Category: Stocks

Financial History is Valuable

Financial History is Valuable

Posted on by David Merkel

I’ve said it before, but I came into the investment business through the back door as a risk manager.? Unlike most quantitative analysts, I came with a greater depth of knowledge of economic history, and a distrust of the assumptions behind most quantitative finance models, because things can be much more volatile than most current market participants can imagine. As a result, I often ran my models at higher stress test levels than required by regulation or standards of practice.

Can countries fail?? Sure.? It has happened before.? Can leading countries fail?? Yes, and consider France, Germany and Japan.? Consider earlier history — the failure of a major power has significant effects on the rest of the world.

Understanding economic history can keep one from saying, “That can’t happen.”? Indeed when governments are pressed, they do their best to extract additional revenue out of those that will complain the least.? Qualitative analyses, if done properly, incorporate a wider amount of variation than the quantitative statistics will reveal in hindsight.? Do you incorporate the idea that all novel securities (new industries) go through a big boom bust cycle?? If so, you would have avoided most of the complex debt securities born in the last ten years, and would have been light on risky debt that was the building blocks for those securities.

Though the job should fall to regulators to bar institutions of trust from investing in novel instruments, and they used to do that, the legal codes and regulators, forgetting history, removed those restrictions, and left many financial institutions to their own wisdom in managing their risks.? Some of those institutions were careful and speculated modestly if at all.? Others went whole hog.

The speculators (not called that at the time) pointed to loss statistics that had been generated during the boom phase of the cycle.? They showed how the junk-rated certificates would even be money good under “stressed” conditions.? All of the way through the boom, they pointed to their backward looking statistics, as leverage levels grew, and underwriting quality fell in hidden ways.

We know how it has ended.? In some cases, even AAA securities will not be money good (i.e., principal and interest will not be repaid in full).? Alas for the poor non-US buyers who sucked down much of the junk securities.

This forgetfulness regarding booms and busts affects societies on a regular basis. It happens everywhere, but the freewheeling nature of the US makes it a model country for this exercise (boom period in parentheses):

  • Residential Housing (2002-6)
  • Commodities (2001-8)
  • Financial Innovation — hedge funds, securitization, credit default swaps (1995?-2007)
  • Cetes (1992-1994)
  • Commercial Real estate (20s, 80s, 2000s)
  • Guaranteed Investment Contracts (1982-1991)
  • Negative convexity trade in residential mortgages (think of Orange County, Askin, Bruntjen) 1990-1993
  • Stocks (20s, mid-to-late 60s “Go-go era,” 1982-1987, 1994-2000, 2003-2007)
  • Energy (1973-82)
  • Developing country lending (late 70s)

This list isn’t exhaustive, but it’s what is easy for me to rattle off now.? Cycles are endemic to human behavior.? Governments and central banks may try to eliminate the negative part of a cycle of cycles, but it is at a price to taxpayers, savers, and increased moral hazard.? Why limit risk when the government has your back?

All that said, relying on historical patterns to recur, or simple generalizations that say that “the current crisis will follow the same track as the Great Depression,” are too facile and subject to abuse.? The fine article by Paul Kedrosky that prompted this piece makes that point. Too often the statistics cited are from small data sets, or unstable distributions generated by processes that are influenced by positive and/or negative feedback effects.

Studying economic history gives us an edge by giving us wisdom to avoid manias, and avoid jumping in too soon during the bust phase.? I’m still not tempted by housing or banks stocks yet.

That’s why I write book reviews on older books dealing with economic history (among others).? As Samuel Clemens said, “History doesn’t repeat itself, but it does rhyme.”? It doesn’t give a simple roadmap to the future, but it does aid in developing scenarios.? As Solomon said in Ecclesiastes 1:9, “That which has been is what will be, That which is done is what will be done, And there is nothing new under the sun.”

I’ll close the article here, but I have an application of this for politicians and regulators that I want to develop in part two.

Happy New Year to my Readers

Happy New Year to my Readers

Posted on by David Merkel

At the beginning of each calendar year, I sit down and see how my expenses have tracked over the past year.? I make a table and a pie chart to show my wife.? She is always amazed at how much goes to taxes, though the new amazement is what it takes to put children through college.? We spend some time discussing plans for the next year.? Since my wife is not money-oriented (not a big spender, and focused on teaching the children) this gives her a quick way to get reoriented in our financial situation.

After that, I look at investment income.? 2008 was an unusual year for me in this way: it was the first year in my working life that my net worth fell.? Though painful, at age 48, I’m grateful that I have had a good past.

I then look at how individual stocks in the portfolio did.? Here’s a chart for 2008:

The chart is in order from the biggest gain to the biggest loss.? XIRR is the internal rate of return on funds during 2008, and days was the number of days I held a position during 2008.? Needless to say, this was my worst year ever, but I still did better than the S&P 500 by a middling single digit percentage.

That is important to me, because in 2009 I hope to gain my first external client. I have been banging my head against the wall, because I have a small bunch of investors that want to sign on, but they all don’t want to be my first client.? They want to see an institutional investor invest in my fund, then they will invest with me.? Frustrating.

Since strategy inception in 2000, I have beaten the S&P every year except 2007, where I missed by less than a percent.? And, given the performance of many well known value managers in 2008, beating the S&P ain’t bad.

Going back to the table above, I got whacked on names with bad balance sheets, life insurers, and names with too much cyclicality.? I did well on a number of names that I bought cheaply, and particularly on my October reshaping, where I focused on survivability.

I still think survivability is the watchword here.? I’ll be putting out my candidates list for the next reshaping soon, as well as my main industry model, but in an environment like this, raw cheapness doesn’t matter; a company must survive to realize the discount on its valuation.? Remember, the main rule of value investing is not “buy them cheap,” is not “lowest average cost wins,” but is “margin of safety.”

One more note: the present portfolio “long only” portfolio is 22% cash.? That is the highest level in eight years.? I have raised cash into the recent rally through my normal rebalancing discipline.? I will deploy cash as I get opportunity into strong names with strong balance sheets.

Asset Allocation

I also look at our asset allocation.? Excluding our house (no mortgage), it looks like this:

  • 30% Cash and TIPS
  • 20% International Stocks
  • 18% Large Cap US Stocks
  • 17% Small Cap US Stocks
  • 15% Private Equity

I have no debts, but I have eight liabilities, two of which are going to college, and six of which might do so.? That is my main financial challenge for the next fifteen years (the little one is almost seven, and what a cutie.)

Even though I am bearish, I am comfortable with the amount of risk that I am taking, partly because I may derive a business from it through my ability to pick stocks that do relatively well.? The private equity is illiquid, but in this environment even it is doing well — having clever businessmen as friends is a help.

Recent Changes

Here’s a list of my moves since the last time I wrote:

Outright Sale — Gruma SA

Swap — Bought Japan Smaller Capitalization Fund, sold SPDR Russell Nomura Small Cap Japan? (The CEF was trading at an extreme discount)

Rebalancing Sales

  • Assurant (3)
  • RGA
  • Valero Energy
  • CRH
  • Magna Automotive
  • Safety Insurance
  • Charlotte Russe
  • Shoe Carnival
  • Devon Energy
  • Japan Smaller Capitalization Fund

Rebalancing Buys

  • Assurant (2)
  • Charlotte Russe (2)
  • Magna Automotive
  • Shoe Carnival
  • Nam Tai Electronics

I also participated in the RGA exchange, where I traded my A shares for B shares when the discount was wide, and received RGA shares one-for-one when the exchange was complete.

Blog News

I have several book reviews coming, including one on Technical Analysis, and one on how wealthy people got that way.? I also have a panoply of other article ideas:

  • How the lure of free money corrupts politicians
  • Setting up mutual banks
  • The risk of no significant change (not yes we can, but, why do we need to change?)
  • Hidden correlations
  • The mercantilists lost
  • Analyzing TIPS
  • Momentum strategies
  • Buybacks
  • Confidence means keeping assets inflated
  • How securitization could aid resolution of our current crisis

It is a lot of fun writing this weblog.? I enjoy it a lot.? As I close this note, I would like to thank:

  • Those that read the blog
  • Those that comment here, and send me email (all of which I read, but I can’t answer all of it)
  • Seeking Alpha
  • Others that republish me
  • Those that buy products at Amazon through my site
  • Those that buy blogads at my site
  • Other bloggers that give me good ideas
  • And the firm that employs me, Finacorp, but bears no liability for my mutterings here.

2009 may prove to be a better year than 2008.? If that is not true, we will be rivaling the Great Depression.? That said, there are opportunities even in bad economic environments, and lts see if we can’t make the best of what we do get.? Here is to making the most of our opportunities in 2009.? May the LORD bless us all in our endeavors.

Full disclosure: long COP SBS DIIB.PK MGA IBA XEC VLO TNP JSC NTE VSH SAFT CHIC SCVL HIG RGA HMC ESV KPPC DVN ALL PRE CRH PEP GPC LNT NUE AIZ (yes, that is the complete current portfolio)

Public Pension Plans Doubling Down

Public Pension Plans Doubling Down

Posted on by David Merkel

I am not a gambler, and I never will be.? I take the risks of a businessman as I invest, and not those of a speculator.? I found it interesting to to read this Wall Street Journal article where public defined benefit pension plans are not fleeing hedge funds.? This is an area where I half agree.? Because the yields of high yield bonds are so high, this is not a time to abandon aggressive strategies.? Rather, it is a time to embrace them, slowly and carefully.

I looked through the database of my writings in the CC at RealMoney, and I found these two comments that fit the moment well.


 David Merkel
Avoid Esoteric Diversification
4/13/2006 4:00 PM EDT

This isn’t a burning hot issue at present, but I have been impressed with the increasing amount of money getting thrown at esoteric asset classes by pension plans and endowments, in an attempt to diversify and gain higher total returns. In the intermediate term, it is not sustainable. For now, party on, we are in overshoot mode.

By esoteric asset classes, I mean: commodities, timber, credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of asset- and mortgage-backed securities, hedge funds and private equity.

Many novel asset classes provide both higher returns and diversification when they are first used. As more and more players get comfortable with it, they buy in, lowering the required total return needed to attract investors, but pushing up returns to pre-existing holders as the price rises.

This can be self-reinforcing for quite a while, with a lot of money blindly flowing in, until some player games the system, selling securities that fail miserably. A panic ensues, and the asset class goes through a maturation process that learns to distinguish quality within the asset class.

With the rise in yields, high quality bonds have been giving holders a hard time in total return terms. But you don’t buy bonds for total returns; you buy them for income, and diversification; they tend to do well when risky assets break down.

I guess my short summary is this: with risky asset classes so highly correlated at present, if you want to diversify, go to high quality bonds, or cash. The theoretical diversification of risky assets based on correlation measures calculated over long time periods is no longer valid.

Position: none

and —


 David Merkel
Alternatives to the Terror of Actuarial Funding Targets
9/27/2007 2:57 PM EDT

Jordan, my deep suspicion with respect to the pension plan sponsors is that they are looking at the gap between the yield they can get from investment grade bonds and the yield they need to fund the pension promises, and they realize that they are going to have to make a larger allocation to risky assets. After that, they look at the past track record on public equities, and conclude that they have been hurt by the lack of returns over the past seven years. Then they look at the returns in alternative investments, and say, “What great returns! Why have I been ignoring these? If David Swensen can do it, so can I!”

Well, David Swensen is a bright guy who went to the party early. Alternative investments were truly alternative when he arrived. Today they are mainstream, and some of them have gotten overfished. The plan sponsors can allocate all they like to alternatives, but they aren’t magic… they can do just as bad as public equity, and with far less liquidity.

If I were a plan sponsor today, I would begin trimming alternative areas that look crowded, like private equity, commercial real estate, and certain types of hedge funds while the door is still open. For some areas, like CDOs [Collateralized Debt Obligations] the door is already closed.

I would also lower my return expectations, and plan on contributing more. Heresy, I know. But alternatives are over-used, and no longer alternative. They won’t deliver the same high returns in the future that they did in the past.

Position: none

I am not unsympathetic here as public pension plans essentially say, “Well we have to earn enough to meet our actuarial funding targets, and at this point, bonds of the highest quality don’t help us.? Hedge funds promise high returns regardless of market movements, so we need to allocate money there.”

At this point in the cycle, I might have some sympathy, because enough arbitrage relationships are broken, offereing some opportunity.? At the same time, and ordinary investment in a basket of lower investment grade and high yield bonds offers a nice return for those willing to live with some default risk, which is over-discounted here, even with things as bad as they are.

In a bear market, once you have taken a severe amount of damage, the question is “what offers the best return from here?”? The answer might be unpopular, but it should be pursued.? Even as defined benefit managers pursued seeming diversification with bad payoffs as noted above, and should have sought long term guarantees, at a time like now, where guarantees are tremendously expensive, and yields are high? because of possible default, it is a time to take risk, and fund the best entities that may not make it.

These are ugly times, but we have to think like Ben Graham during the Great Depression.? What will survive?? Where can a little bit of additional capital spell the difference between death and survival?

This is a time to take risk.? Things could get worse from here, so don’t overcommit, but don’t fail to commit either.? Make some reasoned judgements about what is likely to do well ten years out, and invest for it.

This is a rough time.? I offer solace to those that are battling the markets; you are having a rough time of it.? The challenge here is whether the risk premium in fixed income assets offers enough compensation versus Treasury quality assets.? My answer is yes, realizing that this is a bumpy trade, and will require patience to receive the returns promised.

Twenty Comments on the Current Economic Scene

Twenty Comments on the Current Economic Scene

Posted on by David Merkel

1) There are firsts for everything.? Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952.? America has always been a pro-debt and pro-debtor nation.? It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period.? But, the Pilgrims did extinguish the debt.? Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity.? With the decline in housing values, the fall in the ratio was inevitable.? The low ratio puts downward pressure on home prices, because it means that more homes are underwater.? Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector.? Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble?? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more.

5) Now these same low yields whack Treasury money funds. How many will close?? How many will cut fees?? How many will break the buck, and credit negative interest?? An unintended consequence of monetary policy.? Another unintended consequence reduces liquidity in the repo markets.? Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates.

6) Brave Ben Bernanke is fighting the Depression.? If his theories are right (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy.? But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle.

7) Inflation is the lesser evil at this point.? It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go, and Elizabeth Warren now confirms it for the Treasury.? My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.”? So it is for the TARP bailout.? Policy made hastily rarely works.? Spend more time, get it right.? The market won’t die as you work it out.

9) But will AIG die, or the automakers?

10) Even VCs are looking at the survivability of their portfolio holdings.? Who can survive and become cash-flow positive in a tough environment.? Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers.? Watch the loan covenants, so that you can get good recoveries in a default.? If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults.? For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices.? Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss.? This is a tough time for anyone taking credit risk.? That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics.? I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers.? He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes.

16) You can give the banks funds, but you can’t make them lend.? Would you lend if you didn’t have a lot of creditworthy borrowers?

17) The export boom is dead, for now.? Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed.? Sorry, but the secret to changing the residential real estate market is not lowering interest rates, but writing-off? portions of loan balances.? Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater.? Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?

19) On commercial property, when do you extend on a loan vs foreclosing?? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan.? More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position.? With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now.? (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar?? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever.? Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized?? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming.? As the interest rate differentials narrow in real terms, the US Dollar should improve.

But, there are complicating factors.? Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates.? Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply.

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies.? For now, put your macroeconomics books on the shelf, because they won’t be useful for some time.

The Sterility of Stability

The Sterility of Stability

Posted on by David Merkel

One of the great conceits in investments is trying to earn above average returns with low variability of returns.? Yet, when you consider the Madoff scandal, it is what can attract a lot of money from credulous investors.

One of the glories of a capitalistic economy is that markets are unstable, they adjust to point out what is no longer needed.? Often the adustments occur violently, because businessmen/consumers chase trends, which can lead to bubbles and bubblettes, until the cash flows of the assets cannot bear the interest flows on the debts that have been created to buy the assets.? Attempts to tame this, such as Alan Greenspan’s aggressive provisions of liquidity just build up more debt for an economywide bubble, followed by a depression.? We got the Great Moderation because of trust in the Greenspan Put.? The Fed would only take away the punchbowl for modest amounts of time, so speculation on debt instruments, real estate, financial institutions, etc., could go on to a much greater degree.? Boom phases would be long; bust phases short and low-impact.

There have been problems with lax regulation of bank underwriting, and investment bank leverage, but the key flaw was mismanagement of the money/credit supply.? Had the Fed held credit tighter during the ’90s and 2000s, we would not be here now.? The Fed could have kept the fed funds rate high, rewarding savings, perhaps leading to a lower cuurent account deficit as well.? Debt growth would have slowed, and securitization, which hates having an inverted or flat yield curve, would have slowed as well.? GDP growth would have been slower, but we would not be facing the crisis we have now.

Or consider housing, and how it became overbuilt because of lax loan underwriting, accommodative monetary policy, and a follow-the-leader mania.? Here’s an old CC post from the era:


 David Merkel
Pensions, Energy and Housing
8/18/2005 3:32 PM EDT

1) For those with stable businesses that throw off a lot of earnings and cash flow, and want to dodge the tax man, here’s a possible way to do it, courtesy of the Wall Street Journal: start a defined benefit plan. Disadvantages: complex, relatively illiquid and expensive. Advantages: you can sock away a lot, and defer taxes until you begin taking your benefit, possibly (maybe likely) at lower tax rates.

(This message brought to you courtesy of one actuary who won’t benefit from the message itself… but hey, it helps the profession.)

2) Sea changes in the markets rarely take place in a single day or week. Tops, and changes in leadership tend to take place over months, and feel uncertain. Though Jim is pretty certain that it is time to shift out of energy, I am willing to hang on, and get my opportunities to average down if they come at all. My rebalance points are roughly 20% below current prices anyway, so I’d need a real pullback in order to add.

Though there may be temporary inventory gluts, the basic supply/demand story hasn’t changed, and energy stocks still discount oil prices in the 40s, not the 60s.

3) Contrary to what Jim Cramer wrote in his housing piece today, you can lose it all in housing. Granted, it would be unusual to see homeowners in multiple areas in the country lose their shirts all at the same time; that hasn’t happened since the Great Depression, and we all know that the Great Depression can’t recur, right?

Thing is, local hot real estate markets often revert; if the reversion is bad enough, it leads to foreclosures. Think of Houston in the mid-80s, and Southern California in the early 90s. For that matter, think of CBD real estate in the early 90s… not only did that threaten real estate owners, it did in a number of formerly venerable banks and insurance companies.

Real estate is not a one way street, any more than stocks are. We have never financed as much real estate with as little equity as today before. We have not used financing instruments that are as back-end loaded before. Finally, this speculation is being done on a basis where renting is far cheaper than owning, leaving little support for property prices if the incomes of leveraged homeowners can’t be maintained in a recession. (Oh, that’s right. No more recessions; the Fed has cured that.)

Look, I’m not pointing at any immediate demise of housing in the hot markets. I still think that any trouble is a 2006-7 issue. But this is not a stable situation; if you have a large mortgage relative to your income, make sure your employment situation is really stable. If you can make the payment, prices on the secondary market don’t matter. If you can’t… those prices matter a lot.

One more note: an average investor can sell all of his stocks in the next 20 minutes, with little effect on the market. This is true even in a bad market. In a bad real estate market, you can’t sell; buyers are gunshy — it is akin to what I went through as a corporate bond manager in 2002. There are months where there is no liquidity for some bonds at any reasonable price. So it is for houses in some neighborhoods when half a dozen “for sale” signs go up. No one can sell except at fire sale prices.

None

Well, that’s the macroeconomic problem with stability.? When it gets relied on, after a self-reinforcing boom, it goes away.? Trust in stability is dangerous in other contexts, though.? From another CC post:


 David Merkel
Oil and Economic Strength (and a Rant on the Sharpe Ratio)
8/31/2005 3:13 PM EDT

I haven’t really talked about the issue of whether high oil prices portend economic strength or weakness for a good reason. No one knows. There are too many moving parts, and separating out the different effects is impossible; opinions here come down to more of one’s personality (optimist/pessimist) or investment positions (stocks/bonds/energy).

Even if someone did tests using Granger-causality, I’d still be suspicious of the result, whichever way it would point, because of the high probability of finding spurious correlations.

And, speaking of spurious correlations, since Charles Norton brought up the Sharpe ratio, I may as well say that it is a bankrupt concept as commonly used by investment consultants. First, variability is not risk. Losing money over your own personal time horizon is risk (which implies that risk varies for each investor). Second, there is not one type of risk, but many risks. Systematic risk may be measurable in hindsight, but never prospectively.

Third, any measure going off historical values is useless for forecasting purposes, because the values aren’t stable over time. When managers get measured in order for clients to make decisions, they are using the figures for forecasting purposes. It is no surprise that they don’t get good results from the exercise.

Why do figures like a Sharpe ratio gets used, then? Because consultants like simple answers that they can give to their clients, even if the answers yield no insight into the future. (It makes the math really simple, and allows a large number of strategies to be rapidly compared. It eliminates real work and thought.) Investment is a far more messy process than a few simple ratios can illustrate, and those that use these ratios get the results that they deserve.

Finally, an aside. Why am I so annoyed by this? Because of money lost by friends and clients who have been led along this path by investment consultants. There is a real cost to bad ideas.

Position: none

And this CC post as well:


 David Merkel
Time Series Regression and Correlation (for wonks only)
7/12/2007 3:11 PM EDT

We’ve had a few discussions here recently involving correlation, so I thought I might post something on the topic. First, it is easy to abuse statistics of all sorts. Few on Wall Street really understand the limitations of the techniques; I have seen them abused many times, often to the tune of large losses.

When comparing multiple time series of any sort, the results can vary considerably if you run the calculation daily, weekly, monthly, quarterly, annually, etc. As you use fewer and fewer observations, the parameters calculated will change. The best estimate will be the one using all available observations, that is, assuming that the underlying processes that generated the time series will be the same in the future as in the past.

It gets worse when comparing the changes in time series. Here moving from daily to weekly to monthly (etc.) can make severe differences in the calculations, because two data series can be almost uncorrelated in the short-run, and very correlated in the long run. My “solution” is that you size your time interval to the time interval over which you make decisions. If daily, then daily, annually, then annually. Again, subject to the limitation that that the underlying processes that generated the changes in time series will be the same in the future as in the past.

But often, the results aren’t stable, because there is no real relationship between the time series being compared. High noise, low signal is a constant problem. Humility in financial statistics is required.

As an example, calculations of beta coefficients often vary significantly when the periodicity of the data changes. People think of beta as a constant, but I sure don’t.

For those who want more on this, there are my two articles, “Avoid the Dangers of Data-Mining,” Part 1 and Part 2.

Enough of this. Back to the roaring markets! Haven’t hit the trading collars yet!

Position: none, but intellectually short Modern Portfolio Theory [MPT]

My point is this: investors look for stable relationships that they can rely on.? Those relationships are precious few.? Sharpe ratios aren’t stable; correlation coefficients aren’t stable; return patterns aren’t stable.? They shouldn’t be stable.? They rely on a noisy economy? which is prone to booms and busts, and industries that are prone to booms and busts.? Seeking stable returns is a fool’s errand.? Warren Buffett has said something to the effect of, “I’d rather have a lumpy 15% return, than a smooth 12% return.”? Though we might mark down those percentages today, the idea is correct, so long as the investor’s time horizon is long enough to average out the lumpiness.

So, if we are going to be capitalists, let’s embrace the idea that conditions will be volatile, more volatile on a regular basis, but given the lower debt levels across the economy because of regular shakeouts, no depressions.? But this would imply:

  • Higher savings rates.
  • Greater scrutiny of balance sheets.
  • Aversion to debt, both personally, and in companies for investment.
  • Less overall financial complexity, and a smaller financial sector.
  • Lower P/Es at banks.
  • Even lower P/Es in non-regulated financials.? It’s a violent world.

For further reading:

Book Review:Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell

Book Review:Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell

Posted on by David Merkel

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.

If you want, you can find it here: Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell

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.

Book Reviews: The Complete Guide To Option Pricing Formulas, and Derivatives, Models on Models

Book Reviews: The Complete Guide To Option Pricing Formulas, and Derivatives, Models on Models

Posted on by David Merkel

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.

If you want it, you can find them here:

Derivatives Models on Models

The Complete Guide to Option Pricing Formulas

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.

Twenty-five Facets of the Current Economic Scene

Twenty-five Facets of the Current Economic Scene

Posted on by David Merkel

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?

3) As housing prices fall, which they should because housing is in oversupply, more homeowners find themselves in trouble.? Remember, defaults occur because a property is underwater, and one of the five Ds hits:

  • Divorce
  • Disability
  • Death
  • Disaster
  • Dismissed from employment

As it stands now, the jumbo loan market is looking at more trouble — there was a lot of bad underwriting there during the boom.

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.

10) General Growth Properties relied on continual prosperity, and look where it led them.? Better, consider the Rouses who sold to them near the peak.? Good sale.

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.

Now, it is possible that Congress could double down on its stupidity, and cause Fannie and Freddie to not require appraisals on refinanced loans.?? They have enough credit risk as it is; should they do loans that are not adequately secured by the property?

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.

15)? What is stronger now, fear or greed?? Let’s take up greed.? I got a large-ish amount of responses to my pieces Does Not Pass the Japan Test, A Reason to Sell Stocks Amid the Rally, and my more bullish piece Momentum in the S&P 500.? There are a lot of bulls here:

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.

16) On the fear front, we have:

Here’s the main graph from the second piece:

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.

17) Less helpful are pieces like this one: Five Sparks for a Stock Market Comeback.? His five sparks are:

  1. No More Downward Revisions to GDP Growth
  2. An Enormous Government Stimulus Package
  3. An End to Redemption-Related Selling by Hedge and Mutual Funds
  4. Increased Lending
  5. 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.”

18 ) There are other reasons for concern, among them low t-bill yields.? There is significant fear, such that short term investors will take zero, rather than put principal at risk.? Maybe we should call t-bills the biggest mattress in the world to hide money under.

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.

22) So what would it mean for the Fed to issue debt?? Is it just an alternative to Treasuries and the Fed’s present relationship with the US Treasury?? A way to pay interest to those that participate in the Fed funds market, but can’t leave excess reserves at the Fed?? Or, a way to have a sovereign default without a sovereign default?

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).

25) Three articles to close with:

Industry Ranks Update

Industry Ranks Update

Posted on by David Merkel

Okay, here are my current industry ranks:

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.

A Reason to Sell Stocks Amid the Rally

A Reason to Sell Stocks Amid the Rally

Posted on by David Merkel

After I wrote the piece on momentum, I thought, “Wait a minute.? Momentum and valuation are stronger together than separate — run the calculations and write a new piece.

That’s what led to this article.? I added valuation metrics to the momentum regressions for one month and one year returns and found they were of little value.

Ouch. Not what I expected, so I tried momentum and valuation variables to predict ten-year returns. The results for the regression were significant.

Some definitions:

  • Last year: total return over the last year for the S&P 500
  • Last month: total return over the last month for the S&P 500
  • Last 10: total return over the last 10 years for the S&P 500
  • DP: dividend yield
  • EP: earnings yield
  • Int: 10-year Treasury yield
  • Inflation: trailing 12-month inflation from the CPI
  • EP10: earnings yield using trailing 10-year earnings.

Trying to forecast ten years into the future, technical variables diminish and fundamental variables show their stuff.? As I have stated before, both current period and long term earnings matter in estimating fair value.? Though I am using Shiller’s data set, it shows that 10-year average earnings are not enough.

That is a big enough finding on its own, but I have something more: using this formula, stocks are expected to earn 2.26%/yr over the next ten years.? After a pathetic decade, do we have another to come?? I(Ask Japan, they have gotten zero over more than 20 years…)

Why might that low return be true?

  • Bad momentum begets bad momentum.
  • Government bond yields are low offering little competition to stocks.
  • Earnings yields still are not high.

Valuations are better than when I wrote the piece, Kiss the Equity Premium Goodbye, but the same problem still exists to a lesser extent.? Where are the projects with high returns on assets that can easily be invested in?? At present, we are not seeing them in bulk.

That is what helps laed me to consider that corporate bonds and bank loans may still be better investments at this point in the cycle — less downside and perhaps a competitive upside.

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