Category: Stocks

Ten Points About the Markets

Ten Points About the Markets

Posted on by David Merkel

1) It is a wonderful thing to be the world’s reserve currency; we can milk the rest of the world until things change.? There is some push from emerging markets to have a change, but the effectiveness of that push is questionable.? Someone has to give the US an ultimatum, and no one is there yet.

2) With the decline in fixed income volatility, mortgage yields are falling.? Good for mortgages, but the real question is what happens when the Treasury starts borrowing like a maniac.

3) Many hedge funds have raised the gates.? Capital cannot easily exit.? GIven the weak balance sheets that hedge funds have, this is normal for a bear market.? The only surprise is that investors did not anticipate the troubles.

4) Perhaps the money to banks from the government is going only to relatively sound institutions.? That is consistent with the idea of making some institutions sound, and letting them buy up marginal banks.? Upshot: don’t expect an early increase in lending.

5) Analyze those that are on the other side of the table.? If they have a reputation for being smart, be extra careful.? Many municipalities and other entities lost money dealing with investment banks.? No surprise.

6) Many do not understand mark-to-market accounting.? First, GAAP is the least of the problems — collateral agreements require MTM.? Regulators can ignore MTM as they please. Second, MTM is misapplied by auditors; it does not mean “last trade,” but an estimate of where a liquid market would trade.

7) Shut the barn door after the cow has escaped.? Yes, loan underwriting standards have tightened, in the middle of a credit bust.

8 ) There is less cash flow to service; the financial sector should shrink.

9) S&P 500 at 600?? Not impossible, and not likely, but if profit margins crush down, possible.

10) where could longs make money in October 2008? Nowhere.? Real bear markets crush almost everyone.

In closing, I am not concerned about the victory of Obama.? The new president will have little freedom, and will face significant unsolvable problems.

Time to Ditch the Style Box

Time to Ditch the Style Box

Posted on by David Merkel

If you were trying to create a system for controlling investment risk in equity investing, how would you do it?? What I would do is look at the factors that are the least positively correlated in terms of return generation, and focus on them.

But what do investment managements consultants do?? They divide the world up into managers that look at two factors: large/mid/small capitalization, and value/core/growth.? This has been popularized by the Morningstar “Style Box.”

Looking over the last 15 years, the style box is very correlated with itself.? The lowest correlation is 75%, between largecap value and smallcap growth.? That is not a reason to categorize managers; the difference between the average largecap value and growth manger is teensy. It is even true between largecap value and smallcap growth.? And in more recent years, the correlations have been tightening to nearly 90% at worst.

So, consider country allocations.? Over the last 15 years, the correlations in developed markets have been 45% at worst, with the average being near 70%.? Looking at the last few years, both figures are higher.? My opinion: the advent of naive quantitative investing has pushed all correlations higher.

But now consider correlations across economic sectors.? Over the past 14 years, the correlations have been 32% at worst.? Across industries, which are more diverse than sectors, some of the correlations are negative, perhaps affording true diversification.

My point here is that those that look at capitalization size and value/growth are missing the boat.? If you classify managers based on that, you are focusing on minor concerns that do not aid much in diversification.? Better to focus on the industries that a manager invests in, and/or the countries that those companies are located in — there is a real oportunity to limit risks through either of those two methods.

Now, as for me, when I pick stocks, I start with the industry.? I ignore the factors in the style box.? I look for industries that are near the bottom of their pricing cycle, and buy the highest quality companies there.? For industries that are doing well, but are undervalued, I buy companies with undervalued growth prospects, with good quality balance sheets.

I strongly believe that the investment consultant community has shortchanged its clients by focusing on the “style box.”? Very little of the risks of the market result from factors in the style box, while much resluts from industry selection, which is a richer model.

So, as for me, if I have to be squeezed into the style box, call me midcap value with some style drift, buying companies larger and smaller, and outside the US, as conditions dictate.? I’m looking for the best value over the next three years, and I don’t like non-economic factors distracting me.? Why should that be such a crime, that the ignorant gatekeepers screen me out?

The risk model for the investment consultants is broken.? Let them find one that better reflects the way that the market works.

The Trouble with Investment Management Consultants

The Trouble with Investment Management Consultants

Posted on by David Merkel

I have been on both sides of the table in equity money management.? I have hired and fired managers.? Now I am looking to be hired as a manager, and I face something that distresses me — the consultants that advise potential clients.? Personally, I think the consultants could do a lot better if they abandoned their overly simplistic model that categorizes managers on capitalization, value/core/growth, and domestic/international.? It does not serve their clients well — I believe the most fundamental risk model in a globally connected world considers industry exposures, and ignores other variables.

Why?? Industries tend to occupy specific areas of the “style box.”? At one firm that I worked at, external consultants complained that our risk control procedures were nonstandard, because they were focused on industries and sub-industries.? I counter-argued that our methods were better, because with a given industry, there was little variation in market capitalization and value/growth, but industry performance varied considerably.? Though I am no longer with the firm, it continues to do well, while many that used the consultants’ model have died.

Look at it another way. Isn’t investng about finding attractive opportunities, regardless of how big they are, where they are located, or how quickly they grow?? I think so, as does Buffett, Munger, Muhlenkamp, Heebner, Hodges, Rodriguez, Lynch, and many other successful fundamental investors.

Sometimes largecap names are attractive, sometimes smallcap.? Sometimes deep value is attractive, sometimes growth at a reasonable price.? Good managers analyze where the best value is, regardless of non-economic factors.

But if you have to cram me into the style box, fine, I am a midcap value manager that buys a few foreign stocks.? But there is a huge loss in constraining intelligent investors through the style box.? The better a manager is, the more one should ignore non-economic distinctions, and let him perform.

Recent Portfolio Moves

Recent Portfolio Moves

Posted on by David Merkel

Since I wrote my last portfolio update two months ago, it is time for a new report.

New Buys

  • PartnerRe
  • Allstate
  • Assurant
  • Nucor
  • Genuine Parts
  • Pepsico
  • CRH
  • Alliant Energy

New Sells

  • Avnet
  • Lincoln National
  • YRC Worldwide
  • CRH
  • Jones Apparel
  • Assurant
  • Group 1 Automotive
  • Smithfield Foods
  • MetLife
  • International Rectifier
  • Cemex
  • Officemax
  • Universal American

Rebalancing Buys

  • Shoe Carnival
  • Charlotte Russe
  • Devon Energy (2)
  • RGA
  • SABESP
  • Ensco International (2)
  • Industrias Bachoco
  • Magna International
  • Valero
  • Kapstone Paper
  • Hartford International (3)
  • Cimarex Energy
  • Lincoln National
  • Smithfield Foods
  • Allstate
  • ConocoPhillips (2)
  • Tsakos Energy Navigation

Rebalancing Sells

  • PartnerRe
  • Safety Insurance
  • Devon Energy
  • Ensco International
  • Hartford Financial (3)
  • Kapstone Paper
  • Cimarex Energy
  • Nam Tai Electronics (2)
  • Honda Motors (2)
  • Lincoln National (2)
  • ConocoPhillips
  • Charlotte Russe
  • Shoe Carnival

I’ve had a lot of trades over the past two months, which is normal for me when volatility rises.

I have been asked by a number of parties why I don’t write about the insurance industry in this environment, given my past experience.? My main reason is that I have left it behind.? When I became a buyside insurance analyst, I had strong opinions about what made a good or bad insurance company.? For the most part, those opinions were correct, but there is a fundamental opaqueness to insurance.? One truly can’t analyze it from outside.? No boss would hear that, even if true.

I benefitted from the cleaning up of insurance assets 2002-3, and thought that the cleanup had persisted.? Largely, it has, but many life companies rely too heavily on variable products for profitability, and as the market has fallen, profits from variable products have fallen harder.? Thus my mistakes with Hartford, MetLife and Lincoln National.

That brings up two other possibilities where things can continue to go wrong in life insurance.? If fees are permanently reduced the companies might have to write down the deferred acquisition costs [DAC] that they capitalized when originally writing the business, if the expected cumulative fees are less than the DAC.? The second issue is hedging the guaranteed living benefits.? I will never forget the look that the CEO of Principal Financial gave me when I asked him how well the futures/options hedges during a month where the S&P 500 is down 20-30%.? It was not a pleasant look.? Not that that scenario could ever happen. 😉

My picks in pure P&C insurance have fared better.? Safety Insurance is a solid company; so is PartnerRe.? Would that I had done more there, and less in life companies, especially the equity sensitive ones.

So what do I hold today among insurers?

  • Allstate
  • Assurant (bought after the marginally bad earnings announcement)
  • Hartford (yes 🙁 )
  • PartnerRe
  • Reinsurance Group of America
  • Safety Insurance

Yes, I am overweight insurance, and I have paid the price, particularly with Hartford.? There is an uncertainty connected with life insurance holding companies about the ability to upstream dividends to service debt.? That uncertainty only appears in bear markets, and all the hubbub over optimizing the capital structure is so much hooey.? Assurant is in better shape because it ceased buying back stock because of the (somewhat bogus) investigation of a few of their executives.

Two final notes to close.? I had a bad October, worse than the S&P 500 by a significant margin.? My exposures in life insurance and emerging markets drove that.? Second, I may have my first equity client, and so I may be curtailing some of my discussion of individual names in my portfolio, and deleting my portfolio at Stockpickr.com.? My clients come first.

Full disclosure: long ALL AIZ HIG PRE RGA SAFT SCVL CHIC COP HMC NTE XEC KPPC ESV DVN TNP VLO MGA SBS CRH LNT PEP GPC NUE (what have I left out?!)

What is the Value of Market Dividend Yields?

What is the Value of Market Dividend Yields?

Posted on by David Merkel

Blogging is often a cooperative venture, so this piece begins with thanks to three people:

When I read the piece at The Capital Spectator, my response was “Huh, neat article, wonder how it would look with a larger data set?”? Given Eddy’s help, I had that data set, and so I got to work.? Here is the main result:

The results at The Capital Spectator went from 1995 to 2003. My results go from 1871 to 2003. His results give a tight relationship, while mine indicate a loose relationship.? His R-squared was far? higher than my 7%.? Why?

In aggregate, many relationships in finance are tenuous.? Do interest rates mean-revert?? Yes, but the tendency is weak.? In this case, high dividend yields foreshadow high five-year total returns, but that tendency is weak.

In the graph above I tried to highlight the eras for different alignments of dividend yields and future five-year returns.? Depending on the era, the relationship of dividend yield to future returns differed.? In the long run, there is a weak positive relationship between dividend yields and total returns, but in the short run, many other factors predominate.

So what does this tell us?

  • Use larger data sets when possible.
  • Realize that many relationships in finance are not stable.? Indeed, that is a strength of Capitalism.? It adjusts to changing conditions, and is not stable.
  • When dividend yields are high the market is attractive.? Of course, factor in how high bond and cash yields are at the time.
  • Beware relying on intermediate-term relationships in quantitative finance.? They last for less than a decade.
  • Beware trusting correlation coefficients calculated over short intervals.
  • In finance, we know less than we think, so we should be cautious in our conclusions.
  • The best forecasts come when we are at extreme values of the system.? In the middle, everything is a muddle.

I am a firm believer in dividends. My portfolio has an above average dividend yield.? In general, high dividend yields pay off in investing, subject to credit quality.? But, the payoff varies over time; a heavy reliance on the dividend yield of the market as a sole indicator is not advised.

Neomercantilism and Sloppy Central Bankers

Neomercantilism and Sloppy Central Bankers

Posted on by David Merkel

When I wrote for RealMoney, one of my continuing themes was that the Federal Reserve was less relevant because neomercantilistic nations like China (and perhaps OPEC nations) had reasons for promoting exports to the US that were less than economic.? As such they would buy US fixed income in order to facilitate their exports.? What could be sweeter?? You send goods; we send promises, denominated in our own currency.

With that, I want to point to a short post from Marginal Revolution.? Like me, he takes the “modified Austrian” view that the bubble was caused not only by the Fed, but also by the neomercantilists, both of which I fingered in my “Blame Game” series.? Buying longer dollar-denominated debt stimulated mortgage rates more than the Fed could, because under normal conditions the Fed can only affect the short end of the yield curve.

PS — What a long day, to NYC and back.? I appeared on Fox Business News show “Happy Hour.”? They said I did very well.? If I get video I will post it here.? As I have said before, time on live television goes fast.? The four minutes seemed like the blink of an eye.? At the end, Liz asked me for a third stock, and I blanked out, so I said Assurant, a company that I love, but don’t currently own.? I will own it in the future.? I meant to say Pepsico, but it just didn’t come to mind.

I also had dinner with my friend Cody Willard after the show.? Though our rhetoric is different, we basically agree that the actions of the government in the bailout offer much possibility/potential for favoritism.? Also, that it is easy to start a bailout, and hard to end one.

Let the government chew on this: Pepsico issued $3.3 billion of corporate debt yesterday.? For a company with recession-proof products and a Aa2/A+/AA- balance sheet, for them to pay 4%+ over Treasuries is astounding.? Liquidity?? What liquidity?? If financing needs are outside the A-1/P-1/F1 CP box, there is no help.? Not that there should be help, but the corporate bond market is a truer indicator of our stress than the money markets, which still aren’t in great shape.

Full disclosure: long NUE PRE PEP

Survive, survive…

Survive, survive…

Posted on by David Merkel

I’m traveling, so no significant post this evening.? I would merely point you to the interview with Anna Schwartz suggesting that the Fed is fighting the last war, and is not fighting the solvency crisis, as they consider it a liquidity crisis.

As for me, with the total level of debt in the economy relative to GDP being so high, bear markets in credit should persist until that ratio is significantly reduced.? I am not a bull here on credit.? Focus on companies that can survive without external financing for three years.

I have made changes to my portfolio that reflect this.? More on that in the next few days.

Our Monetary Policy is not an Asset

Our Monetary Policy is not an Asset

Posted on by David Merkel

It is an interesting academic question for Dr. Bernanke.? “Perhaps we should consider asset prices in our monetary policy after all?”? Nice to be considering that idea now, when it is too late.? The Fed has toyed with the idea in the past, often obliquely through the wealth effect, and how asset price inflation affects the creation of credit in banks.? Consider this post from RealMoney:


 David Merkel
The Media Overstated Greenspan’s Point
8/26/2005 1:36 PM EDT

Tony, you probably have more experience than me in this, so if you disagree after I write this, I defer to you.

I’m not sure the media didn’t get Greenspan’s point, but merely cast it in the most sensationalistic way. That the FOMC uses asset prices in making decisions is nothing new; the 1999 transcripts indicated how they used them with respect to the wealth effect.

Secondarily, though they haven’t stated it as plainly, when asset markets have an effect on depositary institutions, the Fed has a responsibility to protect the depositary institutions; the only real debate is whether it should be done through regulatory or monetary policy means. Cramer prefers regulatory means (boost regulatory capital held against risky loans), and I would agree, except that the Fed for political reasons doesn’t like to hold a smoking gun. That’s why they didn’t raise margin rates during the Nasdaq bubble, and why they are conducting a very quiet campaign through the bank examination process to put the fear of God into bank CEOs.

Where the media errs is that the FOMC would focus on assets solely. It’s just one criterion among many for a FOMC that has been notably elastic in their decision-making process (and monetary policy) during Greenspan’s tenure.

Partly, I see Greenspan’s comments as partly about the past to the present, but also pointing the way he would go in the future, if he had the opportunity. That said, barring unusual circumstances (i.e. a dilatory President Bush) he only has three FOMC meetings remaining … what Greenspan thinks about the future conduct of monetary policy is irrelevant, if the new Fed chairman thinks differently.

Position: None, but all of the likely successors to Greenspan worry me, and that is saying a lot…

I’ve argued in the past that both asset and goods/services price inflation should influence monetary policy.? I’m no great fan of fiat money, but if you are going to have fiat money, you must regulate the growth and nature of credit in order to make the system work in the longer-run.? Better we should move to a gold standard (after the crisis) or something like it.

Get the government out of the money and credit business.? They have not done well at it.? We would have more recessions/panics, but they would be shorter and sharper, but much easier for the system as a whole to recover from.? Under a gold standard, we could not build up the kind of leverage that we have done now, or at the Great Depression.

So, Professor Bernanke, that’s a really interesting academic point about asset prices and monetary policy, but there are no bubbles to avoid now, and it is not possible to reflate a bubble, short of massive monetary inflation, leading to price inflation of real assets.? Monetary policy works through stimulating healthy sectors of the economy; unhealthy sectors face credit spreads so large that moves by the Fed are useless, unless they themselves lend to or buy bad debt from the damaged sectors, with losses getting washed to taxpayers through reduced/negative seniorage.

And, if I may say it plainly… I think the governments and central banks of the developed world are going to find out that they are smaller than the size of the credit problems, which will lead to:

  • A severe credit-driven recession, and/or,
  • Significant socialization of the financial system (much more than what has been done so far), and/or
  • Insolvency of several major developed country governments.

The problems of excess leverage can be shifted, but they can’t be eliminated by government action.? I am repositioning my portfolio into companies that can survive the worst (hopefully), largely because I don’t think the present government policies will work in the intermediate-term.

Curves and Corporate Credit

Curves and Corporate Credit

Posted on by David Merkel

Just a brief note on corporate bonds.? When I was a corporate bond manager 2001-2003, I learned a lot about inverted curves.? It was a tough time.? But what kind of inversion am I talking about?

Ordinarily, when there is little doubt over the creditworthiness of a company, the amount of incremental yield over Treasuries (spread) rises with the length of the security.? This is normal, leaving aside times when the yield curve is flat or inverted, because usually, the risk of default rises with time with even the best securities, because the future is less certain than the present.

The second stage is an inverted spread curve for a given company, which given a positively sloped Treasury yield curve, might leave the corporate yield curve positively sloped, but less so than Treasuries.? This indicates moderate worry over the credit risk of the company in question.? (Note: during a time of credit stress, the Treasury curve is almost always positively sloped, as the Fed tends to loosen during times of credit stress.)

Next is an inverted yield curve, where short term yields are moderately higher than long term yields.? This indicates significant worry over the credit risk of the company.

Finally, there is an inverted dollar (price) curve for the company.? This is where default is viewed as a likelihood.? The prices of the longest-dated bonds reflect current estimated recovery levels after default.? Short-dated bonds may trade near par. (Par: usually $100, also usually the amount of principal remaining to be received.)

This is a qualitative/quantitative way of thinking about the corporate bond market during a time of credit stress.? What percentage of the market falls into each bucket?

  • Not inverted
  • Inverted spread curve
  • Inverted yield curve
  • Inverted dollar price curve
  • In default

The more names in lower categories, the greater the degree of credit stress.? For companies with multiple issues of bonds, it is a simple way of characterizing the market, even in the absence of rating agencies.? (As a closing aside, equity implied volatility tends to rise as a company goes down the list.)

Wait, that’s not quite a close, and not an aside.? That is another way to lookat corporate bonds.? As the implied volatility of the equity gets higher, the more they migrate down the list.? Remember, leaving aside bank loans, usually only stable companies issue corporate debt.? As their prospects get less certain, implied volatility of the equity rises, and their debt moves down the list.

Debt and Sweat

Debt and Sweat

Posted on by David Merkel

Ordinarily, when I sit down top blog, I know what I want to write.? That’s not true now.? Yes, I could do a few book reviews.? I have six books read, and ready to go, but given the volatility of the markets, I feel I have to say something about the current activity.

I am a strong believer that there are few free lunches.? If there are simple policies that will easily produce prosperity, they would likely have been done by now.

As I have commented before, what we are seeing now is a shift in debt from the banks to the government.? Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question).? As jck noted yesterday, this has led to a selloff in Treasuries.? (Interesting that it happened on a day when the cash markets were closed, but the futures markets were open.? The reaction of cash bond market today is similar to that which the futures market exprerienced yesterday.)

Which brings me to my first point.? Today, when the rally in the fixed income markets gets reported (the markets again, were closed yesterday, you will likely hear that spreads rallied sharply.? But watch for the discussion of yields and prices (if there is any).? It’s quite possible that yields rise from Friday to the close of business today.

Second point, today $250 billion of the $700 billion got used on nine big/critical banks.? Now, this may have been somewhat coercive to some of the nine banks; as was said at Bloomberg:

None of banks getting government money was given a choice about it, said one of the people familiar with the plans. All of the banks involved will have to submit to compensation restrictions, said the person.

The government will also guarantee the banks’ newly issued senior unsecured debt, making it easier for them to refinance their liabilities, the person said.

Possibly the following message was delivered, “Be a good boy and get in line.? This is good for the nation, and we won’t be around for a decade.? You want to be a survivor, right?? You want friendly regulators when we review the levels at which you are marking your illiquid assets?? We thought so.? Sign here.”? (No surprise that Goldman then applies for a NY State, rather than Federal bank charter.? State regulation, particularly when you are a local champion, is much more flexible.? Just ask AIG. 😉 )

Though this leads to a short-term bounce in bank share prices, the long term effects are less clear, which brings me to my third point.? It’s one thing to bolster their balance sheets.? It is another to get them to lend, particularly in the bear phase of the credit cycle.? Also, as leverage comes down, and it will come down, so will profitability at the investment banks, and probably other banks as well.? Securitization will be less common, eliminating hidden leverage that allowed for less capital.

The same thing is going on in Europe, though they actually think about how they might pay for the bailouts.? In the UK, it pushes the national debt to GDP ratio to 100%.? As it gets closer to 150%, the international debt markets usually start to choke.? We have traded bank credit risk for national solvency risk at the margin.? Maybe that will be different here, if only government creditworthiness is perceived to be safe.? It is a “new era,” right? 🙁

I find it interesting that Barclays is refusing help.? Either the UK regulators aren’t so coercive as those in the US, or Barclays is not as levered as I thought.? Or, it could be hubris on the part of Barclays’ management team.

Even Japan is getting into the act, though these measures seem so weak that I wonder why they would bother.? The government and Bank of Japan stop selling bank shares, and allow companies to buy shares back more aggressively.? That may push share prices up in the short run, but it substitutes debt for equity, which shouldn’t have much of a long-term impact.

On the Central Banking Front

Now, with the seemingly limitless amount of US liquidity being to the short end of the US money markets, you would think that we would get a bigger move than we have gotten so far. This will take time, but watch the yield as well as the spread.? Also remember that LIBOR has become somewhat of a fiction at present.? There many quotes, but not so many loans to validate the quotes.

What is being done that is new?

  • TAF expanded to $900 billion.
  • New commerical paper program where the Fed backstops the A-1/P-1/F1 CP market, including ABCP.? Terms here.? FAQ here.? This is big, and it is much easier to start such a program than to end it.? It is difficult to end any program where credit is granted on less than commercial terms.? My guess is that it will be extended past its April 30th, 2009 planned expiry date.
  • Swap agreements allowing unlimited dollar liquidity to foreign entities through agreements with their central banks.
  • The Fed can now pay interest on reserve balances held at the Fed, which allows them to increase their balance sheet significantly.? In one sense, they become the Fed funds market.

What is not new is the idea that all we have to do is restore confidence, and everything will be fine.? No, we have to delever, and the US Gowernment is included in the list of those that need to delever.? There is no national reform going on here, but merely a shifting of obligations from private to public hands.

For investors:

For those that are investors, the biggest bounces tend to occur during depressionary conditions.? I would not get overly excited about the rally yesterday.? As John Authers at the FT points out, given the extreme changes being made, there should have been a bounce.? The question is whether it will persist.? I was a net seller into the rally toward the end of the day.? I think we have more troubles ahead.? Two things to watch:

  • LIBOR, CP yields and the TED spread. (The short end)
  • Overall yields of medium-to-long Treasuries and other long-dated debt.? (The long end.)

I expect yields to rise, even if some spread relationships fall.? The added financing needed by the US government is large.? Let us see where Treasury buyers have interest.

There are elements of this that remind me of my The US Dollar and the Five Stages of Grieving piece. This is for two reasons: first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them.? Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving.? We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering.

I’m skeptical, but I hope that I am wrong, lest we get to the fourth stage “depression,” before we finally reach “acceptance.”? As it is, I am looking for companies with blaance sheets strong enough to survive the worst.? That is my task for the next few days.

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