I am usually not crazy about books that propound a simple way to beat the market.? This is one of those books.? What makes me willing to write a review about this book, is that the writer, Charles Kirkpatrick is willing to incorporate some fundamental measures into his analyses, notably price-to-sales, which will help with industrial companies, but not with financials.
This is a simple book that reinforces the idea that one needs to pay attention to valuation (in a rudimentary way), and also to momentum.? While I don’t endorse the specific methods of the book, I will say that for someone with a low amount of time, and wanting to do a little better than the market averages, he could do so over the intermediate-term with the methods in the book.
Note: I am not endorsing the technical methods in the book, but most of the methods boil down to momentum, anyway.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? I?m not out to sell things to you, so much as provide a service.? Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books.? I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.
This is not my ordinary book review.? These are good books that will only appeal to a small fraction of my readers, because few will have need for the knowledge. Both are written by Espen Gaarder Haug, who is kind of a character.? He collects option pricing formulas the way some people collect Barbie Dolls, Beanie Babies, or Baseball Cards.? He has interacted with some of the brightest minds in the field, and collaborated with a few of them.? In both books the math is significant — it would help if your calculus was sharp, and for any value some algebraic knowledge is needed.
Let’s start with the more esoteric of the two books, The Complete Guide To Option Pricing Formulas.? Almost every option formula is included there, together with ways of estimating volatility, certain statistical techniques, aspects of compound interest math, etc.? The book is very comprehensive, and for those that need how to estimate the value of standard and non-standard options, it is a good book to keep on hand as a reference, together with the free CD-ROM containing an Excel add-in that allows you to use the formulas inside Excel.? I have used them for some of the insurance companies I have worked for; the software was easy and reliable.
The second book Derivatives, Models on Models, is different.? He interviews 15 significant thinkers on options and derivatives, and presents 15 papers by them.? Most of them contain tough math; some I couldn’t understand.? The real value of the book was in the interviews, where many of the interviewees showed significant knowledge of the limitations of their models, and how derivatives were misunderstood by the public, or by their users.
There are quirky aspects to this book, including cartoons and photos that are somewhat self-aggrandizing to the author, but make the point in a humorous way.? I liked both books, but only a modest fraction of my readers should have any interest here.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? My objective is to aid my readers, and not explicitly take money from them.
1) So many managers lose confidence near turning points, like Bruce Bent in this article.? Still others maintain their discipline to their detriment, not realizing that they have a deficiency in their management style.? Alas for Bill Miller.? A bright guy who did not get financials, or commodity cyclicals.
2) We will see rising junk bond defaults in 2009.? Some defaults will be delayed because covenants are weaker than in the past.? But defaults primarily occur because cash flow is insufficient to finance the interest payments on debts.? That can’t be avoided.? After Lehman, what can you expect?
4) I am not a fan of workouts on residential mortgage loans.? Most of them don’t work out.? Loans typically default because of one of the 5 Ds, and modifying terms is adequate to help a small number of the borrowers.
5) I’ve talked about this for a while, but Defined Benefit pensions (what few remain) have been damaged in the recent bear market.? What should we expect?? When companies offer a fixed benefit, and rely on the markets to fund it, they rely on the kindness of strangers, who they expect to buy equities when they need to make cash payments on net.
6) There are two credit markets.? Those that the government stands behind, and those that it does not.? That is the main distinction in this credit market, with Agency securities falling into a grey zone.
7) If we were dealing with your father’s financial instruments, we would use his financial rules.? As it is, more complex financial instruments that are more variable in their intrinsic value must be valued to market, or, the best estimate of market. There are problems here, but remember that market does not equal last trade for illiquid, complex securities.? Also, there should be caution over level 3 modelled results.? From my own work, those results are squishy.
8 ) During a crisis, many relationships boil down to liquidity.? Who has it? Who needs it, and at what tradeoff?? The same is true of venture capital today.? Who will fund their commitments?? Beyond the issue of dilution looms the issue of survival.? VC backed companies lacking cash will have a hard time of it in the same way their brother public companies do.
9) The Fed ain’t what it used to be.? Today it has all manner of targeted lending programs, and a disdain for stimulus through ordinary lending.
11) How can SunTrust be in this much trouble, needing a second does of TARP funds so soon?? I don’t get it, but it is endemic of our banking sector.? The TARP Oversight Panel is supposedly going to ask a bunch of questions to the Administration regarding past use of TARP funds, but the questions are vague and easy to answer in generalities.
12) There were warnings of trouble inside both Fannie and Freddie, as well as a few recalcitrant analysts outside as well (including me).? Now they recognize the trouble they are in, maybe.? (Also: here.)? Congress does what it can now, not to identify what went wrong, but to divert attention and blame away from themselves.? No one supported the expansion of Fannie and Freddie more than Congressional Democrats.? Political critics were marginalized.
13) The euro makes it to its ten-year anniversary, and we are told… see, as sound as a Deutschmark.? Well, maybe.? Having a strong currency might be fine for Germany, but what of Greece, where the credit default swap market is pricing in a 12%+ probability of default over the next five years?? They might like a weaker euro.
14) Is Britain a greater default risk than McDonalds?? Is the US a greater default risk than Campbell Soup?? Sovereign default is a different beast than corporate default.? Corporations don’t control their own currency (hmm… does that make Greece more like a corporation of the Eurozone? or more like California in the US?), and so bad debt decisions compound over longer periods of time, until we end up with inflation, a forced debt exchange, or an outright default.? It is possible for the US to default without Campbell Soup defaulting, but the life of any US corporation would be made so much more difficult by an outright default of the US government, that I would expect an outright default to cause most US companies, states, and other nations to fail as well, because of implicit reliance on the creditworthiness of the Treasury.
Bottom-callers are out in droves, with many sophisticated arguments.? They all hinge on one idea: that we can return to normalcy soon with a compromised financial system, and debt levels that are record percentages of GDP.
The basic idea behind the two pieces is this: sure, we’re at average valuation levels now, but in a real bear market values can get cut in half from here.? My view is this: we’re not at table-pounding valuation levels yet, but someone with a value and quality bent will make money over the next ten years.
An End to Redemption-Related Selling by Hedge and Mutual Funds
Increased Lending
Tax Cuts
I fear this confuses the symptoms with the disease. Yes, it would be nice if many of these happened, but with the deficit hitting record levels, 2 and 5 are problematic.? In an over-indebted economy 1and 4 are tough as well.? As for point 3, you may as well argue with the sunrise, because most investors are trend-followers, whether they know it or not.? Redemptions typically end after the market has turned significantly.? It’s not a leading indicator, nor is it necessarily an “all clear.”
19) From the “read your bond prospectus with care department,” Catastrophe bonds are only as good as the collateral backing the deal or creditworthiness of the obligor.? Though it may have seemed a good idea at the time, allowing for lower quality collateral has caused the creditworthiness of several catastrophe bonds to suffer as Lehman defaulted, and as losses on subprime mortgages rose.? My take is this: analyze all the risks on a bond, even the obscure ones.? A lot of exchange traded note [ETN] investors probably wish they had paid more attention to who they were lending the money to, rather than the index attached to the notes.
20) The “read your bond prospectus with care department” does have a humorous side, as Paul Kedrosky points out on this amendment to some new Illinois GO bonds.? They don’t sound too worried, but maybe the lawyers have to be more pro-active, and put the following new risk factor into the prospectus:
Endemic Political Corruption
Your investment in the state of Illinois is subject to risks involving political corruption, which is a normal fact of life in Illinois. In lending to the State the lender bears the risk that the corruption level gets so great that it affects the trading value of these securities, and that interest and principal repayment could be impaired.
21)? Even if you don’t have 5 of your last 9 Governors removed due to scandal, like illinois, it’s tough to be a state nowdays.? Now you have the credit default swap [CDS] market spooking investors in your bonds.
I’m not sure, but I would be careful here.? What can be used for a single limited pupose today can be put to unimaginable uses tomorrow.? The Fed’s balance sheet is already at much higher levels of leverage than it was three months ago.? Does it really want to take on more?? Granted, seniorage gains/losses go back to the Treasury, which then can borrow less or more in response, but as the Fed’s balance sheet gets more complex, it makes it more difficult to gauge their policy responses, and I think it will lead to a lack of trust in the Fed and the US Dollar.
23) With conditions like these, should we be surpised that volatility is high in the equity markets?? By some measures, it is higher than that in the Great Depression.? I’m not sure I would call it a “bubble” though.? Extreme Value Theory tells us (among other things) that when a probability distribution is ill-defined, don’t assume that the highest value that you have seen is as high as it can get.? Records beg to be broken.
24) It’s not as if I am the only one thinking about issuing longer US Treasury debt.? Now the Treasury is thinking about it as well.? It will fill a void in our debt markets that life insurers, endowments, and DB pension plans will want to invest in (and create a bunch of new leveraged fixed income investments for speculators).
Remember, my model can be used in two ways: in the red zone, for short term momentum players.? (Look at all of those relatively stable predictable industries.)? Or, the green zone, for value/contrarian players.? (Look at all of those cyclicals and financials.)
Which do you think will do better?? Mean reversion or relative safety?? My portfolio is spread across both, so I don’t have a dog in that fight.? I do think that portfolios in this environment have to aim to be self-financing, avoiding the need for capital raises in an environment where capital is scarce.
Away from that, I am still not a believer in financials, aside from insurers, and I don’t see much good among housing or autos, regardless of who gets bailed out.
I often fail, and am no good at identifying short candidates because I am not good at timing.? I can spot a bad balance sheet easily, but often companies with the worst balance sheets soar during the bull phase of the market.? What that suggests to me regarding shorting is:
During the bull phase identify bad balance sheets, but don’t short anything.? Make your list of future failures.
Watch for when junk yields rise over 500 bps, then start shorting the names you identified.? There is a risk that you can’t get a borrow, but then buy puts if you can’t get the borrow.
So, maybe I could do shorting.? I’ve gotten a lot of names right, but timing is problematic.? You don’t want to short names too soon, or you won’t be able to carry your position to its demise.? But one name you could not short (using stock) was Tribune after Sam Zell took it private.? I wrote twice about Tribune, and for two reasons:
As I have said elsewhere, it stinks that Sam Zell influenced Tribune employees to invest in a failing business.? It is usually a bad idea to invest in the company that you draw wages from, because it lacks diversification.? Beyond that, if the buyout by Zell had lasted five years, I could argue that the employees had gotten their money’s worth through wages.? As it is, after one year-plus, they got hosed.
It’s sad, and it may get sadder still, as other newspaper holding companies die.? Will the New York Times survive?? Maybe.? What I do know is that its economics are poor, and that they are borrowing against their last solid assets.? Does that sound like a recipe for success?
The plan the Treasury is considering would encourage banks to issue new mortgages at lower rates by offering to purchase securities underpinning the loans at a price equivalent to the 4.5% rate.
The Treasury would fund the purchases by issuing Treasury debt at 3%, suggesting the government could make a profit on the difference.
One of the major ways that we got into this crisis is that we had? a large number of parties willing to buy lower quality assets that they levered up their (then) higher quality balance sheets to buy.? Clip a spread and make free money.? The US government may repeat this error.? To make it absurd, why doesn’t the US Government buy every dodgy asset?? It could make money on them, and save money for taxpayers.? Well, the money has to come from somewhere, whether from citizens in the US, or foreigners.? At some level, those lenders revolt, particularly as they realize the the risks being taken by the US government are increasing, and may compromise their credit interests.
The US government is becoming a hedge fund, and we as taxpayers are becoming mutual owners of the beast.? We are all hedge funds now.
I am a skeptic on leveraged ETFs in one way.? My view is that the more levered they get, the less likely they are to replicate the behavior of their index, however levered.
To get high amounts of leverage, they must rely on futures, options, swaps, and options on swaps, and the higher the amount of leverage they attempt to replicate, the greater the amount of slippage they will experience versus their multiplied index.? There is also slippage from rolling futures from month to month.
Here’s my challenge, and I may do this myself, or, though I encourage others to do it.? Add the performance of the bullish and bearish funds of an index together, for a given amount of leverage.? If there is no friction or fees, they should do as well as T-bills.? My guess is the higher the leverage the lower the aggregate returns.
Let the games begin.? Does anyone want to run this analysis before I do it, say, six months from now?
So Jimmy Rogers thinks the US dollar is going down?? He might be right.? There are few roads out of this crisis (more than one can be used):
High inflation (raise the nominal value of collateral behind loans, maybe?)
Internal Default (with depression)
External Default (including currency controls, and forced conversion to a new currency)
Large rise in taxation (leading to deep depression).
The Japan game, where the government attempts to force liquidity into the economy, leading to a low- or no-growth malaise.
At present, I think the government is pursuing the last of those, and avoiding inflation for now.? It is not in the DNA of the Fed to inflate, ever since the era of the ’70s.
Now, there is one idea floating around that I would like to suggest that we don’t do, or, if we do do it, let’s do it in limited amounts, like TIPS.? There is a proposal for Obama bonds — bonds issued by the Treasury in a currency other than dollars, such as the Japanese Yen.? It’s been done before; but I would urge against it because it gives up a key advantage that all of our debt is denominated in a currency that we think we control.? Why outsource that advantage to another central bank?
A Modest Proposal for Balancing the US Budget in the Short-Run
1/9/2007 11:06 AM EST
This is not meant seriously, but an easy way to balance the US Budget in the short run is to issue Japanese Yen-denominated debt. Current interest costs would drop rapidly, and the budget would balance.
What’s that you say? What if the Yen appreciates versus the Dollar? The US has an ill-disclosed balance sheet, with many of its liabilities omitted, or merely disclosed as footnotes… Medicare, Social Security, the old Federal Employee defined benefit plan, etc., are all off the balance sheet. (And on the plus side, so is the value of most of the property of the government, as well as the present value of its taxation capabilities.)
Leaving aside other things that are off-budget (e.g., Iraq, Katrina relief), borrowing in foreign currencies is just another tool that the Federal government can use to put off today’s costs off to a future date. It’s something that our government does well.
Position: none, though I own TIPS, realizing that they are only second best to developed market foreign currency debt, and the US Labor department controls the CPI calculation…
My Idea
Lest I merely seem to be a critic, I have another idea that I think is more powerful: Issue 40-, 50-, 75-, and 100-year bonds.? Issue TIPS versions as well.? Hey, issue a perpetual — Consols!? As I have said earlier:
George, I’m really glad to see that the Treasury has finally gotten a lick of sense, and is re-issuing the 30-year, which they should be able to at yields lower then the current long bond maturing in 2031 (probably 10 basis points lower).
Timing is anyone’s guess, but I would suspect two auctions — in November 2005 and February 2006 — in order to give the new benchmark bond sufficient liquidity. Given the absence of long issuance, demand for this bond will be very strong in the hedging community.
Now, the Treasury won’t do this, but my guess is that there is even more demand for a 50-year, or even a century bond (100 years). It would help pension funds and structured settlement writers match their liabilities. Those bonds could sell at yields less than the 10-year. Won’t happen, but I can dream.
none mentioned, though I own Treasury Securities of various sorts, both directly and indirectly (don’t we all?)
There is a decent amount of demand for safe long-dated debt from pension plans, life insurance companies, and other long-term fixed income investors.? These bonds would likely have lower yields than the 30-year bond, because of buyers that like long fixed income because of its reliability in a crisis.? (And, for bond geeks — high positive convexity.)
Personally, I think the market would happily digest a lot of really long debt from a seemingly strong entity like the US Government.? What, are we going to let the Europeans have a monopoly on long sovereign debt here? ;)? US Treasury, be innovative — show the world how confident we are in the future of the US by issuing debt as long as we think this republic will last.? Surely that is longer than 30 years.
I’ve been asked by a number of readers for my opinion on the economic team being put together by the incoming Obama administration.? I’m not that excited, but then Bush Junior’s economic team was pretty consistently disappointing.? What we have is a bunch of Clinton-era retreads in Summers, Orszag, and Geithner.? Bob Rubin may not be there, but those that learned from him are there.
And, this is change.? I have sixty cents sitting next to me.? That’s change also.? Moving from Paulson to Rubin’s students is exchanging one part of the intellectual framework of Goldman Sachs for its cousin.? As Ron Smith said to me off the air when I was recently on WBAL, the economic advisors of Bush and Obama are members of the same intellectual country club.? There is little real change there.
But, look at it on the bright side.? The best part of the Clinton administration was the Treasury Department and the affiliated entities.? Perhaps that will be true of the Obama administration as well — pragmatism ruling over dogmatism, and a fear of freaking out the bond market.? Could be worse.? Save us from misguided idealists (perhaps Bernanke — a pity he didn’t pick a different dissertation topic), who think they know how to fight economic depression, but really don’t, and waste a lot of time and money in the process.
As it is we get two new programs this morning that are more of the same😕 Keep expanding the Fed’s balance sheet; don’t think about the eventual unwind.? Create more protected lending programs that encourage lenders to flee unprotected areas of the market for protected areas.? Do anything to shift debt from private to public hands; but don’t do anything that truly reconciles bad debt.
I do have a beef with the selection of Geithner, though.? This Bloomberg piece gives a sympathetic rendering of his attempts to deal with derivatives.? He tried to achieve consensus of all parties.? My view is that the areas where he could achieve compromise were areas that were important but not critical.? He needed to take a bigger view and question the incredible amounts of leverage, both visible and hidden, that we were building up and focus on what regulatory structures could properly contain the increased leverage, lest the gears of finance grind to a halt, as they have done today.
We can be less sympathetic, though.? Chris Whalen’s (Institutional Risk Analytics) opinion of him is quite low, or, as he was quoted in this NYT article:
?We have only two things to say about Tim Geithner, who we do not know: A.I.G. and Lehman Brothers,? said Christopher Whalen of Institutional Risk Analytics. ?Throw in the Bear Stearns/Maiden Lane fiasco for good measure,? he said.
?All of these ?rescues? are a disaster for the taxpayer, for the financial markets and also for the Federal Reserve System as an organization. Geithner, in our view, deserves retirement, not promotion.?
Ouch.
?He was in the room at every turn of the crisis,? said another executive who participated in several such confidential meetings with Mr. Geithner. ?You can look at that both ways.?
This Wall Street Journal editorial is similarly bearish.? Geithner was in the room on every bad decision, and a few non-decisions.
My view is that he is a bright guy who is out of his league in trying to deal with the aftermath of the buildup in leverage, that has lead to the collapse in leverage that we all face.? Now, I can’t be that critical of him, because he has been cleaning up after the errors of many, a small fraction of which he bears some responsibility for.
No one is equal to solving this crisis.? It is bigger than our government, which made an intellectual mistake in thinking that it could promote prosperity through Greenspan-like monetary policies, which almost everyone lionized while they were going on, except a few worrywarts like me, James Grant, etc., who followed the buildup of leverage in the Brave New World.? Now we face its collapse; let’s just hope and pray? that it doesn’t lead to worse government than what we have now.
PS — If I were offered the opportunity to fix things, I would take it, and:
Create a means of resolving home foreclosure issues in a manner similar to Chapter 11, which would lead to more compromises.
Institute true tax reform that eliminates the sheltering of income, and eliminates all tax preferences.
Wind down the Fed’s current “solutions”
Begin inflating the currency to force up the value of collateral relative to nominal debt levels
The last one I like the least, but I’m afraid it would have to be done.? Phase two would be:
Move to a currency that is gold-backed.
Replace the Fed with a currency board.
Create a new unified regulator of all depositary institutions.
Slowly raise bank capital requirements, and make them countercyclical.
Bring all agreements onto the balance sheet with full disclosure.
Enforce a strict separation between regulated and non-regulated financials.? No cross-ownership, no cross-lending, no derivative agreements between them.
Bar investment banks from being publicly traded, and if regulated, with strict leverage/risk-based capital limits.
Move back to balanced budgets, and prepare for the pensions/entitlements crisis.
On that last one, there are few good solutions there, but we would have to try anyway.? So it goes.
This book is big, very big at ~700 pages. It is a testimony to the idea that history doesn’t repeat itself, but it often rhymes.
The book is arranged chronologically, and geographically within each time period.? Time is spent on each are roughly in proportion to the amount of unique data that we have from each era.? Thus, the recent past gets more pages per year.? Roughly one-quarter of the book goes from ancient times to 1800, and one quarter to the 19th century.? Half of the book is 1900-2005.
There are several things that the book points out, common to each time and area investigated.
1) It is very difficult to eliminate interest.? Even when governments or religions try to restrict interest, either in rate charged or in entire, systems arise to create promises to pay more in the future that than full payment today.
2) The more technologically advanced economies get, the lower interest rates tend to get.
3) Boom/bust cycles are impossible to avoid.
4) Governments introduce currencies and often cheat on them (debasement, or inflation of a fiat currency).
5) Governments do sometimes fail, whether due to a lost war, civil war, or default, taking their currencies and debt promises with them.
6) The economic cycle across the world is usually more correlated than most people believe at any given point in time, even in ancient times.? (How much more today… decoupling indeed…)
7) Cultures that allowed for a moderate amount of debt financing prospered the most, in general.
Those are my summary points after reading the book.? Homer and Sylla drew some but not all of those conclusions.? It’s an ambitious book and and ambitious read.? Sidney Homer did a lot of significant work researching from the past to the middle of the 20th century, and Richard Sylla did an admirable job giving the grand sweep of the increasing complexity of the bond markets as the 20th century progressed until 2005, which was an interesting point at which to end the fourth edition.? The fifth edition, should there be one, will prove even more interesting as it surveys the end of the housing and credit bubbles, and the shape of the financial system in their aftermath.
This book is a must for those that like economic history.? I really enjoyed it.? For those without such an interest, it’s a big, somewhat-expensive, show-off book that will be occasionally useful as a reference.
PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? I’m not out to sell things to you, so much as provide a service.? Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books.? I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.
I am usually not crazy about books that propound a simple way to beat the market.? This is one of those books.? What makes me willing to write a review about this book, is that the writer, Charles Kirkpatrick is willing to incorporate some fundamental measures into his analyses, notably price-to-sales, which will help with industrial companies, but not with financials.
This is not my ordinary book review.? These are good books that will only appeal to a small fraction of my readers, because few will have need for the knowledge. Both are written by Espen Gaarder Haug, who is kind of a character.? He collects option pricing formulas the way some people collect Barbie Dolls, Beanie Babies, or Baseball Cards.? He has interacted with some of the brightest minds in the field, and collaborated with a few of them.? In both books the math is significant — it would help if your calculus was sharp, and for any value some algebraic knowledge is needed.
The second book Derivatives, Models on Models, is different.? He interviews 15 significant thinkers on options and derivatives, and presents 15 papers by them.? Most of them contain tough math; some I couldn’t understand.? The real value of the book was in the interviews, where many of the interviewees showed significant knowledge of the limitations of their models, and how derivatives were misunderstood by the public, or by their users.
