Category: The Rules

The Rules, Part XXXVII

The Rules, Part XXXVII

Posted on by David Merkel

The foolish do the best in a strong market

“The trend is your friend, until the bend at the end.”? So the saying goes for those that blindly follow momentum.? The same is true for some amateur investors that run concentrated portfolios, and happen to get it right for a while, until the cycle plays out and they didn’t have a second idea to jump to.

In a strong bull market, if you knew it was a strong bull market, you would want to take as much risk as you can, assuming you can escape the next bear market which is usually faster and more vicious.? (That post deserves updating.)

Here are four examples, two each from stocks and bonds:

  1. In 1998-2000, tech and internet stocks were the only place to be.? Even my cousins invested in them and lost their shirts.? People looked at me as an idiot as I criticized the mania.? Buffett looked like a dope as well because he could not see how the enterprises could generate free cash reliably at any intermediate time span.
  2. In 2003-2007, there were 3 places to be — owning homebuilders, owning depositary financials or shadow banks, and buying residential real estate directly.? This was not, “Buy what you know,” but “Buy what you assume.”
  3. In 1994 many took Mexican credit risk through Cetes, Mexican short-term government debt.? A number of other clever investors thought they had “cracked the code” regarding residential mortgage prepayment, and using their models, invested in some of the most volatile mortgage securities, thinking that they had eliminated all risk, but gained a high yield.? Both trades went badly.? Mexico devalued the peso, and mortgage prepayments did not behave as expected, slowing down far more than anticipated, leading the most levered players to? blow up, and the least levered to suffer considerable losses.
  4. 2008 was not the only year that CDOs [Collateralized Debt Obligations] blew up.? There were earlier shocks around 2002, and the late ’90s.? Those buying them in 2008 and crying foul neglected the lessons of history.? The underlying collateral possessed no significant diversification.? Put a bunch of junk debt in a trust, and guess what?? When the credit cycle turns, most of those bonds will be under stress, and an above average amount will default, because the originators tend to pick the worst bonds with a rating class to maximize the yield, which allows the originator to make more.? Yes, they had a nice yield in a bull market, when every yield hog was scrambling, but in the bear market, alas, no downside protection.

I could go on about:

  • The go-go years of the ’60s or the ’20s
  • The various times the REIT market has crashed
  • The various times that technology stocks have wiped out
  • And more, like railroads in the late 1800s, or the money lost on aviation stocks, if you leave out Southwest, but you get the point, I hope.

People get beguiled by hot sectors in the stock market, and seemingly safe high yields that aren’t truly safe.? But recently, there has been some discussion of a possible “safety bubble.”? The typical idea is that investors are paying up too much for:

  • Dividend-paying stocks
  • Low-volatility stocks
  • Stable sectors as opposed to cyclical sectors.

A “safety bubble” sound like an oxymoron.? It is possible to have one?? Yes.? Is it likely?? No.? Are we in one now?? Gotta do more research; this would be a lot easier if I were back to being an institutional bond manager, and had a better sense of the bond market pulse.? But I’ll try to explain:

After 9/11/2001, institutional bond investors did a purge of many risky sectors of the bond market; there was a sense that the world had changed dramatically.? At my shop, we didn’t think there would be much change, and we had a monster of a life insurer sending us money, so we started the biggest down-in-credit trade that we ever did.? Within six months, yield starved investors were begging for bonds that we had picked up during the crisis.? They had overpaid for safety — they sold when yield spreads were wide, and bought when they were narrow.

But does this sort of thing translate to stocks?? Tenuously, but yes.? Almost any equity strategy can be overplayed, even the largest and most robust strategies like momentum, value, quality, and low volatility.? In August of 2007, we saw the wipeout of hedge funds playing with quantitative momentum and value strategies, particularly those that were levered.

Those with some knowledge of market? history may remember in the ’60s and ’70s, there was an affinity for dividends, with many companies borrowing to pay the dividend, and others neglecting necessary capital expenditure to pay the dividend.? When some of those companies ran out of tricks, they would cut or eliminate the dividend, and the stock would fall.? Now, earnings coverage of dividends and buybacks seems pretty good today, but watch out if one of the companies you own has a particularly high dividend.? You might even want to look at some of their revenue recognition and other accounting policies to see if the earnings are perhaps somewhat liberal.? You also compare the dividend to what the cash flow from operations is, less cash needed for maintenance capital expenditure.

I don’t know whether we are in a “safety bubble” now for stocks.? I do think there is a “yield craze” in bonds, and I think it will end badly when the credit cycle turns.? But with stocks, I would simply say look forward.? Analyze:

  • Margin of safety
  • Valuation, absolute & relative
  • Return on equity
  • Likely and worst case earnings growth

And then balance margin of safety versus where you have the best opportunities for compounding capital.? If relative valuations have tipped favorably to less common areas for stock investing that considers safety, then you might have to consider investing in industries that are not typically on the “safe list.”? Just don’t? compromise margin of safety in the process.

The Rules, Part XXXVI

The Rules, Part XXXVI

Posted on by David Merkel

It almost never makes sense to play for the last 5% of something; it costs too much. Getting 90-95% is relatively easy; grasping for the last 5-10% usually results in losing some of the 90-95%.

When I was a corporate bond manager, and doing my own trading, I had a first question in dealing with any broker: Am I getting a good deal?? If the answer to that question was “yes,” then the proper response is “Done.” Don’t haggle.? Even if you get a slightly better deal, it will damage your reputation.? The best reputation to have is between “reasonable” and “tough.”? Tough is worth more when you are driving the deal.? When the deal is offered to you, and it is a good one, reasonable preserves your reputation as a fair negotiator.

You never want to be seen as a pig.? Once you seem to be a pig, opportunities dry up.? The guy who followed me after my time as a corporate bond manager was a pig, according to my brokers, and as such, the ability to do deals suffered.

This is true of much of life.? In negotiation, leave something on the table for the other guy.? You want to be able to do more deals afterward, and a reputation for being tough but fair is the gold standard.

Kids play for all of the marbles.? Intelligent adults play to win a competent fraction of the marbles.? That is an intelligent way to view many aspects of life.? And so I encourage you to play fairly, but cleverly, for your share.

The Rules, Part XXXV

The Rules, Part XXXV

Posted on by David Merkel

Stability only comes to markets in a self-reinforcing mode, from buy and hold (and sell and sit on cash) investors who act at the turning points.

Beyond the vicissitudes of the markets, there are businessmen.? They have a sense of what their capital costs.? They reason regarding acquisitions and selling off their own holdings/subsidiaries.? They ask themselves how permanent current financing conditions are likely to be.

They don’t play momentum; they just look for when buying or selling businesses makes sense.? The market, on the other hand, has many that only want to buy what is rising, and sell what is falling, to a first approximation.

The market is about business, not stock trading.? Businesses are primal, trading markets are secondary. When businessmen find a publicly-traded business trading at an attractive value, they buy it, particularly if there are synergies between the businesses.? Thus during the bust phase of equity and credit markets, M&A often consists of cash-rich firms buying out firms that are in distress.

The same is true in boom times.? Companies sell themselves, or subsidiaries to leveraged players who think the game will go on much longer than reality will bear.? The sellers sit on the cash; the buyers enjoy the losses when the bust comes.

Volatile markets favor those with strong balance sheets — those that can wait for a better day, or, those that can wait for better opportunities. In either case, they can wait; they do not have to buy or sell now.? They are experiencing no cash flows forcing them to action.

Those with strong balance sheets focus on return on book capital, and avoid leverage.? They look to grow the book value (“net worth”) of their company, and ignore secondary goals.? They are shareholder-oriented.? They take advantage of both sides of the boom-bust cycle — selling near peaks when return on capital is lousy, and buying near troughs when return on unlevered capital is fat.

This is simple stuff, but hard to execute, because the fear/greed cycle interferes with rational calculation.? Regardless, absolute valuation investors put in the tops and bottoms of markets by their selling and buying.? To the degree that technical analysis works, it is because they trace the bread crumbs of large valuation oriented investors.

That’s all for now.? Thoughts?? Give it to me in the comments.

 

The Rules, Part XXXIV

The Rules, Part XXXIV

Posted on by David Merkel

“Once something is used for hedging purposes, it becomes useless for predictive purposes.”

I know this is kind of a trivial insight now, but when I originally wrote it, it was more cutting-edge.? That said, it is still not fundamentally understood by most.? Most still look at a fragment of the puzzle.? Few look at the whole.

My poster-child for fragmentary thinking is this article: The end of stock market crashes? Do I disagree that correlations begin rising among risky assets toward the end of a bull market?? Not at all.? I have even written about it on occasion.

But if few understand this, then only a few will take shelter when correlations get high.? The rest will continue the disorderly party until the “market cops” show up in the bear market.

If it becomes a widespread idea, a market rule, etc., it may constrain behavior for some time, leading to no large crashes, but after a long while with no crashes some will assume that such crashes are not possible, and the rule is out-of-date.? Four? examples:

  • Stocks should yield more than Treasury bonds.
  • Stocks should yield more than 3%.
  • Q-ratio
  • CAPE10

Many items that have intermediate-term wisdom, and are known to have that wisdom, eventually get ignored.? The first two I listed were common market nostrums in their day.? The second seem to have more long-term validity, but get ignored by many who say, “It’s different this time!”

But even if everyone agrees that a certain risk measure is a correct risk measure, and it becomes a part of the market’s furniture, that doesn’t mean risk ceases.? It does mean risk takes a different form.? I think of all of the people decided not to take equity risk during 2000-2007, and decided to invest in residential real estate, or take risk through CDOs, subprime RMBS, etc.

Yes, they avoided risk in the stock market.? They ran into something far more fundamental.? The risk from all risky assets, public, private, leveraged, unleveraged, is everywhere, and it is very difficult to hide while taking risk.

The markets incorporate a lot of rules that have partial validity.? They are known variably, and apply variably.? At some points these rules seem sharp and prescient.? At other times they seem weak and outmoded.

This brings me back to my view that the market is an ecosystem where no strategy has permanent validity.? Strategies ebb and flow as many parties search for scarce returns.? There are well-known limits to markets, like the Q-ratio and CAPE10.? If the markets come up with another one, like risky asset correlations, it will have validity, restraining speculative behavior, until people overwhelm it, and a new bust happens.

The boom-bust cycle cannot be repealed.? But it takes many forms.

 

The Rules, Part XXXIII

The Rules, Part XXXIII

Posted on by David Merkel

When politicians don?t have answers, they blame speculators, financiers (Wall Street), or foreigners.? They do anything to take the spotlight off their culpability or ineptitude.

The above saying is similar to the idea that when a company blames short sellers, it is usually a sign that the short sellers are right, and the company is mismanaged.? Think about it: when a short seller builds a short position, someone else is building a long position.? The borrowed shares that are sold have to be sold to someone.? Also note that the shorting does not change the cash flows of the company.? Even the dividends don?t change because the shorts pay dividends to the extra shares.

The shorting is a side bet on a greater question: will the company be able to produce free cash flow adequate to justify the current stock price?

What applies to companies also applies to nations.? During a debt crisis or a currency crisis, there will be an appeal against speculators that are shorting the debt.? Well, guess what, for every unit of debt shorted, there is another party buying the debt.? This applies to credit default swaps as well ? on the other side of the trade there is a guy saying, ?What a nice yield.?

The politicians complain, but they could fight back: they could buy in their debts and squeeze the shorts.? What?s that, you say?? If they did that, they would either have to raise taxes or cut programs?? And that is anathema?? Well, then the shorts aren?t to blame.? The government is to blame; it has made its own bed, let them sleep in it.

After all, shorts target companies that are mismanaged; they have no free cash flow, and can?t fight back.? The same for nations that are mismanaged; they have structural budget deficits, and a political culture that won?t change it.? No surprise that the shorts show up.

The shorts don?t change anything; they recognize a fundamentally weak situation, and locate a stock lender and a dumb buyer.? Same thing for a bond lender, and a dumb buyer as far as countries or deeply distressed companies are concerned.? And all of this can occur via derivatives if this is the best manner of doing the trade.

In the end, only free cash flows matter, and companies with large free cash flow never have to worry about the shorts.? Same for nations that have their budgets in accrual balance.

The Rules, Part XXXII

The Rules, Part XXXII

Posted on by David Merkel

Dynamic hedging only has the potential of working on deep markets.

Arbitrage pricing can reveal proper prices in smaller less liquid markets if there are larger, more liquid markets to compare against.? The process cannot work in reverse, except by accident.

The recent case of JP Morgan’s hedging activities bring to light an observation that should be clear to all but isn’t.? Hedging only works when you are small relative to the markets in which you hedge.

Let’s consider tranched credit index default swaps.? We can create models where the prices of each tranche can be calculated given default frequency and severity.? But default is not a constant beast.? Defaults come in waves, and when incidence is high, so is severity of loss.? Vice-versa when incidence is low, leaving aside fraud.

We might have a good idea of where credit default should trade for a basket of corporate debtors “credits” so long as we look at the thing as a whole,? and don’t carve it up.? In general, a basket of borrowers is easier to predict than individual borrowers.

But the basket gets difficult when we split it up into first loss, second loss, third loss, etc. claims where different parties lose their capital at differing levels of total loss.? Yes, in theory, we can come up with prices.? We can even come up with hedge ratios? that show the theoretical tradeoff between tranches as losses increase or decrease, which might work, might, if you are a small player in that market.

Woe betide you, if you do anything too fancy, and you are big relative to the market.? Because you are big, you have affected the prices of the market.? Price relationships that were normal before you arrived have shifted and reflect your interests, which in the short-run makes your accounting look better.? As the bubble grows, those investing in the bubble look better.? But as the bubble expands, those that have invested in it find a wave of cash fighting against them, but it doesn’t matter, because momentum investors are still buying.

At the end, the large investor amid the bubble finds himself stranded.? The market knows his positions, and he can’t make trades to extricate himself, because the terms are onerous.

Look, I used to trade small-issue lesser-known bonds.? I only bought stuff that I knew would be money-good, i.e. pay off.? In that case, you have the option of speculating when spreads are wide, and selling when they get tight.? But if you do that with bonds that you don’t know whether they will likely pay in full, the ability to hedge is meaningless, because your hedge could break in a default.

And so it was for JP Morgan.? When you get too big relative to the market, it had better be when you are the buyer or seller of last resort, and you are catching the turn.? But in normal markets, bigs are pigs, and are likely to be slaughtered.

It doesn’t matter what your model says is the right tradeoff if you are too big relative to the market.? Your own actions have poisoned the signals that your models receive.

Amaranth fell into this same bucket, with a talented energy trader who understood how the market generally worked.? As his success grew, so did his size, and he didn’t realize that the size of the fund was distorting market prices.? At the end there was one unlikely scenario that was unhedged, and that was the scenario that occurred, and the results led to the collapse of the fund.

If Amaranth had been smaller they could have traded out of it.? At their size, they were “elephants in an elevator.”

Size matters, and for investment purposes, smaller is better.? And for the most part, less complex is better too.? Don’t demand liquidity from markets, or you will lose.? If liquidity comes to your door, and it seems to be a good deal, wave it in.

The Rules, Part XXXI

The Rules, Part XXXI

Posted on by David Merkel

The offering of liquidity through limit orders is a real service to the market, and on average gets rewarded in lower overall execution costs.? In choppy markets, it can really add value.

I urge all investors to place limit orders as a normal practice.? Better not to get filled on a few orders every now and then, than to get ripped off by market makers when a market order hits a thin market and you end up with a lousy fill.

Patience is a virtue in trading.? Don’t insist that you will get a full position on a stock you you want to own.? Rather, have multiple companies that you might want to own at their respective prices, and own the ones that the market is willing to sell to you.

When you think about “flash crashes” and what drove them, there are many factors involved, but one thing is clear: someone placed a market order at the wrong time, asking to buy or sell, no matter what.

Personally, anytime I place orders that are large relative to the ordinary volume of the market, and/or where the bid/ask spread is wide, I use discretionary reserve orders.? Say the bid is 20.50 for 200 shares, and the ask is 21.31 for 300 shares, and I am looking to buy. I would place a discretionary reserve order showing 100 shares at 20.49, but offer 41 cents of latitude, but with 2000 shares available to be bought.? In doing this, the bid/ask does not change, but if a program trade sweeps through the market seeking to sell at less than 20.90, my trade executes, and some will wonder, “Where did that come from?”

My view is that with high frequency trading, managers must adopt tactics, particularly on less liquid stocks, that we become invisible liquidity providers.? We match stealth with stealth, but look to get good fills on solid companies at very good prices.? We become market makers in a sense, up to the level of our price limits.

If I have done my fundamental homework right, putting out limit orders, even those that are “good till cancelled” offer value to me and my clients, because we get shares at prices that offer good value, and and sell shares at prices that represent full value or more.

The Rules, Part XXX (30)

The Rules, Part XXX (30)

Posted on by David Merkel

In the recent run-up, there was talk of the infallibility of equities.? This led to a higher level of variable compensation in the economy through option and share issuance and low pressure to raise fixed wages.? This was yet another form of hidden leverage, which hid the unprofitability of enterprises through share dilution.

That was written in 2001, after the flop of the Nasdaq.? I have sometimes said that bubbles are financing phenomena.? That’s true, but we can phrase it more generally: bubbles occur because of an asset-liability mismatch.? People go long a long-duration asset with short-duration funding.? The short duration funding can be borrowing, or vendor finance, or it can be a labor commitment in order to get equity or option awards.

People chase the long-term asset that seems so valuable, and give up time and interest (money’s version of time) to get it.? They give up more than they imagine for something of uncertain value.? In other words, a mania.? Give up something relatively certain in the short run for something with uncertain long run potential.

The attitude could be summed up with a conversation I heard in early 1998 between my boss and his best salesman, where the salesman said, “It’s a no-brainer, have the market pay your employees.”? His idea was that a constantly rising stock market would provide compensation to employees through stock awards, options, 401(k)s, etc., even as the market was straining at valuation limits.? It is probably a sign that the market is overheated, when market-based rewards become common.

Startups by their nature require that employees be flexible, and give up a lot of fixed guarantees.? What payments they receive at the beginning are small, and less than their work might deserve in most established contexts.? But there is the possibility of the big payoff, and the possibility of total loss.? The asset in question has a lot of variability, but the liability, the work that must be put in, is big, and may not vary much for success or failure.

In the tech bubble, many parties extended vendor credit because there were big profits to be made in the future.? Alas, but they lent to those with very uncertain prospects, and in March of 2000, the chain of leverage started to collapse, both for vendors, and for those that worked in the industries.? Just as hedge funds have a hard time holding onto good employees when performance goes bad, so it is for tech companies when financing dries up, and the stock price craters.? Rats desert the sinking ship.

“Free money” brings out the worst in people.? Do something small in the present and reap a huge future.? Sadly, it rarely works that way, except at the very beginning of a boom.? At the end of the boom, it is a maelstrom, with many people demanding to throw their money away in search of riches that will never be.

From a dated piece:

Crowd-following is common to humanity.? It takes a lot to stand apart from highly correlated behavior.? I?ve told this story before, but in late 1999, I was talking with my mother (a very good self-taught investor), she told me about many of my cousins who were speculating in tech stocks.? I said to her, ?They don?t know anything about investing!?? My mom replied, ?Oh, David.? You?re such a fuddy-duddy.? I just bought some Inktomi!?

Now, to set the record straight, that was just 1% (or less) of my mom?s assets, so an occasional flyer is acceptable.? Call it ?Mad Money.?? ;) ? For my cousins, it was most of their investable assets.? My mom is fine, and the fuddy-duddy did all right also, but the cousins swore off stock investing.

I am close to concluding that it is impossible to teach the average person how to do well in investing.? They don’t have the patience or the willingness to learn. (Few want to be called “fuddy-duddy” by their mothers.) 😉

Getting rich quick is very rare, but it entrances some people several times in their lives, and rarely does it end well.? It is far better for most people to work hard in areas of the economy that are being rewarded, and invest excess cash in a mix of? stocks, long-dated investment grade bonds, money markets, and a little gold.

After all, it’s not what you make, it’s what you keep.

The Rules, Part XXIX

The Rules, Part XXIX

Posted on by David Merkel

Risk premiums should never be capitalized, they should only be taken into income as earned.

This may end up being another odd post of mine.? I’m going to start writing about bank regulation, but I will end up talking about monetary policy.

There are many people who hate the rating agencies. They hate them because they are a convenient target, and most people don’t understand what they do. Rating agencies provide opinions. Nothing more, nothing less.

Many people would like to get rid of the rating agencies. But it’s not that easy. Regulators outsource their credit rating function to the rating agencies because they don’t want to do that work.

There is a way to eliminate the rating agencies, and I have written about that before. But the idea is so radical, that the banks would rather have the rating agencies exist, than use my idea.

So what’s my idea? Simple. If you were setting up a portfolio, what would you assume would be the minimum that you could earn on the portfolio? My minimum would be buying Treasury bonds and earning interest on them.

So if I am looking at a portfolio of risky assets, I would split each asset into two. I would mirror the cash flow pattern of each asset, and construct an equivalent Treasury portfolio to mimic the cash flows. All of the cash flows above that amount from the risky asset are the risky cash flows. The amount of capital that banks hold as reserve against losses should be proportionate to the present value of risky cash flows.

Unlike my last piece on this, I am not saying that the whole present value of risky cash flows should be held as capital against losses. But the regulators should use this, if we are not using rating agencies, as a proxy for credit risk in bank asset portfolios.

Why is this a good measure of credit risk inside banks? The market for lending is fairly efficient. Debts that have more risk have higher interest rates.

This measure of risk benefits from the concept of simplicity. It can be applied everywhere. And, there is good theoretical justification for it. Any return that is upon the government bonds is subject to question.

But suppose we decided to use this as a major portion of our formula for regulating bank capital. What would happen to monetary policy?

Well, if the Fed tries to do something similar to ?operation twist” it would require banks to hold more capital against their positions, because the safe interest rate falls, it causes the risky portion of each loan to rise. As such, any sort of ?operation twist” would fail, because the rise in capital levels, would blunt any advantage from over Treasury interest rates.

From my vantage point, it would be a real plus to have monetary policy neutered in that way. The Fed, should it deserve to exist, should be concerned with the banking system and its solvency. It should not be concerned with the overall level of interest rates. If lowering interest rates lowers the judgment of solvency, then that would restrain the Fed from being too aggressive in lowering rates. And that would be good. The Fed has generally not succeeded with monetary policy. They have been too loose in the past, leading to the problems of the present.

And, as I have said before, we should not have unelected bureaucrats driving our economy, rather, we should have Congress do it because we can vote them out.

That’s all for now. Thanks for reading me. I appreciate all of my readers.

The Rules, Part XXVIII

The Rules, Part XXVIII

Posted on by David Merkel

Rebalancing of any sort in investing presumes an underlying stability to the economic system, and thus, market returns.? Rebalancing will not protect against socialism, war, or an overleveraged position.

The concept of rebalancing requires the idea of reversion to mean.? It will not protect you when profound shifts are happening, where the market are moving to a new equilibrium different from the old one.

Many shifts in the markets are precipitous; they don’t allow for slow adjustment.? That’s why many lose out when sharp shifts occur.? Especially in leveraged positions, the question comes: “Do I take my loss, invest more, or just let it ride?”

The best answer is forward-looking, only asking what is most likely.? The best preparation is also forward-looking, but with a glance to the past, asking what could happen at worst, which is worse than the worst of the past.

There are times when it seems that stability is no more, or that the boundaries for stability are far larger than normal, such as now.?? At such a time, it may pay to follow market trends, realizing that there many participants like you that are struggling to figure out the situation that everyone is in.

The point is to be forward-looking.? Ignore the past.? Ask what is most promising over your favored time-horizon.

So when it makes sense, add to a position that has lost money.? When it doesn’t make sense, sell the whole position and realize the loss.? Could this be simpler?

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