Quantitative Methods – Page 27

The Education of a Corporate Bond Manager, Part II

Posted on 17 July 201018 July 2010 by David Merkel

For a new corporate bond manager with very little apprenticeship-type training, I had to learn some things on the fly.? Of my first tier brokers, roughly half of them took pity on me initially and explained to me the rules of the road.? That happened partly because I wanted to try some things that my old boss rarely did, and as I did that one of my brokers would explain to me, “If you’re going to do that, you have to do it this way…” which I would confirm with one or two of my major brokers.

If I wanted to buy a bond that was not presently being offered, I learned to find out who brought the deal and made a market in the bond issue, and told them, “If you find a few million bonds in a such and so spread context, I would be happy to pick some up.? Now, the less I knew about the price context, the more conservative I would be about price and size.? If I found a large amount offered to me at my level (rare), I would honor it by buying a small amount, and then backing up my price level to where I would not be offered so much, and try for more at better prices.

Price discovery is tough business, because some bonds trade rarely.? There are things to help you:

Comparable bonds in the same industry
Credit spreads across rating categories
Credit spreads across the maturity spectrum within rating categories
Spreads on credit default swaps on the same name.
Value of scarcity vs cost of illiquidity, and vice versa
Proper spread tradeoffs on premium vs discount bonds, call features, put features, off-the-run vs on-the-run issues, etc.
Calculating the spread on the last few trades, however dated, and then massaging the spread into what it is likely to be today.

My client was growing rapidly, and 30% of its liability structure was long because they wrote a lot of structured settlements.? [Geek note: structured settlements arise when a plaintiff wins a court case, and a stream of payments must be made by a defendant for the rest of the plaintiff’s life.? There are often inflation clauses, which makes the stream grow over time.? The defendant has insurance companies bid on paying the liabilities, and low bidder wins.]? I could buy a lot of long illiquid securities if my credit analysts liked the credit risk on the companies in question.

As such, I had a list of issues at various brokers that I wanted to buy if they became available.? Those ranged from moderately liquid to very illiquid.? I had a list that I sent out every now and then that I called the “Odd Duck” list; for fun, the last name on the list was the ultimate odd duck, AFLAC.? That got a few chuckles.

But with a rapidly growing client, much as I liked to source bonds that I fundamentally liked on the secondary market, I had to buy a lot of bonds in the new issue primary market.? Under normal conditions, the bond market has a lot of IPOs each day, as new bonds get issued, most often from companies that have issued before, but the characteristics of the new bond are different.

Now sometimes, when the corporate bond market is cold, or a deal is complex, it will take days for the deal to close, and sometimes a week or more.? But when things are hot, deals can close in seven minutes.? When I would see a new deal, the first thing I would do is analyze where we were in the speculation cycle for new deals.? As I said in my last piece, on average, new deals are brought a little cheap, because there is a price to gain liquidity that the issuer pays.

When deals were closing slowly, like say in half a day or more, I would send the deal terms to the analyst, and ask if she liked the credit.? If she said no, I would refuse the deal.? Otherwise I would put in for my normal allocation of bonds, subject to my limit for the company in question, and varying with the attractiveness of the deal, and how much cash I had to put to work.? When the market was rational, typically I would get good allocations, and deals would trade up a decent amount after issue.

But when the market was hot, and deals would close within an hour, I would work differently.? When the deal would come, I would put in for bonds, so that I would get some allocation.? I would ask for the high end of what I would normally ask for, knowing that I would get scaled back considerably.? Then I would send the details to my credit analyst, telling them that if they did not like the company, I would sell the bonds.

Eventually, most of my analysts during the times when the market was hot would come to me and say, “How can you put in for bonds without an opinion from us?”? First I would reassure them, and tell them that I valued their opinions, and that I would not hold onto a bond permanently unless they liked it.? I would sell all bonds they did not like, but when the technicals favored it, within a few months.

Second, I would tell them, “I do the one-minute drill,” which elicited the obvious question, “What’s the one minute drill?”? I then led them through a series of Bloomberg screens that would allow me to get a quick read on creditworthiness:

GPO – how has the stock price moved over the last year?? Down hard is a deal killer.
HIVG – how have option implied volatilities moves of late? Up considerably more than the market is a bad sign.
CH6 – how is operating cash flow doing?? If it is considerably worse than earnings, that ‘s a bad sign.
DES – what industry is it in?? Do I hate that industry?? If so, don’t play.
DES3 – all of the major financial ratios for the company.? What do the typical bond ratios look like?? Are they materially worse than those for the industry?
CH2 or ERN, are earnings declining?? If so beware.
CRPR – what are the credit ratings?

Then I would tell the credit analyst that if a company passes these tests, the odds of the company doing badly while I wait for the analysis of the credit analysts was slim.? Then I would get a smile from the analyst, who would go and do their analysis without fear of something going badly wrong while they do their analysis.

But there is one last complexity here.? When deals are running hyper-hot, and are closing in minutes, it is good to take a step back and ask on each deal if the yield spread is too tight. Bond syndicates price some deals too tight, and instead of the deals rising after issuance, something horrible happens.? I will bring that up, and other matters, in part III.

Book Review: Fortune’s Formula

Posted on 17 July 2010 by David Merkel

When I reviewed the book Priceless, I thought I had reviewed “Fortune’s Formula,” because I had written several pieces on the Kelly Criterion at the blog and at RealMoney (free at TSCM).? But I found that I had not, so I offer you this review of a book I greatly enjoyed:

The book asks a simple question: in making a bet, investment, or business decision, what is the optimal amount of capital to allocate?

But the author, William Poundstone, is not going to give you the answer immediately.? He is going to take you on a journey where you can meet many odd personalities from the ’50s to the early ’00s, and how they came to look at the problem.

Ed Thorp was fascinated with Blackjack, and originated card-counting to improve the probability of winning, to what the card counter had and edge versus the casino.?? He meets John Kelly, Jr. while working together at Bell Labs on Information Theory.? He discovered that an economic actor with an edge could size his bets as a ratio of his edge in? betting divided by the odds received on the bet.

Thorp eventually published a paper, “Fortune’s Formula: A Winning Strategy for Blackjack,” which led to a torrent of interest from gamblers.? With the aid of several backers, Thorp tried out the methods with some success in Reno, with two wealthy gamblers as backers.? That tale was hairy, to say the least, but they more than doubled their money.

Thorp later applied himself to the sleepy market for stock warrants in the 1960s. He developed delta-hedging along with a colleague.? As the book progresses, gambling ceases to be the focus, and advanced strategies for making money on Wall Street with little risk becomes the rule.? And, as in Vegas, as they took steps to lessen the edge in blackjack, on Wall Street competition itself eroded the edge.? But Thorp set up a hedge fund to take advantage of securities mispricing.

One odd sidelight is the number of parties that came up with the option pricing formula known as Black-Scholes, long before B-S wrote their paper.? Life reinsurance actuaries had a version of it in the ’60s, Bachelier had a version of it around 1900. And there were others, but the point was that no one took advantage of the knowledge, except in rough ways, prior to the B-S paper.

Yet option theory could be applied to a wide number of situations, convertible bonds and preferred stocks, even corporate bonds themselves, in addition to warrants and options.? Those that did it early made a lot of money.

A more generalized version of the Kelly Criterion says to focus on the choice that offers the highest geometric mean return.? This led to a conflict with academic economists who insisted the optimal strategy was derived from utility maximization.? What is not disputable is that the Geometric mean will maximize terminal wealth, a result found by Bernoulli and Latane.

The book takes us through financial crisis after crisis, showing how bet sizes were too large relative to the results.? It also takes us to the end where a number of the protagonists end up decidedly wealthy from their attempts to beat the market.

Quibbles

Though Poundstone’s aim is the Kelly Criterion, more of the book is dedicated to finding edges, whether beating the dealer in blackjack, or arbitrage of securities.

If you want to buy the book, you can buy it here:? Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

Who would benefit from this book

Many people would enjoy this book, written in 2005.? Poundstone tells a good story and illustrates how a number of clever men found edges, pursued them, and triumphed.? The reader may not be able to beat the world after reading this, but it may teach him about how bright men found ways to pursue their advantages.

Full disclosure: I bought my copy with my own money.

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.

The Education of a Corporate Bond Manager, Part I

Posted on 16 July 201016 July 2010 by David Merkel

In 2001, I became a corporate bond manager by accident.? I had been the mortgage bond manager and risk manager of a unit managing the assets of a medium-to-large life insurer, when the boss left to take another job in the midst of a merger.

The staff and I got together, and the credit analysts told me that I should lead the organization during the merger.? When I asked why, they said they trusted me, appreciated my growing bond skills, that I was the only one who understood the client, and said that I had a better call on credit than the boss had.? I was surprised by that last comment, but upon meeting with the management of our parent company that was selling us, along with the life insurance company that we managed, they told me that yes, I should lead the unit until the merger closed, but rely on the high yield manager in our group to advise me for the duration, which was going to be three months.

The first thing that I did was a bond swap, trading away an older bond of a company for a new issue.? There was some hurry in the matter, so I entered into the swap before I could consult the high yield manager.? After I could talk with him, he pointed out that I had offered terms more favorable than I should have.? On a $5M swap, I ended up losing $20K.? We worked through the swap a number of different ways, which solidified my knowledge of corporate bond pricing.? I did not make that error again.

In the corporate bond market, new deals come frequently.? My former boss would do almost all of his bond buying on new deals, and almost never in the secondary market, because he knew that new deals almost always came cheap.? There is a price to be paid by corporations to gain liquidity.? The life company that I managed money for was growing like a weed (their products were perpetually underpriced), so I had a lot of money to put to work.

But, I already had a large portfolio of corporate names.? I was familiar with many of them to some degree because of my stock investing.? How could I go through the whole portfolio to look for bombs that might be lurking? Ask the credit analysts to give me a review on every name?? I did not want to kill them, or me for that matter.

I took the idea home , and thought about it, and then it struck me.? Thinking of bonds as having sold a put option to the equity, why not look at the amount that the stocks of the companies issuing the bonds had fallen in price since issuance of the bonds?? I set a threshold of 50%, and that gave me a list of about 30 names to hand to the analysts.? Manageble.? Cool.? (Oh, and tell me briefly about these 20 private bonds where there is no stock price.)

The analysts came back with their opinions, and surprisingly they advised selling half of the bonds and keeping the other half.? That was more than I expected.? But I started selling away, and began to learn the art of price discovery.? When you want to sell a bond, you first have to look at what investment banks ran the books of the deal.? There is an unwritten rule that if they play that large role in origination, they have to make a market in the bonds thereafter.? So, I consulted the various investment banks and inquired about levels, and then said something to the effect of, “If there is a reasonable bid (naming the spread over Treasuries) we would be interest in losing a few million bonds.? If there is an aggressive bid, we could be induced into selling a few more.? We might even be willing to sell the whole wad if they make us the offer that we can’t refuse.”

If there were multiple banks that traded the bond, I would set the above up with just one bank.? You never wanted to make it look like there were two sellers out there, or bids would vanish.? Beyond that, it was bad etiquette to employ two banks without telling them that they were in competition with each other.? If not. you could end up with two orders to buy your bonds, and you would have a moral obligation to meet both orders, even if that was against your interests.

Usually the broker would ask for the total size of the wad available for sale.? The idea was to get the buyers to think economically.? Yes, they could get a small amount of bonds if they met the spread, but was it worth it to bid for more?? Also, if they bought the wad, they would know that there were likely no more bonds on offer, the selling pressure would be gone, and the bonds would likely trade up from there.

I sold away a decent amount of the bonds that the analysts wanted gone, and then 9/11 hit.? What a day.? Since we worked inside the insurance company that we manager money for, and we had two TVs on the corners of our trading floor, all of a sudden our area was flooded with people staring at the spectacle.? I almost felt like Crocodile Dundee as I had to maneuver my way around and over them.

I gathered my staff and told them to look at their portfolios, and e-mail me threat reports so that I could inform our client.? After that, take the rest of the day off, as there is nothing to do here; many of them wanted to mourn friends that might be dead (I lost two acquaintances).? I summarized the threat reports, and submitted them to the client by 4PM.? We repeated that process for the next eight business days, until the crisis was past.

I had worries over One Liberty Plaza, next to the former World Trade Center, which seemed to be leaning, and might fall.? We owned the AAA portion of the CMBS that contained the loan for that building.? As I scoured the web, I concluded there was no danger, the building only looked like it was leaning; the dark coloration was deceptive.

Eventually trading resumed.? If you remember Metcalfe’s Law, the value of a telecommunications network is proportional to the square of the number of connected users of the system.? Well, after 3 days, 2 of 12 major brokers were running, which meant that there was no trading.? After 4 days, 6 brokers were up, so I made an offer on some AA Manufactured Housing ABS, deeply below where there market was prior to the crisis.? I got hit, and I owned the bonds.? Some said to me, “Why not wait?? Why offer liquidity now?? I said that some had to make some bids to restart the market; my client had ample liquidity, and I was offering liquidity at a price; if someone was that desperate for liquidity, they could have it at my price.

After 5 days 8 of the 12 were up, and after 6, 10 of 12.? The last two took a while to re-emerge, but were back after 10 days.? Even so, things seemed sluggish.

I began to do the same with corporate bonds, doing a large auction offering liquidity, specifying bonds that I wanted at certain levels, and the amounts.? I ended up buying half of my list, and still my client had ample liquidity.? What a high quality problem to have.? More in my next segment.

Brief Reviews of Three Books

Posted on 10 July 201012 February 2011 by David Merkel

These three book reviews are for books that I scanned, and did not read in depth.

Quantitative Equity Investing

The first book: Quantitative Equity Investing, is a book for practitioners with strong math skills, not average investors.? It reviews basic econometrics and factor analysis, and then applies these tools in an effort to sort out anomalies in investment markets, tease out important factors driving markets, and find workable trading strategies, considering execution costs, slippage, etc.? It has a brief section on algorithmic and high frequency trading.

On the whole, I didn’t find anything that new or amazing in the book.? Though there were a few things in the book that I hadn’t seen before, they were trivial things that I looked at and said, “Oh, yeah, of course.”

The book is generic in the way that it deals with the topic.? It is no going to give you ideas to pursue, but only tools that you can use if you have ideas tht you want to analyze, and turn into strategies.

Who would benefit from this book?

You have to have a very strong math background, including the type of Matrix Algebra that one would use in graduate-level Econometrics.? To that end, this book would be most useful to grad students wanting an introduction to how to apply their math skills to the markets.

The book is available here: Quantitative Equity Investing: Techniques and Strategies (The Frank J. Fabozzi Series)

The New Science of Asset Allocation

This book uses Modern Portfolio Theory in order to analyze asset allocation decisions.? Those that have read me for a while know that I think that is a flawed paradigm, in need of replacement.? For those that want a reasonable understanding of that paradigm in a short space, the book does that very well.

That said, the book has its virtues.? The chapter on the “Myths of Asset Allocation” shows that the authors have some depth of insight into the foibles and misunderstandings that surround asset allocation.? The book also goes into the importance of qualitative analysis of managers, looking up from the numbers so that you can avoid allocating money to the next Madoff.? It also describes the use of derivatives in order to control risk exposures.

Each chapter ends with a short summary of the takeaways from the chapter, which serves to reinforce the points of the book.

Though the book has the word “new” in the title, I did not find much new in it.? If one is looking for novel implementation methods for asset allocation, best to look elsewhere.

Who would benefit from this book?

This is not a book for average investors.? It is for professionals who want to brush up their asset allocation skills, and young professionals wanting insight into asset allocation.

The book is available here: The New Science of Asset Allocation: Risk Management in a Multi-Asset World (Wiley Finance)

The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

To me, this was the most interesting book of the three, but I feel it was mistitled.? A better title would have been: “Fueled: The Effects of? Using Food for Fuel” or something like that, because the central question of the book is to what degree has using crops to produce biomass for fuel production (usually ethanol) affected the costs of food and fuel.

I found the book is very even-handed, to a fault.? It argues that the use of crops for fuel production had little impact on food costs, and that there were many other factors that made food prices rise when ethanol production was going gangbusters.? Weather, domestic and foreign demand and many other factors had a role in moving food prices, not just ethanol.

After reviewing the book, I have a better sense of the complexity of the question, and that it will not admit easy answers.

Who would benefit from this book?

Anyone who wants a basic understanding of food economics, and how that is impacted by a wide number of factors including using crops for the production of fuel would benefit from this book.? The book is well written, and seemingly balanced.

The book is available here: The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.? I review about 80% of the books that get sent to me.

Book Review: Priceless

Posted on 9 July 2010 by David Merkel

I really enjoyed the book Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street (review forthcoming), so when I learned the William Poundstone had written a new book, I went out and bought it.

This book, Priceless: The Myth of Fair Value (and How to Take Advantage of It), covers rationality in decision making, and how markets and marketers take advantage of the deficiencies in rationality in average people.

There are many in the investment community that admire behavioral finance, and many who say that it might be true, but where are the big profits to be made from it?

This book doesn’t cover behavioral finance per se, but it does cover its analogue in pricing and marketing.? In a negotiation, the first person to put a price on the table tends to push the final price agreed to closer to his price.? Leaving aside no-haggle dealerships, why do car dealers post high prices for vehicles?? Because only a minority does the research to understand what the minimum price is that a dealer will accept.? The rest pay more, often a lot more.? Personally, I do a lot of research before I buy a car, and it helps me spot dealer errors in pricing.

The book is replete with examples of how there is no “fair” way to price things out.? What are the proper damages for a jury settlement?? The attorney for the plaintiff is incented to come up with the highest believable amount for the jury, because they will render a verdict less than that.? Make the ceiling as high as possible, and the plaintiff will get more.

We call placing the first price on the table “anchoring,” because it pulls the final result toward itself.? The book is filled with experiments dealing with anchoring.

The book also spends a lot of time on the “ultimatum game,” where a person gets $10, and must offer some of it to a second person, but if the second person turns him down, the first person gets nothing.? The main lesson here is that pride is stronger than greed.? Yes, it can be construed as a question of fairness, but when someone gives up money to deny money to someone else, it is not fairness but envy.? Why pay to make someone else worse off?? To teach him a lesson?? What an expensive lesson.

Much of this book was a walk down memory lane for me.? I discovered Kahneman and Tversky in the Fall of 1982, and I found their ideas to be more cogent than much of the “individuals maximize utility” cant that was commonly heard from most professors teaching microeconomics.? People are far more complex than homo oeconomicus.? Small surprise that most tests of microeconomics as a system are not confirmed by the data.

Kahneman and Tversky showed via a wide array of examples that the decisions people make are affected by the way they are presented to them.? People can be manipulated in limited ways in order to affect the decisions that they make.

The book deals with many marketing tricks, particularly the powerful word, “free,”? and how it dupes people into buying something to get something for free.? For another example, why companies sell really expensive items that few will want, because people will buy the next most expensive item with greater probability, versus less expensive items of the same class.

An Opportunity in Comerica Warrants

Posted on 19 June 201019 June 2010 by David Merkel

This will be a bit of an unusual post for me.? How often do I suggest option trades?? Almost never.? But because of auctioning of TARP warrants, there are a decent number of very long dated options trading on some bank stocks, and many of them are cheap.? I’m here to talk about the cheapest one this evening, Comerica.

Comerica warrants [CMA/WS] closed at $14.50 today, a price that makes the computer say, “does not compute.”

The Comerica warrants are trading so cheaply that they discount negative volatility.? At zero volatility, the warrants would trade 5% higher:

And at a fair-ish volatility level, 17% higher.

Now there are two ways to extract value here.? Buy the warrant and sell short 2/3rds of a share of the common stock, which is empirically delta-neutral.

As the delta of the positions change, adjust your hedge in the common stock to reflect it.? The other way is not to short the common stock, but to short long dated options.? The most liquid long dated options are the 40s expiring in 2012.? The hedge would be to sell options on 170 shares of stock against every 100 warrants owned.

Over ten months the transaction makes a profit with CMA stock between 30 and 53.? That is one wide band, and there is still room for adjusting hedges in ways that could improve matters.

Now, I am open to feedback from readers/bloggers who trade options.? What’s wrong with this idea?? Free money is rare in the markets, but this warrant really seems like a mispriced security.

Full disclosure: no positions

PS — note that you may not get favorable margining being long the warrant and short the option.

The Financial Equivalent of Bungee Jumping

Posted on 7 May 2010 by David Merkel

One quick note on my book reviews.? I have two books read, and ready to review.? I am reading Harry Markopolos’ book on Madoff, and am almost done.? That book really needed a stronger editor.? Next in the queue after that is Tony Boeckh’s new book, The Great Reflation.

I had other things planned to write this evening, but the brief plunge in the equity markets this afternoon caught my attention.? What caused the mini-panic?? Was it:

Dynamic hedging, a la 1987?
A “fat finger” placing a sell trade that was too large?
Panic of a single trader? Or, maybe a few?
Or, program trading gone awry?
Or, some combination thereof?

The “fat finger” hypothesis seems to be ruled out.? The NYSE says that there were no erroneous trades on their exchange, though they blame NASDAQ, and the NASDAQ is canceling trades where the rise or fall was over 60%.

My guess is that electronic trading got out of control, because human beings would not offer to sell the stock of valuable companies for exceptionally low prices, in some case less than a buck or less than a penny.

Yes, there might have been some dynamic hedging.? And some traders likely panicked and sold when they should not have.? But, buyers came in and prevented the market from tripping circuit breakers that would have shut down the markets for half an hour.? We came with a few points on the Dow of doing that.? No telling what might have happened if that had occurred.? There might have been a greater panic, or, a greater resurgence in the last half hour.? Curious that we got so close to that uncertain trigger, but did not cross the line.? More grist for the mills of conspiracy theorists.? All I can say is that I snagged some shares of Noble Corp @ $35.40, near the low of the day.

I said to one of my sons — there are four ways to act on a day like today:

The brave man: “Buy, buy, BUY!!!”
The wise man: “I will buy a little more of this undervalued stock.”
The indexer, or buy-and-holder: “Huh?”
The wimp: “Get me out of these stocks, they are killing me!”

We do not know what tomorrow will bring.? I had a very good relative value day, while losing quite a bit in absolute terms.

But my sense of the day is that some algorithmic trading programs went wild, and made trades that no sane human would.? John Henry may yet prevail in the markets.

But one note before I close: NASDAQ should not have canceled the trades.? It ruins the incentives of market actors during a panic.? Set your programs so that they don’t so stupid things.? Don’t give them the idea that if they do something really stupid, there will be a do-over.? In the absence of fraud, trades should not be canceled.

Full disclosure: long NE

The Rules, Part XII

Posted on 30 April 201020 June 2017 by David Merkel

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

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

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

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

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

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

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

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

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

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

The Lack of Cultural Agreement Roars, the Eurozone Mews

Posted on 28 April 2010 by David Merkel

Economic systems are the result of cultures.? Where there is little cultural agreement, the economic system will be unstable, as will be governmental action.

No, this is not another “Rules” post.? But this is a post about the Eurozone and Japan today.? Japan faces trouble, but there is cultural agreement on what should be done, so there is no great crisis today, though the demographics may force issues eventually.

The Eurozone does not publicly recognize that there are large disagreements over what economic policy should be.? In the countries that are in economic trouble, there are many that push their governments to spend more on them, forcing the governments to borrow more.? This is particularly true of the unions.

My view of unions is that they slowly kill whomever they serve.? Industries with high unionization die eventually.? Countries that support unions die slowly as well.

Unions introduce inflexibility into the economic process which has a huge cost, eventually.? Greece is controlled by its unions.? They are willing to seek their own prosperity even if it leads to the destruction of the nation.? They don’t think the nation will be destroyed, but think that there are parties in power that hold back value from them, and they must be opposed, deluded fools that the unions are.

But there is a bigger problem for the Eurozone.? What do they do about Portugal, Ireland, Spain, and maybe Italy?? Yeah, the Eurozone could rescue Greece, but could it rescue Spain?? The answer is simple, NO.? But rescuing Greece discourages Spain from taking hard actions.

There is a lot of moral hazard involved in rescuing countries in the Eurozone.? Far better for nations to rescue banks that have lent to Greece, Portugal, Ireland, Spain, Italy, etc.? From what I have read, Europeans don’t exist.? Nations exist around a common culture and language.? Nations in Europe exist, and many act against the concept of a Eurozone.

Both positively and negatively, one can say that the Eurozone can’t make everyone into Germans.? The Germans exercised discipline that other nations would not.? Because of the size of Germany, and those allied with them in the Eurozone, the Euro is a hard currency, harder than many cultures/nations with lower labor productivity would like.

Why is the Euro weak?? Because the present crisis has relegated it to the status of an experiment.? Wondering over how Eurozone obligations will be repaid is an issue outside the Eurozone.? There are solutions, but they are painful — 1) let Greece become a state of Germany.? Not happening. 2) Let the Eurozone pour money into Greece; I’m sure they will reward you by adopting austerity measures, not. 3) Let Greece default, and then, let the Eurozone attempt to ameliorate it.? It will be difficult, and I doubt that debts to Greece will be settled at over 40% per Euro.

The major trouble is that banks in countries with relatively orthodox finances have lent to countries with liberal finances.? Well, who else could have done it, but the banks making the loans are in a fix because their health is subject to the creditworthiness of those that they lent to, which should be no surprise, but we forget.

Thus the big crisis in Europe is really over the soundness of the banking sector.? Rather than bailing out nations in trouble, far better to bailout your own banks that made bad loans, and let the profligate nations fail.? Remember, the Eurozone was not a promise to support profligate nations, but an effort for responsible nations to share a common currency.? If nations are not responsible, it is not the responsibility of the other Eurozone nations to subsidize them.

Do you want to save the Eurozone?? Save it by protecting your own banks, and letting profligate nations fail.? You will end up with a “hard” Eurozone of nations that are not profligate, and can live up to the demands of a strong currency.? The Eurozone exists without the UK.? It can exist without Greece, Portugal, Spain, Italy, and Ireland.

Subsidies don’t work, and that is what the loans to Greece are.? The Greeks will just suck them in, and continue their unruly fracas over who gets what.? Far better to let Greece fail, and scare marginal nations to clean up their acts.

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I don’t write this because I want the US Dollar to prosper because of a failure of the Euro.? Hey, I want credible alternatives to the Dollar, because it is at best the best of a bunch of sorry currencies, and I am not ready to sign on to the cult of Gold.? I like gold as a currency, but am not crazy about it as an investment.

My view is that the Euro can exist even after the failure of nations that leave the Euro, and that Euro obligations could still be enforced on defaulting nations because of the large amount of commerce inside Europe.

My advice to European statesmen, including those that share my surname, is to focus on your national interests.? The Eurozone is too vague to matter to those who elect you.? Focus on protecting your banks, rather than those the banks have lent to, which would waste money.

The Rules, Part X

Posted on 18 April 201020 June 2017 by David Merkel

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become.? This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack.

I was at a conference on Stable Value Funds, I think around 1995.? The meeting hadn’t started? but a few attendees? had arrived.? We were talking about the need to find yield in the market when one said (with an arrogant attitude), “Yield?? Why not total return?”

A tough question, and one none of us were ready for at the time.? My thoughts a few days later were on the order of, “If only it were that simple.? Right, you can generate positive returns over every time horizon worth measuring.? Okay, Houdini, do it.”

Total return investors don’t have long time horizons.? Investors with short time horizons either aim for momentum plays, or aim for yield.? Momentum persists in the short run, so play it if you must, remembering that the market gets more volatile when many play momentum.

Yield is less volatile than momentum, at least most of the time.? But yield is a promise, and frequently disappoints during times of stress.? Look at all of the dividend cuts over the past two years.

But consider this from a different angle.? Imagine your boss comes to you and says, “I want you to deliver the best returns to me every day versus the S&P 500.”? Okay, beat the S&P 500 every day.? That means the portfolio has to be a lot like the S&P 500, with some tweak that will beat it.? Anything too different from the S&P 500 will miss too frequently.

Now, I would say loosen up, why constrain daily performance?? Aim for great returns over the long haul, and don’t sweat years, much less days.? Great asset management requires a willingness to be wrong over significant periods, with a strong sense of what will work in the long run.

Those with short horizons will tend to index relative to their funding need, whether it is cash, short bonds, or indexed equities.? Note that most managers should have long horizons, but clients evaluate the returns of the past quarter or month, and the manager feels as if he is on a short leash, which makes him look to the next month or quarter, and makes him invest more like an index.

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If you have a good manager, set him free — lengthen the performance horizon; give him room to do things that are unorthodox.? Ignore the consultants with their foolhardy models that constrain manager behavior.? Let me tell you that you are brighter than the consultants, and can better manage managers than they do.? Their models encourage managers who hug the indexes to avoid doing too much worse than them, and so you get index-like performance.

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At turning points, a different breed of investor shows up.? At busts, investors show up who will buy and hold, bringing stability to the market.? They look at fundamental metrics and conclude that their odds of losing money are small.? At the booms, a different investor leaves.? They will sell and sit on cash.? Similarly, they think the odds of losing money, or, not making as much, is large.

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Good money managers think long term, but all of the short-term measurements fight against that.? They force managers to think short term, or else their assets will leave them.? That is a horrible place to be.? Better that clients should ignore the consultants, and aim for the long-term themselves.? You will do much better choosing managers for yourselves and ditching the consultants who (it should be known) merely chase performance.? With help like that, you may as well invest in the hottest stocks with a portion of your portfolio — you might do better than you are doing now.