Category: Speculation

QUEASY — QUantitative Easing Aids Speculators Yields

QUEASY — QUantitative Easing Aids Speculators Yields

Posted on by David Merkel

Okay, I am going out on a limb here, so please understand that what I am saying is a bit of an experiment.? When quantitative easing was originally done in Japan, it was after:

  • a credit-fueled expansion that pushed the stock and real estate markets to new heights, which have not been seen for 19 years.
  • productive capacity was built up that the rest of the world would not need.
  • anticipated returns on equity for investment projects were in the low single digits.

Now, during the time of quantitative easing, the following things happened:

  • money market rates were near zero.
  • relatively few private investors wanted to borrow money for investments to expand productive capacity.
  • government deficits expanded dramatically in a futile attempt to simulate an over-indebted economy.
  • Speculators borrowed money in yen in order to do carry trades.? They borrowed the surplus yen from the quantitative easing, and used the leverage to speculate on higher-yielding debt.? This had little benefit for the average person in Japan, though many played the carry trade game internally, buying investments denominated in Australian, New Zealand, or US Dollars.

Back to the present, and back to the US.? Short-term borrowing rates have been falling, as there is a lack of demand to borrow short-term.? Contrast that with one year ago, where there was no lack of demand to borrow short-term, but no willingness to lend.

An amazing change indeed, but much of it stems from a lack of demand for short-term borrowing. Some attribute the low TED (3-month Eurodollar less Treasury yield) spread to risk-seeking, but I think that banks don’t have many uses for surplus cash now.

As it is, with low US Dollar LIBOR lending rates, it makes the US Dollar a honeypot for speculators.? Borrow in Dollars, invest in your favorite higher yielding currency, or in higher credit risk instruments.? For the foreign currency trade, the added kick is that the US Dollar may decline in value.? That said, many said the same would happen to the yen; that it would decline in value, and it did not.? I have many reasons to think why the Dollar will decline, but the carry trade argument goes the other way for me.

Now, maybe the excess liquidity is fostering day traders as well.? We saw the same phenomenon in 1999-2000.? The liquidity should not have leaked out, but it did, and to those that would only speculate.

So what is the Fed doing?? Is it ending quantitative easing?? It seems not.? They will buy mortgages until they reach their preannounced limit, most likely.? That said, the Treasury might reduce funding to the Fed.? They see less need to fund the Fed, though that will force the Fed to decide how large it wants its balance sheet to be in a time of crisis.

Here’s my concern — having carry traders absorb excess liquidity that the Fed has put out is a waste of Fed resources, and indicates that Fed policy is too loose.? Don’t buy more mortgages and agencies, and consider selling bonds back in to the market.? Let short-term rates rise to reflect the true scarcity of short-term ways to profit.? Let savers earn some money — there is no benefit to having monetary policy so loose.

To summarize: Japan did not benefit from many years of quantitative easing, but it provided a lot of fuel for carry trades around the world until most of them blew up over the last two years.? It seems to me that excess liquidity created by the Fed is going the same way now, because consumers and businesses don’t want to borrow to the same degree as they did during the boom phase.

It will take a long time for balance sheets to heal.? It depends upon the rates of debt forgiveness/compromise, and paying it down.? During the Great Depression, Debt/GDP peaked several years after the Depression started, and after the peak it took about ten years for it to come down to a more normal level in 1941.? I suspect that we will go through this same process again, before the economy grows robustly as it did post-1941, regardless of what the Fed and Treasury do.

Book Review: Finding Alpha

Book Review: Finding Alpha

Posted on by David Merkel

I found this book both easy and hard to review.? Easy, because it adopts two of my biases: Modern portfolio theory doesn’t work, and the equity premium is near zero.? Hard, because the book needed a better editor, and plods in the middle.? I don’t ordinarily do this, but I felt the reviews at Amazon were valuable, particularly the most critical one, which still liked the book.? I liked the book, despite its weaknesses.

One core idea of the book is that risk is not rewarded on net.? It doesn’t matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds).? Junk underperforms investment grade bonds on average.? Lower beta and standard deviation stocks overperform on average.

A second core idea is that some people are so risk averse that they only accept the safest investments, which leaves investment opportunities for those that are willing to compromise a little with credit quality or maturity.? Moving from money markets to one year out is an almost riskless move for most, and usually adds a lot of excess return.? Bond ladders do the same thing, though Falkenstein does not discuss those.

Also, the move from high investment grade to low investment grade does not involve a lot more investment risk, but it does offer more yield on a risk adjusted basis.

A third core idea is that equities, though more risky than high quality bonds, have not returned that much more than bonds when the returns are measured properly.? See this post for more details.

A fourth core idea is that people are more willing to take risks to be wealthy than theory would admit.? Most of those risks lose money on average , but people still pursue them.

A fifth core idea is that alpha is hard to define.? Helpfully, Falkenstein defines alpha as comparative advantage.? Focus on what you can do better than anyone else.

A sixth core idea is that leverage, however obtained, does not add alpha of itself.? This should be obvious, but people like to try to hit home runs.

A seventh core idea is that when an alpha generation technique becomes well-known, it loses its potency.

An eighth core idea is that people are more envious than greedy; they care more about their relative position in this world than their absolute well-being.

One idea he could have developed more fully is that retail investors are easily deluded by yield.? They underestimate the amount of yield needed to compensate for illiquidity, optionality, and default.? Wall Street makes money out of jamming retail with yieldy investments that deliver capital losses.

Another idea he he could have developed is that strategies that lose their potency lose investors, and tend to become less efficiently priced, leading to new opportunities.? Investment ideas go in and out of fashion, leading to overshooting and washouts.

How one achieves alpha is not defined — Falkenstein leaves that blank, because there is no simple formula, and I respect him for that.? He encourages readers to devise their own methods in areas where there is not a lot of competition.? Alpha? comes from being better than your competition.

Summary

What this all says to me is that investors are too hopeful.? They look for the big wins and ignore smaller ways to make extra money.? They swing for the fences and get an “out,” rather than blooping singles with some regularity.? I like blooping singles with regularity.

I recommend this book for quantitative investors who can find a way to buy it for less than $40.? The sticker price is $95, though it can be obtained for less than $60.? Try to find a way to borrow the book, through interlibrary loan if necessary — that was how I read Margin of Safety by Seth Klarman.? Klarman’s book is not worth $1000.? Falkenstein’s book is not worth $95.? Falkenstein’s very good blog will give you much of what you need to know for free, and even more than he has covered in his book.

This book would also be valuable for academics and asset allocators wedded to Modern Portfolio Theory and a large value for the equity premium, though some would snipe at aspects of the presentation.? Parts of the book are more rigorous than others.

If you still want to buy the book at the non-discounted price, you can buy it here: Finding Alpha: The Search for Alpha When Risk and Return Break Down (Wiley Finance)

PS: Unless I state otherwise, I read the books cover-to-cover, unlike most book reviewers.? The books are often different from what the PR flacks encourage reviewers to think.? If you enter Amazon through my site and buy anything, I get a small commission.

Avoid Risk; Make Money.

Avoid Risk; Make Money.

Posted on by David Merkel

Sometimes a single article can change my direction for publishing for an evening.? So it was for this article, Hedge Fund Keeps Reins on Risk.? I had not heard of Graham Capital Management until today, but given what I read, I like what they do — they focus on risk.

I am currently reading Eric Falkenstein’s book, Finding Alpha, and I am a little less than half through it, but he makes the point quite ably that the way to make money is to avoid risk, and that those that do avoid risk tend to do better than those that take a lot of risk.? I know that this is tough to understand for those that have bee indoctrinated by Modern Portfolio Theory, but I will phrase it my own way.? Take risk when you are paid to take it; avoid undercompensated risks.

Here’s the money quote from the WSJ story:

The firm’s risk manager Bill Pertusi leads a meeting at 9:30 a.m. each day in a large room in Graham’s 93-year-old Irish Tudor mansion. There, a group of seven or so people — always including Messrs. Tropin and Pertusi — discusses all aspects of risk: market risks, risks in individual traders’ portfolios and how they have changed since the day before, risks to the way the firm is investing its cash, counterparty risk — or risk that the firm on another side of a trade will fail, even evaluations of whether traders’ are in positions that are “crowded” with other hedge funds.

“I’m not aware of anyone who has a daily meeting just to talk about risk in the absence of talking about opportunity,” according to Leslie Rahl, managing partner of risk-management firm Capital Market Risk Advisors.

Graham requires managers of some of its funds to fill in a survey every Friday, answering the question: “How much money would we lose if you had to completely liquidate your portfolio in one, three or five days, in both normal and stressed environments?”

Risks are multi-dimensional, and a wise manager thinks through all aspects of his risks.

  • How creditworthy are my counterparties?
  • How readily can I convert my portfolio to cash if I had to?
  • What are my competitors doing?? Are my positions in strong hands or weak hands?? How many are making the same bet that I am?
  • Have the fundamentals of my positions changed?? Have the views of other major players in the market changed?
  • Has the time horizon of other investors alongside of me changed?
  • What cash flow yield am I likely to get, and how might that vary?
  • What should we do about major moves in the markets that we trade — go with the trend, or resist it, or ignore the move?
  • Am I implicitly taking the same bet through seemingly different? areas of my portfolio?

Limit the downside, and the upside will provide for you.? I am not saying to avoid risk, but to take prudent risks.

Now, I try to avoid making a lot of market calls, because those who do make a lot of calls are incautious at best.? I do believe that this is a time for caution with respect to the equity markets and the corporate bond markets.? I agree with Jason Zweig here, it is a time to trim risk positions.

On another front, consider illiquidity.? Taking on illiquid investments is a bet the the future will be very good; there will be no reason to liquidate funds.? This is why there should be a substantial yield or likely return premium for investing where there is no liquid public market.? The university endowments have stumbled here; they needed more liquidity than they thought.?? So have pension plans, who aimed for high returns at the worst possible moment.

That said, some pension plans are taking money off the table in stocks in the present environment.? Good move, I think.? Even the venerable Value Line is recommending lower commitments to common stocks.

Human nature does not change, and that is what makes behavioral finance and value investing stronger.? As the market moves up, shorts cover, but greed and envy drive people to invest more in the hot sectors.

This is not limited to retail investors, though.? Even investment banks are getting into the act.? Add to the leverage and let’s take some sweet bets!? Devil take the hindmost!

I get it, and I don’t get it.? This is a time to decrease risk, even though I might be early.? The troubles of our financial sector are not solved.? Our consumers are still overleveraged.? I don’t see how we get sustainable decent returns on capital in the present environment, aside from stable sectors of the global economy.? Avoid risk; make money.

Return of the “Carry Trade”

Return of the “Carry Trade”

Posted on by David Merkel

The idea of a carry trade is simple.? Borrow inexpensively, and invest at a higher yield.? Make money.

Too easy you say?? Right.? Usually something has to be compromised for a carry trade to work, usually betting on lower rated credits performing, or currencies not moving against those borrowing in a low interest rate currency, and investing in a high interest rate currency.? Or, borrow short and lend long when the yield curve is steep, hoping the situation will correct with the long yield coming down, rather than a 1994 scenario, where short rates outrace long rates higher.

Carry trades blow up during times of high volatility, which typically have high yield bonds or countries seeming to be more risky than usual. Carry trades return when times are quiet, allowing placidity to clip yield.? As the WSJ has commented, that time is now, and the carry trade has returned.

I’m going to use the Japanese Yen as my example here.? Because of the chronically low interest rates there, it is a favorite currency for borrowing, and using the money to invest in higher yielding currencies.

That’s the yen over the last five years.? Wish I could have gotten option implied volatility over the same period, but I got nearly the last two years here, by using the CurrencyShares Yen ETF:

You can see how option implied volatility peaked in late October of 2008.? At that time, with the strength of the yen, which would not crest until mid-December, there was a rush to buy protection against the rising yen, because those with carry trades on were losing money, and wanted to get out.? Momentum carried the yen for another six weeks.

After significant fury, the implied volatility settled out at a baseline level, and the carry trade returns because conditions are more placid.? Implied volatility and the currency have stabilized for now.

As another example. consider this:

The Powershares DB G10 Currency Harvest Fund [DBV] borrows in the three lowest yielding currencies of the ten countries that it tracks, and invests in the three highest yielding.? This is the perpetual carry trade fund.

Note the plunge into October/November 2008.? High yield currencies were getting killed, and low yield currencies were rallying.? Since then, the performance of DBV has improved.? Why?? The currencies are more placid, so clipping excess yield makes sense to some in the short-run.

And so it will be until the next big implied volatility explosion occurs.? Carry trades don’t offer significant profits across a full cycle, but can profit those who time it right, few as those people are, and matched by those who lose.

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PS — Sorry for not writing about commercial mortgages, as I said I would.? I will get to it soon, but I have been hindered by personal issues.

Twenty Notes on Current Risks in the Markets

Twenty Notes on Current Risks in the Markets

Posted on by David Merkel

1)? A modest proposal: The government announces that they will refinance all debtors.? Not only that, but they will buy out existing debt at par, and allow people and firms to finance all obligations at the same rate that the government does for whatever term is necessary to assure profitability or the ability to make all payments.? The US Treasury/Fed will become “The Bank.”? No need for the lesser institutions, The Bank will eat them up and dissolve their losses, taking over and refinancing their obligations.? Hey, if we want a single-payer plan in healthcare, why not in finance?? Being healthy is no good if you can’t make your payments. 😉

This scenario extends the US Government’s behavior to its logical absurd.? The US Government would never be large enough to achieve this, but what they can’t do on the whole, they do in part for political favorites.? They should never have bailed out anyone, because of the favoritism/unfairness of it.? Better to have a crash and rebuild on firmer ground, than to muddle through in a Japan-style malaise.? That is where we are heading at present.? (That’s the optimistic scenario.)

2)? I have exited junk bonds, and even low investment-grade corporates.? Consider what Loomis Sayles is doing with junk.? Yield = Poison, to me right now, which echoes a very early post in this blog.? There are times when every avenue in bonds is overpriced — that is not quite now, because of senior CMBS, carefully chosen.? All the same, it makes me bearish on the US Dollar, and bullish on foreign bonds.? This is a time for capital preservation.

3) High real yields are driving the sales of US Government debt.? Is that a positive or a negative?? I can’t tell, but there is always a tradeoff for indebted governments, because they can usually reduce interest expense by financing short.? When their average debt maturity gets too short, they have a crisis rolling over the debt.? We are not there yet, but we are proceeding on that road.

4)? I have a bias in favor of buyside analysts, after all I was one.? But this research makes me question my bias.? Perhaps sellside analysts are less constrained than buyside analysts?

5) Debtor-in-possession lending is diminishing, reflecting the likelihood of loss.? In some cases that may mean more insolvencies go into liquidation.? Interesting to be seeing this in the midst of a junk bond rally.

6)? Short-selling isn’t dead yet.? Would that they would take my view that a “hard locate” is needed; one can’t short unless there is a hard commitment of shares to borrow.

7) Should we let managers compete free of the constraints imposed by manager consultants?? You bet, it would demonstrate the ability to add value clearly.? I face that? problem myself, in that I limit myself to anything traded on US equity exchanges.? As such, I have beaten most US equity managers (and the indexes) over the last nine years, but no one wants to consider me because I don’t fit the paradigms of most manager consultants.

8 )? Is there a fallacy in the “fallacy of composition?”? I think so.? Yes, if everyone does the same thing same time, the system will be unstable.? But if society adopts a new baseline for saving/spending, the system will adjust after a number of years, and there will be a new normal to work from.? That new normal might be higher savings and investment, in this case, leading to a better place eventually than the old normal.

9)? Anyway, as I have said before, stability of a capitalist system is not normal.? Instability is normal, and is one of the beauties of a capitalist system, because it adjusts to conditions better than anything else.

10)? Corporate treasurers are increasingly engaged in a negative arbitrage where they borrow long and hold cash so that the company will be secure.? How will this work out?? Will this turn into buybacks when things are safe?? Or will it just be a drag on earnings, waiting for an eventual debt buyback?

11)? Does debt doom the recovery?? Maybe.? I depends on where the debt is held, and how is affects consumption spending.? Personally, I think that consumers and small businesses are under a lot of stress now, and it won’t lift easily.

12)? So things are looking better with junk bond defaults.? Perhaps it was an overestimate, or that it would not all come in 2009.? We will see.

13)? Junk bonds do well; junk stocks do better.? In a junk rally, everything flies.? All the more to hope that this isn’t a bear market rally; if so, the correction will be vicious.

14)? Eddy, pal.? Guys who criticize data-mining are near and dear to me.? Now the paper in question has a funny definition of exact.? I don’t know how to describe it, except that it seems to mean progressively more accurate.? I didn’t think the paper was serious at first, but given the relaxed meaning of “exact,” it data-mines for demographic influences on the stock market.? Hint: if you have lots of friends when you are nine, ask for stock as a birthday present.

15)? I’m increaisngly skeptical about China, and this doesn’t help.? I sense that the global recession is intesifying, amid the current positive signs in the US.

16)? Do firms with female board members do worse than companies with only male board members?? No, but they get lower valuations, according to this study.? I started a study on female CEOs in the US, and I got the same result, but it is imcomplete at present — perhaps new data will invalidate my earlier findings.? Why does this happen, if true?? Men seem to be better at managing single investments, while women are better at managing portfolios.

17)? Do we have more pain coming from the banks?? I think so.? Residential real estate problems have not reconciled, and Commercial real estate problems are just beginning.? If we mark loans to market, many large banks are insolvent, and this is not an issue that will easily be healed with time.

18)? As a nation, I like Japan, and would like to visit it someday.? What I don’t want is for the US to imitate its economic stagnation, but maybe that could be the best of all possible worlds for the US.

19)? I am de-risking my equity and bond portfolios at present.? I do not think that the present market levels fairly reflect the risks involved.? I am reducing risk in bonds, and looking for strong sustainable equity yields in equities.

20)? Echoing point 17, we face real problems on bank balance sheets from commercial real estate lending.? There is more pain to come.? The time to de-risk is now.

Book Review: Mr. Market Miscalculates

Book Review: Mr. Market Miscalculates

Posted on by David Merkel

Since the first time I read him, I have been a fan of James Grant.? He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.? Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.? When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”? For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.? This book followed the same format, reprinting the best of old columns, with modest commentary.? In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?? Isn’t that a waste of time? That depends.? Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?? Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

  • How does monetary policy affect the financial economy?
  • Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
  • Why do value (and other) investors need to be extra careful when investing in leveraged firms?
  • What is risk?? Variation of total return or likelihood of loss and its severity?
  • Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
  • Why great technologies may make lousy investments.
  • Why does neoclassical economics fail us when trying to understand the financial economy?
  • How does one recognize a speculative mania?
  • And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.? Being too early means you eventually get disregarded.? The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.? That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.? You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

  • Those that have assumed that neoclassical economics adequately explains the way our economy works.
  • Those that want to understand how monetary policy really works, or doesn’t.
  • Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
  • Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,? but your costs don’t go up.?? Also, thanks to Axios Press for the free review copy.? I read the whole thing, and enjoyed it all.

Seven Notes on the Current Market Mess

Seven Notes on the Current Market Mess

Posted on by David Merkel

1)? Avoid short-cycle data.? When writing at RealMoney, I encouraged people to ignore short-term media, and trust those that gave long-term advice.? After all, it is better to learn how to invest rather than get a few hot stock picks.

In general, I read writers in proportion to their long-term perspective.? I don’t have a TV.? I rarely listen to radio, but when I do listen to financial radio, I usually feel sick.

I do read a lot, and learn from longer-cycle commentary.? There is less of that around in this short-term environment.

When I hear of carping from the mainstream media regarding blogging, I shake my head.? Why?

  • Most bloggers are not anonymous, like me.
  • Many of us are experts in our? specialty areas.
  • Having been practical investors, we know far more about the markets than almost all journalists, who generally don’t invest, or, are passive investors.

Don’t get me wrong, I see a partnership between bloggers and journalists, producing a better product together.? They are better writers, and we need to get technical messages out in non-technical terms.

We need more long-term thinking in the markets.? The print media is better at that than television or radio — bloggers can go either way.? For example, I write pieces that have permanent validity, and others that just react to the crisis “du jour.” Investors, if you are focusing on the current news flow, I will tell you that you are losing, becuase you are behind the news flow.? It is better to consider longer-term trends, and use those to shape decisions.? There are too many trying to arb the short run.? The short run is crowded, very crowded.

So look to value investing, and lengthen your holding period.? Don’t trade so much, and let Ben Graham’s weighing machine work for you, ignoring the votes that go on day-to-day.

2)? Mark-to-Market accounting could not be suppressed for long in an are where asset and liability values are more volatile.? Give FASB some credit — they are bringing the issue back.? My view is when financial statement entities are as volatile as equities, they should be valued as equities in the accounting.

3)? Very, very, weird.? I cannot think of a man that I am more likely to disagree with than Barney Frank.? But I agree with the direction of his proposal on CDS.? My view is this: hedging is legitimate, and speculation is valid to the degree that it facilitates hedging.? Thus, hedgers can initiate transactions, wtih speculators able to bid to cover the hedge.? What is not legitimate is speculators trading with speculators — we have a word for that — gambling, and that should be prohibited in the US.? Every legitimate derivative trade has a hedger leading the transaction.

4)? I should have put this higher in my piece, but this post by Brad Setser illustrates a point that I have made before.? It is not only the level of debt that matters, but how quickly the debt reprices.? Financing with short-term dbet is almost always more risky than financing with short-term debt.

Over the last six years, I have called attention to the way that the US government has been shortening the maturity structure of its debt.? The shorter the maturity structure, the more likely a currency panic.

5)? Look, I can’t name names here for business reasons, but it is foolish to take more risk in defined benefit pension plans now in order to try to make up? the shortfall of liabilities over assets.? This is a time for playing it safe, and looking for options that will do well as asset values deflate.

6)? Junk bonds have rallied to a high degree; at this point I say, underweight them — the default losses are coming, and the yields on the indexes don’t reflect that.

7) Peak Finance — cute term, one reflecting a bubble in lending/investing.? Simon Johnson distinguishes between three types of bubbles — I’m less certain there.? Also, I would call his third type of bubble a “cultural bubble,” rather than a “political bubble,” because the really big bubbles involve all aspects of society, not just the political process.? It can work both ways — the broader culture can draw the political process into the bubble, or vice-versa.

The political process can set up the contours for the bubble.? The many ways that the US Government force-fed residential housing into the US economy — The GSEs, the mortgage interest deduction, loose regulation of banks, loose monetary policy, etc., created conditions for the wider bubble — subprime, Alt-A, pay-option ARMs, investor activity, flipping, overbuilding, etc.? In the process, the the federal government becomes co-dependent on the tax revenues provided.

I still stand by the idea that bubbles are predominantly phenomena of financing.? Without debt, it is hard to get a big bubble going.? Without cheap short-term financing, it is difficult to get a stupendous boom/bust, such as we are having.? That’s just the worry behind my point 4 above.? The US as a nation may be “Too Big To Fail,” to the rest of the world, but if the composition of external financing for the US is becoming more-and-more short-term, that may be a sign that the endgame is coming.

And, on that bright note, enjoy this busy week in the markets.?? Last week was a tough one for me personally; let’s see if this week goes better.

Toward a New Concept of Asset Allocation

Toward a New Concept of Asset Allocation

Posted on by David Merkel

To my readers: thanks for your responses to yesterday’s article.? I will do a follow up piece soon.? If you have more comments please make them — they will help me with the piece.? Main new concepts coming — need for a deliverable, speculators can’t trade with speculators, only hedgers.

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Longtime readers know that I am not a fan of modern portfolio theory.? It is a failure for many reasons:

  • It assumes there is one type of risk, the occurence of which is random.
  • It assumes that this risk can be approximated by volatility (variance of returns), rather than probability of loss, and the likely severity thereof.
  • Mean return estimates, volatility estimates, and correlation coefficient estimates aren’t stable.
  • In crises, correlations head to 1 or -1.? Assets divide into safe and “not safe.”
  • Problem: some assets always fall into the “not safe” bucket, but what falls into the safe bucket can vary.? Long Treasuries and commodities could be examples of assets that vary during a crisis, depending on the type of crisis.
  • It does not recognize multiple time horizons easily.? Bonds held to maturity have a different risk profile than a constantly rebalanced portfolio.
  • Risk is the same for all people, and their decision-making time horizons are the same as well.
  • And more…

I’m still playing around with the elements of what would make up a new asset allocation model, but a new model has to disaggregate risk into risks, and ask some basic questions:

  • Where am I getting paid to take risk?
  • Where am I getting paid to avoid risk?
  • What aspects of the financial landscape offer the potential for a change in behavior, even if it might take a while to get there?? What major imbalances exist?? Where are dumb people making money?
  • Where options are available, how is implied volatility relative to long-term averages?
  • What asset classes have momentum to their total returns?

One good example of an approach like this is Jeremy Grantham at GMO.? Asset allocation begins by measuring likely cash flow yields on asset classes, together with the likelihood of obtaining those estimates.? With domestic bonds, the estimates are relatively easy.? Look at the current yield, with a haircut for defaults and optionality.? Still there is room to add value in bonds, looking at what sectors are cheap.

  • Are corporate spreads narrow or wide?
  • How are residential mortgage bonds priced relative to agency bonds, after adjusting for negative optionality?
  • How steep is the yield curve, and where is Fed policy?
  • What is the speculative feel of the market now?? Bold? Scared? Normal?
  • Related, how are illiquid issues doing?? Are they permafrost, or are molasses not in January?
  • If every risk factor in domestic bonds looks lousy, it is time to make a larger allocation to foreign bonds.
  • Cash is underrated, and it is safe.

Understanding bonds is an aid to understanding the rest of the market.? The risk factors in play in the bond market are more transparent than elsewhere, but the rest of the markets eventually adjust to them.

With stocks and commodities, the answer is tougher — we have to estimate future demand and supply for commodities.? Tough.? With stocks, we need to estimate future earnings, and apply a P/E multiple that is consistent with the future yield on BBB corporate bonds.? There is some degree of mean-reversion that can help our estimates, but I would not rely on that too heavily.

There is one more aspect to layer in here: illiquidity of equity investments.? With limited partnerships of any sort, whether they are hedge funds, venture capital, private equity, etc., one has to analyze a few factors:

  • Where is the sector in its speculative cycle?? Where are secondary interests being sold?
  • How much capacity do you have for such investments?? How much of your liability structure is near-permanent?? Is the same true of peer institutions?
  • Is the public equity market overvalued or undervalued?? Public and private tend to track each other.

Beyond that we get to the structure and goals of the entity neding the assets allocated.? Time horizon, skittishness, and understanding levels are key for making a reasonable allocation.

This is just my initial brain dump.? It was spurred by this article in the WSJ, on how asset allocation had failed.? Add in the article on immediate annuities, which are a great aid in personal retirement planning.? For those that think that immediate annuities reduce the inheritance to the children, I would simply say that it is longevity insurance.? If the annuitant lives a long time, he might run out of assets, and might rely on his children for help.? The immediate annuity would be there to kick in something.

Why did asset allocation fail in 2008?? All risk assets failed.? Stocks, corporate bonds, venture capital, private equity, CMBS, RMBS, ABS… nothing held up.? There were just varying degress of loss.? Oh, add in Real Estate, and REITs.? Destroyed.? Destroyed…

When the system as a whole has too much leverage, all risky asset classes get affected.? That’s what happened in 2008, as speculators got their heads handed to them, including many who did not realize that they were speculators.

Sorry, Doctor Shiller, not Everything can be Hedged

Sorry, Doctor Shiller, not Everything can be Hedged

Posted on by David Merkel

Many people don’t think through questions systematically.? That includes very bright people like Dr. Robert Shiller, who said in this article in Fortune, “We should be able to hedge everything from the rising costs of health care and education to national income risk and oil crises.”

Ugh.? And this from an esteemed professor at a significant university?? And one with which I have sometimes agreed?

I’ve written about this before in some of my market structure articles, where I tried to dig into the difference between natural, hedging, and gambling exposures.? I’ll use an ordinary example to illustrate this: the bankruptcy of IBM.

I use IBM as an example because it is so unlikely to go under.? But who would be directly affected if IBM went under?

  • Stockholders, both preferred and common
  • Bondholders
  • Banks that have loaned money
  • Trade creditors
  • Workers

Let’s talk about the bondholders.? They could buy protection via credit default swaps [CDS] to hedge their potential losses.? In order for that to happen a new class of risk-takers has to emerge that wants to take IBM credit risk, that don’t own the bonds already.? It’s not always true, depending on the specualtive nature of the market (and synthetic CDO activity), but one would suspect that those that want to take on the risk of a default of IBM would only do it at a concession to current market bond pricing, or else they would buy the bonds and pay fixed, receive floating on a swap.

But often the amount of CDS created exceeds the amount of debt covered.? I’m not suggesting that everyone owning bonds has hedged, either, but when the amount of CDS exceeds outstanding bonds, that means there is gambling going on, because it means that there are market players that are not long the bonds that are taking the side of the trade where they receive income in the short-run if the company survives, and pay if the company fails.

I call this a gambling market, because there are parties where the transaction takes place where neither has a relationship to the underlying assets.? There is no risk transfer, but only a bet.? My view is such gambling should be illegal, but I am in a minority on such points.

Now think about another asset: my house.? Aside from being somewhat dumpy, beaten-up by my eight kids, the house has a virtue — I live in it free and clear, with no debts to anyone, so long as I pay my property taxes.? So what is there to hedge here?? I’m not sure, maybe future property taxes?

Aside from the county, and my insurance company, I’m not sure who has a real interest in my house.? If I knew that there were many people betting on the value of my house, I might become concerned.? What actions might people take against me in bad or good times?

But maybe no one would have interest in my house.? It’s just one house, after all.? Who would have a concentrated enough interest in it to wager on it?

Now, some would say, we don’t have an interest in your house specifically, but we do have an interest in houses on average? in your area.? That’s fine, but there is no one with a natural exposure to all of the houses in my area, aside from the county itself.

This is why I think that most real estate derivatives involve gambling.? There is no significant natural exposure hedged.? It is only a betting market.

And such it would be for most real assets.? Few would want to create markets where the owner know more than they do, or, where there a few options for gaining control if things go bad.

At the end of the day, all of the assets of our world are owned 100%.? Everything else is a side-bet.? Personally, I would argue that the side bets should be prosecuted and eliminated, which would bring greater stability to the economic system.? No tail chasing the dog.? Let derivative transactions go on where here is real hedging taking place; away from that, such transactions are gambling, and should be illegal.

To Dr. Shiller, many markets are thin.? The concept that everything can be hedged assumes deep markets everywhere, which is not the case.? Time for you to step outside the university bubble and taste the real world.? It’s not as hedgeable as you might imagine.

Problems with Constant Compound Interest (2)

Problems with Constant Compound Interest (2)

Posted on by David Merkel

I had many good comments on part 1 of this series.? One was particularly good that focused on the economy as a whole, and how the promises made by the government were unlikely to be fulfilled with Social Security and Medicare.? Our government attempts to finance programs on the cheap by relying on future growth, which does not always happen.? They move up spending rapidly if growth is large, and small if growth is negative.? In either case, the government grows as a fraction of the economy.

But let me consider asset allocation projections.? It is really difficult to consider average projections of asset returns, whether in real or nominal terms.? Asset returns vary considerably, and the number of years from which average returns are calculated are few relative to the volatility of returns.

We have created an industry of asset allocators, many of which have allocated off of foolish long-term historical assumptions, as if the past were prologue.? Even if they use stochastic models, the central tendency is critical.? What do they assume they can earn over long-dated investment grade debt?? The higher that margin is, the more they lead people astray.? Stocks win in the long run, but maybe by 1-2%, not 4-6%.

Consider defined benefit pension funds — after all, it is the same problem.? What is the right long term rate to assume for asset performance?? Alas there is no good answer, and with private DB plans continuing to terminate because of underfunding, the answer is less than clear.

Scoundrels use the mechanism of discounting to their own ends — they make future obligations seem smaller than they should be, magnifying profits, and minimizing capital needs.? Cash flows are inexorable, though.? There are few ways to avoid the promises from pensions.

Investors, be aware.? Realize that long term investment assumptions are probably liberal.? Also realize that long term assets and liabilities that rely on those assumptions have liberal valuations as well.? After all, who wants to under-report income when the accounting is squishy?

Now, for my readers, what have I missed?

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