Jan 17, 2013
European Dividends Tumble to Four-Year Low as CEOs Hoard http://t.co/D6YdzVqD Favor European Exporters over their Domestic companies $$ Jan 17, 2013
Euro at 10-Month High Poses Economic Threat, Juncker Says http://t.co/bk0FsVEE The #currencywars continue. Rule: Beggar thy neighbor $$ Jan 17, 2013
Russia Says World Is Nearing Currency War as Europe Joins http://t.co/OvVu0ZMH Accept export slowdown? Monetize debt? Stupid QE-like stuf? Jan 17, 2013
Rio Tinto CEO Steps Down http://t.co/lqWyRPES Every CEO should have etched on his wall: “Paying up 4 scale acquisitions is dumb” $$ $RIO Jan 17, 2013
China Capital Flow: Foreign Direct Dis-Investment http://t.co/V8erkuxL Foreign inv’t inflows falling, domestic inv’t outflows rising $$ Jan 17, 2013
China Starts Losing Edge as World’s Factory Floor http://t.co/pG7uOFqX SE Asia benefits as China becomes more expensive 2 operate in $$ Jan 16, 2013
Norway Sees Deeper European Job Pain as Default Fears Recede http://t.co/ztbfvp0H Rising NOK makes exports less competitive &fewer jobs $$ Jan 16, 2013
Often when FX vols spike it means something might break, like the SNB not able continue its EUR peg. But if… http://t.co/fydAlRSX Jan 16, 2013
HSBC needs 2 end its Ping An silence with simple answers http://t.co/8xVAWiHD much alleged insider deal information has been circulating $$ Jan 14, 2013
Mainland alchemists turn damaged zinc into solid gold http://t.co/W4zu69k7 An example of how Chinese banking system papers over bad debts $$ Jan 14, 2013
Rumor: large backlog of Chinese companies want to IPO, but having hard time slowing the required 2 years of rising earnings $$ Jan 14, 2013
Neighbors Grow More Wary of China http://t.co/aYMUvLs2 Ex-pat Chinese moving in, looking a little graspy w/respect to resources, etc $$ Jan 14, 2013
Mineworker Debt Mounts as South African Lending Booms http://t.co/hTkXyCTc There are few places in the world without debt overages $$ Jan 14, 2013

Market Impact

Deutsche Bank Derivative Helped Monte Paschi Mask Losses http://t.co/PeqTdPBT Bad investing led to losses 2 hide. Enter Deutsche Bank $$ Jan 17, 2013
reaching for yield http://t.co/zFaWCA7h @researchpuzzler notes tight junk spreads, but + Ed Meigs & Dan Fuss r ?naysayers on junk credit $$ Jan 17, 2013
Short-term Debt and Financial Crises: What we can learn from US Treasury Supply http://t.co/UG1RvuHm Qty issue ST fin’l sector debt->crisis Jan 17, 2013
22 Insights From The Most Successful Investors In History http://t.co/4u3QVRJL Very nice assemblage of quotes from the best investors $$ Jan 16, 2013
[Will] the Bond Bubble Finally Burst? http://t.co/1c7hOX4W Synthesis of a variety of views: Yes, but not in the short-run… $$ Jan 16, 2013
FINRA to brokers: know your high-yield securities http://t.co/DJHC5NvT Intelligent words from FINRA; b able2show clients all possibilities Jan 16, 2013
The High Yield Market is “Completely Out of Control.” http://t.co/GBUfGOa9 Watch risky debt buyers; c if they need things 2go right2survive Jan 16, 2013
Gold Forecasters Splitting on Peak for Bull Market http://t.co/EIEgk2Al Most-accurate gold forecasters>price will probably peak in 2013 $$ Jan 16, 2013
Whatever Happened 2 Good, Old-Fashioned Accountants? http://t.co/aFofQ4Mv @retheauditors explains y basic blocking&tackling go a long way $$ Jan 17, 2013
Yale May Buy More Hedge Fund Assets After Favoring Cash http://t.co/D0cP9LDV Timing feels wrong here w/credit spreads tight & vol low $$ Jan 16, 2013
Baupost Group Sitting On 116% Return From Madoff Claims http://t.co/u4MYuhJI Bankruptcy judge said ?seller?s remorse,? denied his effort $$ Jan 16, 2013
Leeway on Repo Rules Is Cut Back http://t.co/B16EXZfR “…we’re basically saying all repos should be accounted for as borrowings,” $$ Jan 16, 2013
Inside the Self-Driving Index Funds That Finish First http://t.co/XPEfHyE4 @jasonzweigwsj $BLK low fees, shares sec lending revenue $$ Jan 15, 2013
How2use Twitter & Facebook 2 make $$ from shares http://t.co/lXXw321E Just watch: this causes the next ‘flash crash’ h/t: @abnormalreturns Jan 14, 2013
KRS Spin Machine Is Smearing The Truth Again http://t.co/VGGSkxHX Kentucky Retirement Systems does not use RFPs -> “pay to play” @ KRS $$ Jan 14, 2013
US Not So High Yield Bonds : “It’s Starting To Feel A Lot Like 2007” http://t.co/QUGhAMqC Will supply grow, or will misfinancing start? $$ Jan 14, 2013
SP500 Revisited – Testing 1484/1500 zone and reversal after? http://t.co/8TMktTjD Argues for a correction in stocks in the near term $$ Jan 14, 2013
Hedge-Fund Leverage Rises to Most Since 2004 in New Year http://t.co/rwFVhRmz H0: flexible $$ overallocated to stocks now> correction due Jan 14, 2013
39% of Fund Managers Beat the S&P in 2012 http://t.co/xRx3Juik It was a growth year & not a value year. 48% would b the 10-yr average $$ Jan 13, 2013

Billionaires

I suppose Bloomberg could write a book about hidden billionaires, and call it “The Billionaire Next Door.” http://bloom.bg/WN9Jo8 ?#yeah $$
Erie Billionaire Hagen Revealed as Car Premiums Surge http://t.co/BsMEp8gu $ERIE interesting company w/a unique asset-lite biz model $$ Jan 17, 2013
Hidden Billionaire Milking Saudi Dairy Fortune in Desert http://t.co/XAoRKBRp Bloomberg likes ‘outing’ obscure billionaires like this $$ Jan 14, 2013

Personal Finance

Why you can?t avoid dumb 401(k) mistakes http://t.co/fffPsn0k Plan sponsors chase hot managers & avoid passive options $$ Jan 16, 2013
Behind the indexed annuity curtain http://t.co/Qo7RdSX9 Avoid. Surrender charges r long & high 2pay commission; opaque int crediting $$ Jan 16, 2013
One in four savers has 401(k) ?leakage? http://t.co/TRBsFfwx Retirement seems far away, but $$ needs r near, so ppl tap their 401(k)s Jan 16, 2013
Seven Resolutions to Get Your Nest Egg in Shape http://t.co/cqNqpxJF Good basic advice 4 ordinary people taking care of the nest egg $$ Jan 16, 2013
E-Filing and the Explosion in Tax-Return Fraud http://t.co/9SAE6oPL Identity theft; 1 reason y I do it myself & file on paper $$ Jan 14, 2013
Housing Problems: Where To Get Help http://t.co/3hrCyQFy @retheauditors gives advice to those having issues with foreclosures $$ #goodstuff Jan 13, 2013

Banks and Investment Banks

More Ideological Excuse Making for Bad Banks http://t.co/0wjkQq3n It takes two to tango; it takes two to make a loan. Both deserve blame $$ Jan 17, 2013
A tempest in a spreadsheet http://t.co/W2mwYeHO A reason y having robust “smell tests” r needed when mathematical models get complex $$ Jan 17, 2013
Mortgage Nanny Added to Lender Job Description http://t.co/nRRonPBL Caveat Emptor:May make probs worse by creating illusion of safety $$ Jan 17, 2013
Wells Fargo to Start Jet-Leasing Venture http://t.co/a0FwgcNn FD: + $WFC | I like the fact that theyr starting small #organicgrowth $$ Jan 17, 2013
Jefferies Sets Table in Pay Clash http://t.co/s6utAuEy Or, they could jump 2 $JEF soon 2b $LUK. $$ motivates better, but conflicts occur Jan 16, 2013
Bankers Get IOUs Instead of Bonus Cash http://t.co/fKrpWXZL Will tie employees more tightly, unless they jump to related industries $$ Jan 16, 2013
Report of $JPM Management Task Force Regarding 2012 CIO Losses http://t.co/i7x0Ifi4 [132pp PDF] If interested in $JPM, summary in 17 pgs $$ Jan 16, 2013
Municipalities Should Ditch Wall Street Derivatives Deals http://t.co/Jqmgjllk If Wall St is on other side of table, watch your wallet $$ Jan 16, 2013
Banks say new agency’s oversight is slow, costly http://t.co/aHIGFRUh Banks pine away over the regulatory laxity they had 6-10 years ago $$ Jan 16, 2013
Goldman?s ?Secret? Team Shows Volcker?s Folly http://t.co/fovIyDRf Difficult to stop prop trading, better 2 remake I-banks partnerships $$ Jan 14, 2013
Bank Deal Ends Flawed Reviews of Foreclosures http://t.co/7DoTN8yA absurd, $$ will b distributed w/little regard 2 who was actually harmed Jan 13, 2013

Economic Policy

Portfolio Manager Creates Dazzlingly Deep Presentation On What’s Really Going On With The US Economy http://t.co/vcRHWwEe Long but good $$ Jan 17, 2013
Obama Finds Path to Congress Deals Goes Through McConnell http://t.co/B763HV1u Give him his due; has a nose that can sniff out deals $$ Jan 16, 2013
The Next Tax Increase http://t.co/7beI2QUO What the US Govt has belongs 2 the US Govt. What belongs 2u is subject 2 negotiation $$ Jan 16, 2013
Swap the Debt Ceiling for a Rule That Makes Sense http://t.co/NVYjvTD8 Maybe limit total liabilities of US Gov’t to 2x GDP? Way past that Jan 16, 2013
Why U.S. might be ?a nation of deadbeats? http://t.co/UuOHrKlt Consumers have been paying down debt, but walking away from more $$ Jan 16, 2013
A Credit Downgrade Warning Both Sides Should Listen To http://t.co/TbB3Gbdn Rating agencies r more honest than US Govt. Fitch may d/g US $$ Jan 16, 2013
Treasury Bill Rate Curve Inverts Amid Debt-Ceiling Showdown http://t.co/0KOQqC7A Bill curve showing some inversion due 2 debt ceiling $$ Jan 16, 2013
Money-Printing Will Lead to an Inflation in Another Guise http://t.co/erqP71P7 Debt overload & slack capacity short circuit credit growth $$ Jan 16, 2013
Two Warning Signs for Treasuries http://t.co/BdAcNkHE “yield curve btw 2&10 years is starting to steepen” Resistance 2 neg real rates up $$ Jan 16, 2013
TIPS Implied Inflation 4 2018-22 rose over 2012; flat now http://t.co/R28O77bX 2014 Inflation rising http://t.co/VCfupYLT $$ Fed target 2.5% Jan 16, 2013
US states flirt with major tax changes http://t.co/EnZmtggx Red states moving toward sales & away from personal/corporate income taxes $$ Jan 14, 2013

States & Municipalities

California, Unsaved, Speeds Toward a Wall of Debt http://t.co/pyrObgbr Constants in life that r not comforting: gimmicks in CA budget $$ Jan 17, 2013
California Could Be the Next Shale Boom State http://t.co/r0QChYDh Energy could flow from the Land of Squandered Advantages $$ Jan 16, 2013
Pension Funding Gap Widens for Big Cities http://t.co/a76JAJT0 Expect 2c many fights where bens cut 4 new, active & retired employees $$ Jan 16, 2013

Companies

Suitors Interested in H-P’s Autonomy, EDS Units http://t.co/AXdvxjei Wouldn’t put 2 much into this; $HPQ won’t get good prices $$ Jan 16, 2013
Genworth Shares Soar Amid Plan for Mortgage Insurer http://t.co/Jqmgjllk $GNW moves deck chairs on the Titanic; rewarded for now $$ Jan 16, 2013
Chevron Signs Deal for More Oil Exploration Acres Off China http://t.co/Yqb7yY7g FD: + $CVX smiles as it rides the tiger $$ #risks Jan 16, 2013
My Favorite Tobacco Stock Is Intel? http://t.co/Wupvh1qk @CharlesSizemore explains y it should deliver returns, amid hatred $$ FD: + $INTC Jan 16, 2013
TNT Left at Altar Gets No Immediate FedEx Deal http://t.co/QSdDHarC “FedEx in a good position to wait this out & let TNT come to them.” $$ Jan 16, 2013
Latest IPOs Arrive In The Form of New MLPs http://t.co/cq7XuIKv All of the new MLPs r energy-related $$ Jan 14, 2013
ARM CEO East Says Phooey to the ?Transistor Cliff? http://t.co/wfiIeQau Cost, speed, & power use r the key factors 4 logic chips $$ Jan 14, 2013

Miscellaneous

Davos Pitch for Dynamism Rams Into End-of-Growth Debate http://t.co/1bNvkwD7 I don’t think growth is ended, but bad finances interfere $$ Jan 17, 2013
Global Piracy @ 5-Yr Low http://t.co/YgJlRQSh 2012: Pirates boarded 174 ships globally v 439 in 2011, people taken hostage 585<-802 $$ Jan 16, 2013
NRA Labels Obama Hypocrite on Guns for Child Protection http://t.co/DqIsubsA Administration doesn’t like the argument; hits close 2home $$ Jan 16, 2013
Kidnap insurers eye sales as euro crisis bites http://t.co/w5CfiwOe Stable rates: More competition, & armed guards 4 sea transport $$ Jan 16, 2013
Mathematicians coming of age to become the most sought after professionals http://t.co/thXJdgsS Nerds of the world unite! Big data 2analyze! Jan 16, 2013
The Margin Debate http://t.co/zE6p5oO1 Labor share of US GDP has fallen because growth in the global capitalist labor force, wages fall $$ Jan 13, 2013

Financial Blogging

Your guide 2the financial blogosphere http://t.co/9mkoln2n Comprehensive list of finance bloggers. I’m listed under “Trading & Investing” $$ Jan 14, 2013
What are the 100 Top (Anglo-Saxon) Finance Blogs? A Pseudo-Scientific Study http://t.co/I9UU32zP I ranked higher than I expected 🙂 $$ Jan 14, 2013
The purpose of this site http://t.co/Bp4sqw5o @reformedbroker ‘s excellent piece on how his blogging helps him think & invest better $$ Jan 14, 2013

Painting Kate Middleton

@judehere Perhaps this then? http://t.co/hstcUqPq Jan 16, 2013
@judehere That’s okay. You say he painted the Queen? That’s interesting. Is there an image of that out on the web? Jan 16, 2013
‘ @judehere She seems to be a nice lady, so I wouldn’t be a fan of that. But Freud died in 2011, so the possibility is not there. Jan 16, 2013
But this portrait of Kate Middleton is worse in my opinion http://t.co/LBMKplpo No wonder only 19% like it. (2/2) $$ Jan 16, 2013
Learning to draw, I copied a photo of a friend w/pencil. Another friend said “You took a very pretty girl, & turned her in2 pretty girl” 1/2 Jan 16, 2013

Michael Pettis

Pettis: What I will watch in 2013: 10 things: hard commodity prices, trade numbers, Spanish Bonds, Target 2, & Japan (2/2) $$ Jan 14, 2013
Pettis: What I will watch in 2013: 10 things: China growth, Debt trajectory, financial scandals, bank activities, inflation (1/2) $$ Jan 14, 2013
Pettis: Imbalances can continue for many years, I argue, but at some point they become unsustainable & the world must adjust by reversing $$ Jan 14, 2013
Pettis: Policymakers do this by shortening their time horizons &managing from crisis2crisis, rather than sorting out the underlying problems Jan 14, 2013
Pettis: policymakers… taking steps that protect them from the consequences of the crisis but that also make the crisis worse. $$ Jan 14, 2013
Pettis: It is interesting that policymakers are so pleased by an end (temporarily, I assume) to the financing crisis. $$ Jan 14, 2013
Pettis:We ended 2012 in a burst of optimism for Europe, w/everyone cheering Mario Draghi 4having ?saved? the euro, but I am deeply skeptical Jan 14, 2013

Wrong

Wrong: How to Find a Fund Manager Who Can Beat the Market http://t.co/2Nq1Z9b2 Doesn’t understand difference btw correlation & beta $$ Jan 15, 2013
Wrong: US Budget : Federal finances continue to improve http://t.co/HKzv6pLK It is a *spending* problem that started w/Bush 43, not revenue Jan 15, 2013
Wrong: Municipal Bonds May Not Be Safe From Income Taxes http://t.co/MnIQIdor Would be a big shift, hit blue states hard. Won’t happen $$ Jan 14, 2013
Wrong: Chris Hayes’ Brilliant Explanation Of Money Is One Of The Best Things We’ve Ever Seen On TV http://t.co/e0kxN5oZ #goldstandard $$ Jan 13, 2013

Comments and Retweets

Good night. Blessings to all. Jan 18, 2013
@cogent_rambling Think of judges in a court. No one will forgive a man for doing wrong in one area, because he has done good in others Jan 18, 2013
@cogent_rambling It’s not a question of weakness but wrong. Divorce your wife for no good reason, cheat at your craft, all amounts 2 wrong Jan 18, 2013
@cogent_rambling Good question. God created Lance with a weakness. If Lance had trusted God, he could have overcome it, but he didn’t. Jan 18, 2013
@cogent_rambling Not those that are God-given. Mt 5:48: “Therefore you shall be perfect, just as your Father in heaven is perfect.” Jan 18, 2013
@cogent_rambling One last point: in the view of Jesus is there is no balancing. The least amount of evil poisons any good. Jan 18, 2013
@cogent_rambling Read some of the writings of Kahneman & Tversky. Bad things have 3 times the force of good things. Good doesn’t erase bad Jan 18, 2013
@cogent_rambling Okay, I get it. But doing good things does not erase bad things. Doing things that are notably bad tarnishes anything good. Jan 18, 2013
@cogent_rambling I have heard the word as a part of popular culture, but have no idea what it is beyond a phrase. Jan 18, 2013
@cogent_rambling Okay, I’ll bite. His charitable endeavors, but what else? Jan 18, 2013
@sallyeastman1 Well said Jan 18, 2013
My view: Lance Armstrong is best ignored. Close the browser window, change the channel on the TV, he will go away. I don’t care about him $$ Jan 18, 2013
@AboveAvgOdds Off to meet w/u & Chris Mayer in downtown Baltimore Jan 17, 2013
Endorse. I have read over half of these $$ RT @TheStalwart: The 22 books that Dylan Grice says you must read. http://t.co/QSOWvuBc Jan 17, 2013
@graemehein good point, but most simple models have obv intuition. Complex models have more potential 4 error b/c of 2nd+ order effects $$ Jan 17, 2013
@cate_long Others that did the same in 1994: Piper Jaffray’s Institutional Gov’t Income & FPA’s Fundamental US Gov’t Strategic Income funds Jan 17, 2013
@cate_long Combined w/levering them, and not having the mathematical savvy to price them right http://t.co/5vkUxgO6 Story near the bottom Jan 17, 2013
@cate_long Cate, you’re right, I’m wrong. At the time, David Askin & those like him were notable. W/Citron it was mostly structured notes Jan 17, 2013
@kirstensalyer Sorry, that honor belongs to the first quantitative hedge fund manager, Ben Graham, who was doing that in the 1920s Jan 17, 2013
@cate_long Also used complex RMBS. There was kind of a contest 2c how much negative convexity one could absorb in exchange 4 yield Jan 17, 2013
RT @maxrudolph: #unintendedconsequences when pension regs set up EA designation cut off practitioners from ALM development. Still catchi … Jan 17, 2013
Well done $$ RT @LaurenLaCapra: Jim Chanos talks to @Reuters about Herbalife & whether Ackman or Loeb will win out: http://t.co/sV7B604o Jan 17, 2013
@finsovet @prieur @vitaliyk Honored 2b included in such a group Jan 17, 2013
Think this analysis is correct, but uncertain $$ RT @mickwe: 3D printing is a lot of hype and it’ll never go mainstream http://t.co/8wkr5oxp Jan 17, 2013
I just left a comment in “7 gut checks before the stock market?s opening bell” http://t.co/MrSqVXZF Jan 17, 2013
@niubi If so, good for him. He revolutionized my economic thinking with his last book. Looking forward to the next one. Review copy coming Jan 17, 2013
+1 RT @dpinsen: Paging @TomFriedman: comment on How a ‘model’ employee got away with outsourcing his work to China http://t.co/wukYAV8T $$ Jan 17, 2013
+2, scrap IFRS RT @Alea_: +1 Britain should scrap IFRS accounting standards, MPs told http://t.co/woWmyC2v Jan 16, 2013
@oddballstocks very different mindsets; marketing and operations r different from finance, which is still different from investing Jan 16, 2013
@oddballstocks I did that as well from 1992-1998. Tried very hard to select non-name-brand mgrs w/durable competitive advantages Jan 16, 2013
‘ @ClayNickel It depends on how equitylike the bonds r, & the financing composition of the holders. If the bonds r financed w/sig debt.. $$ Jan 16, 2013
RT @Matthew_C_Klein: The big deal about the German gold story isn’t that they’re taking some of it out of NY but that they’re moving *al … Jan 16, 2013
RT @Matthew_C_Klein: @izakaminska has a thoughtful take on the base money debate between @interfluidity and @NYTimeskrugman http://t.co/ … Jan 16, 2013
‘ @joshuademasi Good point. After all, most nations would love to swap for Norway’s economic situation. $$ Jan 16, 2013
@earwulf Good insights both. We live in “interesting times” in the full meaning of the Chinese curse Jan 16, 2013
@ReformedBroker Rieder is a bright guy, as is my friend Ed Meigs at First Eagle; HY is okay for the short run, but 2 years out… $$ #Boom! Jan 16, 2013
@earwulf Yes Jan 16, 2013
@earwulf No, I don’t really find them persuasive. I do think that some Central Bank will stop sterilizing asset purchases, start new phase Jan 16, 2013
@JacPatterson I thought about that too, & think he really meant “English Language” Finance Blogs Jan 15, 2013
“But that also means you have to keep more $$ around if the puts get exercised, which Buffett had & many don’t.” http://t.co/uEIRn5i3 Jan 15, 2013
@joelight @spbaines the paragraph that starts ‘To screen out such “closet indexers,”‘ is factually wrong, does not understand statistics Jan 15, 2013
@joelight @spbaines I’m not arguing w/R2 as a proxy for active share, though there r better measures; article says correlation, means beta Jan 15, 2013
+10 Mmmmm… RT @dpinsen: Bresaola, lemon, olive oil, Parmesan, and basil joining forces for a great sandwich. http://t.co/pMMVmoI5 Jan 14, 2013
@abnormalreturns I’ve run into a *lot* of people trying to do this. Some are cleverer; not sure how it will work out… Jan 14, 2013
@JayLeonard but gold does control inflation and limits the government’s ability to use monetary policy for its own ends Jan 13, 2013
@JayLeonard Much of the difficulty is not gold vs not gold, but how banks were regulated — short liabs carrying long assets Jan 13, 2013
@GuldbergPeter Thanks, though I have heard that Canada *may* have issues. Jan 12, 2013
RT @GuldbergPeter: “@AlephBlog: Is there anyplace in the world that hasn’t overlent on real estate? Sweden, Canada and actually to some … Jan 12, 2013

FWIW

My week on twitter: 40 retweets received, 1 new listings, 67 new followers, 65 mentions. Via: http://t.co/SPrAWil0 Jan 17, 2013

Matching Assets and Liabilities Personally

Posted on 15 January 201315 January 2013 by David Merkel

An email from a reader:

I saw some of your articles on Seeking Alpha, then read through a bit of Aleph Blog.? Thanks for writing the articles, they are quite interesting.? I have seen the advice “Match Assets and Liabilities” more times than I care to count.? And your insurance example is a very clear one.? However, I have never seen a clearly worked example for an individual.? When I look at it for my own case I never quite see a clear optimality from matching assets with liabilities.? Perhaps part of the difficulty is that most individual liabilities (or at least for me) are flexible in some way (vacation – luxury or basic?).? Another issue is that my major “asset” is my salary – which produces vastly more income than my assets.? So I’d love to see you (or anyone) work out a clear example of how matching works for an individual, particularly one with more salary income than investment income.

If you care for some numbers, here is my rough case:

0) I have a significant buffer.? Green light here.

In addition to the buffer, enough cash to prefund all of the following:

1) 5,000 liability in 2 months

2) 20-30,000 liability in 6-12 months (I have some, but not total, flexibility in timing and amount)

3) 40-60,000 liability in 2-4 years (again flexibility, and hope that investment return could help increase the number)

After that are two larger expenses which I don’t have sufficient cash for.? The amounts would be significantly modified based on investment returns:

4) 100-200,000 purchase to upgrade house? in 5 to 10 years

5) In 30 years retire based solely on savings.

Let me start by mentioning two old articles:

Personal Finance, Part 11 ? Your Personal Required Investment Earnings Rate [PRIER]

Personal Finance, Part 12 ? Longevity Risk

Both concepts play a large role in what I will write here, but I am not going to repeat them here.? I’ll try to keep this simple.

Intuitively, people know that they need to match assets and liabilities, but they sometimes forget that when greed or fear emerge.? If I am planning on buying a house next year, and I have just enough for the down payment and closing costs, why do I not invest the money in stocks?? Because I might not be able to follow through on my goal if the market drops.

If I am planning on retiring in 30 years, but I am risk-averse, why shouldn’t I invest all my money in a short-term bond fund?? Because higher long-run average returns result from bearing moderate risk.? On average, maximum returns result from bearing moderate risk over long periods of time.

So, how does this calculation work?? You create two columns of numbers.? The first column is what I need to fund.? Now when I say that I am not talking about regular living expenses. I am talking about the big ticket items that are required, and that you know about now.? Plot out those cash flows, year-by year.?? For the really long cash flows, like retirement, you might want to add in an adjustment for inflation.

The second column is how much you will save each year after regular living expenses, including the excess assets that you have now.? The difference between those two columns is your net cash flow profile, and by using the IRR or XIRR function in Excel, you can figure out your PRIER.

Don’t expect to earn much more than what long Baa/BBB bonds yield now (presently 4.7%).? If the PRIER is so high that you know that you can’t earn that, then it is time to make hard choices:

Save more
Reduce goals
Work longer
Etc.

Now, as to the investment of funds to achieve those goals, it’s not that complex.? Inside five years, buy short/intermediate term bonds. 5-10 years half intermediate bonds, half risk assets, like stocks. 10-20 years should be 75% risk assets, 25% long bonds.? Beyond 20 years, 100% risk assets, or, extremely long bonds if attractive.

When I say this, I do not mean to ignore market conditions.? There are times when risk premiums are low, like now, 2000, 2007, and it does not look like risk will be rewarded on average over the next ten years — that is a time to preserve capital.? Then there are times when the market has washed out — 2002, 2009, those are times to take more risk.? Stocks are harder to measure, so if you need better guidance, look at the yields on junk bonds.

Asset allocation is a compromise between matching assets and liabilities, and examining relative advantage in the asset markets.? Sometimes stocks are better than bonds, or vice-versa.? Gold works well during times of financial repression.

In Closing

There are a number of key variables we don’t know here:

Future inflation
Likely savings
Asset returns in nominal or real terms

A good plan will attempt to leave some slack in case asset returns are lower than expected.? I would not assume that I could earn more than 5%/year over the long run, or maybe 2.5% after inflation.

Given what I know, this is the best answer I can give.? With more data, I could sharpen it.? But the really hard part is estimating expenses when retirement is a long way off.

The Evaluation of Common Stocks

Posted on 9 January 2013 by David Merkel

Today, Tom Brakke of the Research Puzzle wrote:

?Go to it then. The field is wide open. The old masters have confessed their inability to determine value objectively. More investors than ever before are committing their capital to stocks. Very little has as yet been done in the field of stock evaluation by statistical organizations ? and I say this with full awareness of our own efforts in the past 21 years. Here in the field of stock evaluation you will find a worthy challenge to your intelligence, and exciting adventure too.? ? Arnold Bernhard, founder and editor of the Value Line Investment Survey.

The above excerpt is the last paragraph of Bernhard?s 1959 book, The Evaluation of Common Stocks. It is interesting to consider the changes since that time and to ponder the opportunities (or lack thereof) that exist now as a result of those changes.

Is the field still ?wide open? for the enterprising investor?

When I was writing my Master’s Thesis at Johns Hopkins at the tender age of 21, I did a significant study on what did and didn’t work in stock investing.? My unpublished Master’s thesis anticipated momentum investing, but I did not get it at the time.? It also showed that value effects could make money, as well as tracking insider trading.

My life might have been quite different if I had started a hedge fund in my 20s off of my thesis… might have been richer, but my knowledge of of business was enriched by being an actuary for so many years… admittedly, I was not your normal actuary, but having to solve practical business problems does shape your views of many other things.

But Value Line, as created by Samuel Eisenstadt, discovered quantitative growth investing — price momentum, earnings momentum, and earnings surprise long before the rest of Wall Street caught on.? Once Wall Street caught on in the 90s, a lot of the excess profits got squeezed out, and Value Line lost its mojo.

As an aside, when I was running a set of multiple manager funds that did pretty well in the 90s, one manager had its methods and they were price momentum, earnings momentum, and earnings surprise.? I said to them, “Oh, you do what Value Line does.”? They were as offended as they could be without poisoning the possibility of being hired by us.

In another situation, I ended up hiring a value plus momentum manager in the mid-90s.? Very reliable outperformance.

But let’s go back a little further.? After the Great Depression, a lot of companies sold for considerably less than their net assets.? This diminished but held true until the 60s.? Ben Graham earned his living from arbitrage and net-net value investing.? Buffett, getting started later, did much the same, but being younger, reached a point where the easy opportunities were largely gone, but he had a lot of his investing life in front of him, unlike Graham, who picked that time to retire.

Value investing I do not think is tapped-out, though beating value indexes is difficult.

In the 80s, quantitative value came into existence, along with momentum and size as factors.? But throughout the 90s insider trading, net operating assets, distress and other factors began to be modeled. Now there are many quantitative factors, and it is hard to tell which are redundant.

With Graham, and Buffett and Eisenstadt in their early years, financial data did not flow easily… those who put in the hard work of gathering scarce data earned exceptional returns.? Today, with the internet, mere quantitative investing yields less of an advantage.? In order to do anything worthwhile some qualitative knowledge must be mixed in, or, proprietary data that few have.

Tom asks if the field is wide open.? I don’t know.? We’ve had a lot of discoveries over the past 50+ years, but discoveries are sometimes “forgotten” when they lose their punch.? There may be future discoveries, whether from technical or accounting measures.? I am reluctant to say everything that can be discovered is discovered, but I don’t want to say that there will be some earthshattering theory in the future… that may not happen.

What might happen is an economic disaster like the Great Depression that makes many flee stocks.? Then some of the older theories will work again for a time.? So I would answer Tom — is the field wide open?? No, but it is open somewhat, and with a lot of application and intelligence, it’s possible but not likely that you will do something amazing.