Value Investing – Page 42

Sorted Weekly Tweets

Posted on 17 August 2012 by David Merkel

Note: Tomorrow (Saturday) I will be on WBAL Radio at 8:30 AM Eastern with local radio host Jimmy Mathis, talking about the markets.? If you are up, they do stream the broadcast.

Market Dynamics

Six Weeks of Green: Stocks Quietly Creep Higher http://t.co/XYxAfaOj Markets move up at half the speed they go down http://t.co/d09QUp8y $$ Aug 18, 2012
Premiums dominate in HY CEFs & loan participation CE funds, even the investment grade funds r seeing discounts fade. Too hot. $$ #yieldlust Aug 17, 2012
T. Rowe Price Small Cap Fund Veteran Preston Athey to Exit in 2014 http://t.co/Y6BRCnmW One of $TROW ‘s finest takes a less active role $$ Aug 17, 2012
Paulson Steps Up Gold Bet to 44% of Firm?s Equity Assets http://t.co/5ESGLVdl Makes me bearish on gold. Bad mkt could b a forced seller $$ Aug 17, 2012
What should I do with my money now? http://t.co/xqXtnPqb My view is this, if acctg is conservative, buy stocks P/TB < 1.5, P/E < 10 $$ Aug 17, 2012
Usage: That was a real Facebook of an IPO! 2) We really Facebooked the IPO buyers! 3) Avoid this IPO, it’s going 2b a real Facebook! $FB $$ Aug 17, 2012
Facebook puts follow-on on ice http://t.co/d2CMGLvl Avoiding adding insult to injury. Lousy IPOs in the future will be called “Facebooks” $$ Aug 17, 2012
It’s usually a bad sign when locals are selling, and foreigners buying. How do foreigners have more knowledge? $$ http://t.co/mhOHunFj Aug 16, 2012
Man overrides machine to tackle low bond yield risk http://t.co/IDTSByMr Momentum isn’t everything w/bonds, eventually mean reversion. $$ Aug 16, 2012
Whenever you mention CDS spreads, could you do us the favor of citing that spreads bonds are trading at? You are, aft? http://t.co/o3StHaG0 Aug 15, 2012
You Are Now About to Witness the Strength of Street Knowledge http://t.co/jV4bxWc4 Having a revenue model is an aid to stock performance $$ Aug 15, 2012
Even Amid the Current Turmoil, Stocks Still Beat Bonds http://t.co/fqTWnM6g Issuing this opinion: a crowded trade http://t.co/X6KGWp5b $$ Aug 14, 2012
Silver Hoard Near Record as Hedge-Fund Bulls Recoil http://t.co/gQpc19Hz Pressure for prices to fall amid ETF-based hoarding $$ Aug 14, 2012
Junk-Bond Buyers Plot Escape in Debt Gap http://t.co/lEVYDv9f Smart money moving up in liquidity & down in yield. Junk rally continues $$ Aug 14, 2012
A Green Light for Car Loans http://t.co/VqfWA4AK Banks, Finance Firms Boost Auto Lending; Fed Survey Finds Easier Standards $$ #moredebt Aug 14, 2012
Stocks: The ‘Safety’ Dance http://t.co/N9CNg4aO Defensive stock valuations high relative to cyclicals. Graph: http://t.co/Q17aYeiU $$ Aug 13, 2012
As Corporate-Bond Yields Sink, Risks for Investors Rise http://t.co/WeET5vWD Maybe. Debt-deflation has a funny way of persisting $$ Aug 13, 2012

Rest of World

Mexico’s big oil problem http://t.co/e3b6V19s Yrs of abuse &non-investment by PEMEX, milked by the govt, oil production declining fast $$ Aug 18, 2012
Iranian Currency Traders Find a Haven in Afghanistan http://t.co/Bcw8l03A Sorta fitting that Afghans make $$ breaking sanctions on Iran $$ Aug 18, 2012
Rate Cuts on the Cards for Norway and Sweden http://t.co/REReXdiF We need a new Gresham’s Law on Monetary Policy. See in next tweet $$ Aug 17, 2012
Bad monetary policy drives out good monetary policy when large countries inflate, & exporters in small countries complain about losses $$ Aug 17, 2012
You can say that again $$ RT @saraeisenFX: More signs of worsening credit quality in China http://t.co/KLAApyBy Aug 17, 2012
Aramco Says Virus Attacks Network, Oil Output Unaffected http://t.co/o0p8Rb94 What shall we call this? The Cold Techno-War? $$ Aug 16, 2012
The only way out for China: Andy Xie http://t.co/ROaF0C2S Problems only going2get worse as long as government interferes $$ #chinacrash Aug 15, 2012
Beijing Loan Guarantee Firm Teeters on the Edge http://t.co/XtapRo8W A sign of things to come, and how will China deal with the defaults? $$ Aug 15, 2012
China?s money outflow continues in July http://t.co/xpMby8WI The wealthy of China send capital abroad, so that they can survive anything $$ Aug 15, 2012
German Provinces Struggle to Lure Skilled Workers http://t.co/yN61QTaJ Europe can find work, but will have to find it in Germany $$ Aug 14, 2012
Correlation Breakdown as Proxies for Risk Boost Aussie, Kiwi http://t.co/4zQMFGQd Countries w/good $$ policy draw funds, harming exporters Aug 14, 2012
Africa’s pirates have demands – and letterhead, too http://t.co/GKbc4Jcm Not intimidation, merely “making you an offer you can’t refuse” $$ Aug 13, 2012
Mursi Sidelines Egypt?s Top Generals Amid Power Struggle http://t.co/KAOWGQdE Push is coming to shove; Military vs Muslim Brotherhood $$ Aug 13, 2012

US Economy

The case for supply-side tax cuts http://t.co/EYfStM7t Tax increase of 1% of GDP reduces output over the next 3 years by nearly 3% $$ Aug 17, 2012
London Firings Seen Surging as Finance Firms Add NY Jobs http://t.co/D0to5HSo Finance jobs grow where the regulations are lowest $$ Aug 17, 2012
5 years forward, five year inflation: http://t.co/q98ZknDn Seems to top out @ 2.7% recently, 3% longer-term http://t.co/rqFkN26r $$ Aug 16, 2012
Farmland Prices Surge Across the Plains States http://t.co/we6hZAcP Poss causes: hi grain prices & widespread use of crop insurance $$ Aug 16, 2012
The Downside of a Recovery in Housing http://t.co/BfzmDdYr “potential uptick in inflation measures, of which housing is a big component” Aug 16, 2012
Will births come back with the economy? http://t.co/sYqJjBXm Yes, people have more children when they are optimistic about the future $$ Aug 15, 2012
Wrong: What if baby boomers don’t live forever? http://t.co/kRLnHqrA Even if mortality does not improve @ prior rate, makes little $$ diff Aug 15, 2012
Mathematically Possible http://t.co/ziQNoQx4 Correcting the false assumptions of Obama’s tax gurus | Govt in DC is always dishonest $$ Aug 14, 2012
Clarity of communication is not the Fed’s problem. If you have bad policy, it doesn’t matter how you present it. http://t.co/C27MJ2QX Aug 13, 2012

Pensions

Unions protest Democrats at Illinois State Fair http://t.co/uU7twsOK Govt workers learn hard reality. Benefits not protected by ERISA + $$ Aug 18, 2012
Which means underfunded benefits may never b paid at the level promised. Taxes can’t b raised enough to make it work, either. Sorry $$ 🙁 Aug 18, 2012
@mckpartners There r 3 parties not getting blame here aside from the standard ones: 1) accountants that dreamed up lousy funding rules + $$ Aug 18, 2012
@mckpartners 2) Actuaries didn’t pushback on investment assumptions & 3) Union negotiators thot they were smart trading salary 4 pensions $$ Aug 18, 2012
Annals of dubious research, 401(k) loan-default edition http://t.co/LDLsN0f1 401k loan defaults r 2% of what widely-cited study claims $$ Aug 13, 2012

GSE Bailout Change

Fannie?s and Freddie?s Forgettable Friday http://t.co/kvfNkBcI Investment whose value is dependent on unknowable government policy $$ Aug 18, 2012
GSEs expected to unload delinquent loans after Treasury change http://t.co/2g7tiIxI Portolios to shrink through prepays/writeoffs 15%/yr $$ Aug 17, 2012
Anybody have guesses as2what $FNMA $FMCC $FNMAT $FMCCK should be worth? Pfds ~ 2 coupon pmts? Common stock ~ 0? Prob(going-away present)? $$ Aug 17, 2012
Treasury to wind down GSEs faster, only to be replaced with (insert solution here) http://t.co/mAtyKpHs Future of the GSEs in question $$ Aug 17, 2012
Treasury to Amend Terms of Fannie, Freddie Bailout http://t.co/iZcCdXML Cancels 10% div, all profits go2 Tsy. Comm stocks down 20-25% $$ Aug 17, 2012
Fannie, Freddie Pfds Sink As Treasury Amends Bailout Terms http://t.co/3pGEjsrF Down 52-55% today. That was the crunch you heard $$ Aug 17, 2012

Municipal Bonds

Bondholders, insurers challenge San Bernardino bankruptcy http://t.co/WE2vRb6e They allege SB finances are not in a state of emergency $$ Aug 18, 2012
That really stinks, can’t comment there also $$ RT @Tubulus: @munilass I think your head will slam into your desk – http://t.co/8G1e0plE Aug 16, 2012
The Untold Story of Municipal Bond Defaults http://t.co/2UKKOIUA Trivial thots from researchers @ NYFed, my comment: http://t.co/EP5aUq29 $$ Aug 15, 2012
Looking for Higher Yields? Try ‘Junky’ Municipal Bonds http://t.co/qo9DfZKt Safer than corporate junk, but less liquid. Be careful $$ Aug 13, 2012

Other

Apple judge: ?I see risk? and 7 more newsmaker quotes http://t.co/wyBoToT7 Notable quotes in the business world $$ Aug 17, 2012
The Valley of Free Food: How One Firm Caters to California’s High Tech Giants http://t.co/cijDNgdC Companies r armies; travel on stomach $$ Aug 17, 2012
Texas Seeks Seizure of Life Partners http://t.co/MWofrEv2 ‘Bout time. Life settlements should b illegal; no insurable interest $LPHI $$ Aug 17, 2012
More trial, less error: An effort to improve scientific studies http://t.co/i2PLAD5h Why I am skeptical of much biometric research $$ Aug 16, 2012
when $AMGN ‘s scientists tried to replicate 53 prominent studies in basic cancer biology … they were able to confirm the results of only 6 Aug 16, 2012
Mobile pay war: Wal-Mart and others vs. Google http://t.co/Q30PZQGP So much innovation in payment systems; wonder which will win? $$ Aug 15, 2012
Nassim Taleb: Stay Out of the Investment Industry http://t.co/ZyomTwjB Superinvestors of Graham & Doddsville r @ work & still making $$ Aug 15, 2012
Deep ocean lure grows as high-tech drilling pays off http://t.co/P4UP4ZWs The technology for extracting oil grows ever more complex $$ Aug 15, 2012
Buyers Beware: The Goodwill Games http://t.co/eA7XEXjr Check the cash from operations. Should exceed earnings if Goodwill is valid. $$ Aug 14, 2012
CLEAN UP THE BALANCE SHEET: GET RID OF DEFERRED TAXES http://t.co/DTfT8bRg Future income or losses can’t be assured, so not asset or liab $$ Aug 13, 2012

Comments

@BarbarianCap The firm I was with sold $AIG the day it went into the Dow. Close to a “top tick.” $HIG , did not do hearly as well 🙁 $$ Aug 18, 2012
@The_Dumb_Money @pkedrosky is a bright guy. Many got it right, but fads suck people in. Aug 17, 2012
RE: @boingboing Not too surprising. Many corporations pay low taxes b/c of govt incentives. Relationship 2 mgmt pay s? http://t.co/KoChJizm Aug 17, 2012
@Breakingviews The sooner the euro dissolves, the less will be the pain for all involved. It was a mistake from the start. $$ Aug 17, 2012
@pelias01 Many thanks for the many times you have asked people to follow me. I really appreciate it. Aug 17, 2012
@JimPethokoukis I’m reading it now; that’s a fair assessment. Beyond that, it reinforces how hard it is to do anything in DC $$ Aug 16, 2012
RT @PragCapitalist: Pushing up stock prices does not make underlying assets more profitable. The whole premise of the Bernanke Put is f … Aug 16, 2012
@FeeOnlyIndy I try to be fair, I don’t always succeed, and I do have my biases, so take me with a grain of salt, but thanks $$ Aug 16, 2012
@izakaminska Whenever I go to Boston, I always take the Water Taxi from the airport. Lets me off in Downtown –beautiful view of the city $$ Aug 15, 2012
@munilass Glad u said: “The Fed really ought to be embarrassed that it published something like this.” I didn’t say that & should have $$ Aug 15, 2012
@The_Analyst true… too much quantitative talent went to Wall Street, applied the wrong model: physics, rather than right model: ecology $$ Aug 15, 2012
My friend Eric Hovde sadly didn’t win the Wisconsin Republican Senate primary; Eric would’ve shaken up DC. Thompson is business as usual $$ Aug 15, 2012
“Proppants prop open cracks when hydraulic fracturing is done. $$” ? David_Merkel http://t.co/OuqTSMAc Aug 14, 2012
?I wasn’t that impressed w/Inker’s analysis. Does not take into account dollar-weighted returns. $$ http://t.co/C5Gh0pOl Aug 13, 2012
@nancefinance I was pretty nerdy, though not withdrawn, back then. My mom was a self-taught investor. I caught the bug from her. $$ Aug 13, 2012
When I was a teenager, I remember looking through the bond tables, noting that almost all prices were below 100. Today it is the opposite $$ Aug 13, 2012
@japhychron @Peter_Atwater You were more than mostly right, it’s a great book. Only wish it could have been bigger. $$ Aug 12, 2012

Using Investment Advice, Part III

Posted on 16 August 201216 August 2012 by David Merkel

The next aspect of using investment advice is understanding your own capabilities.? It comes down to what you understand, and what you have time for.

Some investment advice requires constant attention, even assuming that it is right.? Does your job afford you that flexibility?? If it doesn’t, you need to look to longer-term strategies.

There was a period in my life when I did small company deal arbitrage.? More profitable, more volatility, more blowups.? It took a lot of time to do the daily research.? I really felt I was cheating my family in that era.? Value investing does not take nearly that amount of time.

Do you know enough about the investment advice that you can be an intelligent amateur critic?? You don’t have to be an expert but to follow the strategies of others, you have to be intelligent to the point where you can differentiate between strategies that work and those that don’t.

What, that’s a tall order?? Really, it depends on your time horizon.? Value investing will deliver over a decade-long horizon.? Momentum investing will deliver most of the time, so long as too many people aren’t following it.? Value has the advantage that adjustments are infrequent, that’s not true with momentum.

Beyond those two primal strategies, I’m not sure what else works, aside from indexing.? Indexing has its own issue: as long as money is flowing into indexing, indexing tends to outperform.? This is less obvious with stocks, but if you have ever been a bond manager, index bonds trade special (expensive).? They have lower yields because there is a class of investors that has to own them.? If the money flow ever reverses, indexing will not do well.

You are your own best defender.? No one can protect yourself more than you can.? That is why it pays to be skeptical of unusual claims of investing expertise.? If they were really that good, they would invest for themselves, and not solicit outside investors.

After all, in this modern era, if anyone has an infallible investment method and limited capital, they will do best by setting up a hedge fund.? Those who proclaim to you that they have methods that border on miraculous should be questioned closely, because in investing, there are no miracles — only cash flows, and the market’s anticipation of future cash flows.

Now, there are some things with investment advisors that can give you some comfort.? Smaller managers tend to do better, because they haven’t reached the boundary of how much money their ideas can accommodate.? Beyond that, in my opinion, managers that don’t beg for business do better as well, they aren’t spending time on the marketing; they are managing.? Also, managers with a clean revenue model “fee only” aid investors.? The costs are clear from day one, and there are no conflicts of interest.

-==—=-=-=-=-=-==-=-=-=-=–=-=-=-==-=-=-=-=-=-

Taking it back a step, can you critique yourself?? Where have your biggest successes and losses come from?? It might be good to keep a journal, so you can see if your successes stemmed from things you foresaw, or were accidental, and if your losses stemmed from neglect of discipline in following your ideas, or whether the idea itself was wrong.

My personal conviction is that most investors lack patience.? That’s why we sell at the bottom, and buy at the top.? But to be a patient investor requires strong balance sheets, because bad things do occur, and we want to avoid a permanent impairment of capital.

Do you know your weaknesses?? It took me 10 years to wash fear out of my system.? Greed wasn’t a problem.

Understand yourself, and learn self-control.? Don’t compare a stock to where it was, compare it to where you estimate it should be, once you are realistic.

More in Part IV

Using Investment Advice, Part II

Posted on 15 August 201215 August 2012 by David Merkel

Part two is understanding the advice.? A large part of the problem is that many aspects of the advice are unsaid.? For example, with a “buy” recommendation:

What time horizon does this recommendation require?
How likely is it that this investment will succeed?
What risk factors could cause the investment to fail?
How will this advice get updated?
Have prior investors benefited from this advice?
What is the benchmark for the advice?

Time horizon is important, even if it were handled approximately, e.g, “six months to two years.”? Should you buy for the earnings release and sell thereafter, or is this a company going through a multi-year shift?

The likelihood of success is subjective, but still important.? It helps if analysts/touts would clarify how certain they are of success, st least in vague terms.

Listing the risk factors is important.? Analysts do less of this than do companies in their prospectuses/10Ks.? These are important, and it would be valuable for analysts to see if there are any risk factors not listed, or emphasize the importance of key risk factors.

Knowing how frequently the advice will be updated aids the investors — it helps them understand how much help they will get, or whether after the recommendation, they are on their own.

It helps to know whether the adviser has any real talent or not.? Does he just opine, or is his own money on the line?? Has he succeeded in the past?

Finally, the benchmark is of utmost importance.? Buy! Why, what will it do better than?? Is it a relatively good stock?? Is it a relatively good stock in its industry?? Is it a relatively good bond?? Is it just going to do better than cash?? You need to understand the comparison that the analyst is making in order to say the stock is a buy.

More in Part III

Industry Ranks August 2012

Posted on 11 August 201211 August 2012 by David Merkel

My main industry model is illustrated in the graphic.? Green industries are cold.? Red industries are hot.? If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted??? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.? Yes, things are bad, but are they all that bad?? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

If you use any of this, choose what you use off of your own trading style.? If you trade frequently, stay in the red zone.? Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?? Why change if things are working well?? I?m not saying to change if things are working well.? I?m saying don?t change if things are working badly.? Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.? Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then.? This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.? It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and Reinsurance, particularly those that are strongly capitalized.? I?m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle ? I am not interested there even at present levels.? The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their ?regulators.?

I?m looking for undervalued and stable industries.? I?m not saying that there is always a bull market out there, and I will find it for you.? But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.? I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.? The red zone is pretty cyclical at present.? I will be very happy hanging out in dull stocks for a while.

That said, dull is hard to find these days.? Where will demand remain strong, or where will demand rebound are tough questions.

The Red Zone has a Lot of Cyclicals

What I find fascinating about the red momentum zone now, is that it is laden with cyclical companies.? That does not make sense in a confused market environment where the market has no been making any progress.

So, as I considered the green and red zones, I chose areas that I thought would be interesting.? In the red zone, I picked transportation names, energy services, telecommunication services, and wholesale foods.

Much as cyclicals are displayed in the red zone, it does not mean the red zone or cyclicals are a good place to be.? The is a lot of weakness not just in the US, but globally.? I am left hard: where is the economy growing where the culture is honest enough that I trust the statistics?

But what would the model suggest?

Ah, there I have something for you, and so long as Value Line does not object, I will provide that for you.? I looked for companies in the? industries listed, but in the top 4 of 9 financial strength categories, an with returns estimated over 15%/year over the next 3-5 years.? The latter category does the value/growth tradeoff automatically.? I don?t care if returns come from mean reversion or growth.

But anyway, as a bonus here are the names that are candidates for purchase given this screen.? Remember, this is a launching pad for due diligence.

Full disclosure: long for me and clients: HPQ, THG, ESV, KR, INTC, CSCO

Book Review: Moods and Markets

Posted on 11 August 201213 August 2012 by David Merkel

To my readers: this is the second time I have written this review. When I pushed the “publish” button earlier this evening, WordPress ate the document. That’s never happened before, so I did not have a backup. As a result, this review is entirely different than the prior one, and I did it using DragonDictate, so it may sound a little more colloquial than other reviews of mine. Let me know what you think, and if you like my reviews please vote them up at Amazon. As always, whether you agree or not, thanks for being a reader of mine.

This book is about the questions every investor wants answers to:

Why do I tend to get into and out of the market at the wrong times?
Why are professionals prone to the exact same problems?
Why do financial crises happen?
Is there a way to approximately measure where we are in the overall market cycle?

The author has a theory that he calls “Horizon Preference.” Think of it this way: when the market is near bottom, market players have very short time horizons for investment. They hide in cash. More than that, they choose very generic investments; they stay close to home and keep things simple. Fear drives them back to what they know always works in the very short run, which means any opportunity for gain is lost.

At such a time, only the most risk tolerant and experienced remain holding risky assets. Valuations are low. The party is over, the young have left, and the old guys are cleaning up the room. If you look in a financial newspaper, or out on the web, the headlines you read are pervasively negative. But at a true bottom, you’ll see that things have stopped getting worse.

Then optimism begins. It’s a fitful at first. It is two steps forward and one step back, before it becomes three steps forward and one step back, before it becomes an unrelentingly good trend. But as this happens, moods, headlines, move from disbelief, to doubt, to wonder, to optimism, and to greed. As this happens, market players expand their horizons. They are willing to take on new risks, with new instruments, and in new places. They are willing to pay remarkably higher prices for risky assets. This happens with individual investors, professional investors, bankers make loans, regulators, accountants who have to make the numbers for management, etc.

At the top everything is wondrous. Nothing can go wrong. At the top, the attitude is “We are going to make a lot of money.??It?s as if money is free, and anyone can make it in the markets now. Everyone can be rich, just invest in the market. All of the neophytes are playing in the market. The experienced professionals who have seen a few market cycles have begun to edge out of the market, if not raise significant cash. Risk control is derided as a way of losing money. Real heavy hitters don’t need risk control.

All of the discretionary cash is applied to the markets. Various forms of leverage are applied to personal investments, real estate, and business investments. Because everyone knows things are going to go well, they figure they may as well play it to the hilt.

But at the top, things stop getting better. Then pessimism begins.? It’s a fitful at first. It is two steps back and one step forward, before it becomes three steps back and one step forward, before it becomes an unrelentingly bad trend.? Sadly, during the phase of pessimism, things move down about twice as fast as they went up. It’s frightening, and it should be. Bear markets tend to persist until the bad ideas and investments of the up cycle are liquidated, unless the government steps in to arrest the fall.

The planning horizons of businessmen and investors shrink, as do valuations, until we hit the bottom, and the cycle starts again.

What I have described to you is the basic framework of the book. The author then applies that framework to the housing bubble, the possible higher education bubble, changes to accounting frameworks as rising preferences change, and where we are today in the markets. He gives a tour of the various phenomena inside corporations that take place at different points in the cycle. Optimism breeds complexity, lack of risk management, concept stocks, big projects, and a lot of credit. Pessimism breeds simplicity, renewed risk management, and bankruptcies.

This book will give you a feel for what part of the market cycle we’re in, and how you can profit from it. It is not math intensive; the book has no equations. There are a lot of graphs, but they are simple to understand.

Quibbles

In one sense, this book is about the credit cycle, and how it affects all risky assets. But it is couched in the language of how moods change of market participants, which then drives the market. My view of the matter is slightly different. I see market players making estimates of their future well-being, and as that estimate changes, so do their moods change, and the prices of risky assets. I don’t think this is a big difference from what the author is saying, so I heartily endorse this book.

Who would benefit from this book:?? Inexperienced investors would definitely benefit from this book. Experienced investors who are having a hard time with the unpredictability of the market of late would also benefit.? If you want to, you can buy it here: Moods and Markets: A New Way to Invest in Good Times and in Bad (Minyanville Media).

Full disclosure:?I got this book in a weird way. I don’t know the author, but we have a mutual friend, and he suggested to the publisher that he send me a copy of the book. That’s how I got it.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Sorted Weekly Tweets

Posted on 10 August 2012 by David Merkel

Life Insurance Secondary Guarantees

Hartford Mulls Client Buyouts to Cut Risk Buffett Called Ungodly http://t.co/Nv4jRlUC Advice: don’t take the Variable Annuity buyouts $$ Aug 10, 2012
The original: Buffett Says Insurers Took ‘Ungodly Amount of Risk’ http://t.co/pXfXv8ME Warren Buffett again is prescient cc: @PlanMaestro $$ Aug 10, 2012
@PlanMaestro Thanks4 flagging this. Together w/companies scaling back gtees 4 new prods, the buyout offers show the probs in the life biz $$ Aug 10, 2012
@PlanMaestro I am not in favor of peer review. Actuaries call themselves a “profession,” but they really technicians. Aug 09, 2012
@PlanMaestro Regulators not crazy for this, because they can’t understand it, & almost makes the companies self-regulating. Peer Review? $$ Aug 09, 2012
@PlanMaestro But actuaries are trying to get regulators to cmove to a Canadian-style principle based approach. In Actuaries we Trust! $$ + Aug 09, 2012
@PlanMaestro But the devil is in the details, and GAAP reserving does not always reflect antiselection. Stat tries to do that, but + $$ Aug 09, 2012
@PlanMaestro But you’re right, the 10Ks do contain approximate partial sensitivity data on economic value for most important variables $$ Aug 09, 2012
@PlanMaestro In 1999, I saw a VA that guaranteed 7% minimum return if held till death or annuitization $$ Aug 09, 2012
@PlanMaestro I said “Wow, how do you guarantee the better of 5%/yr and performance of the underlying 4 just 2.25%?” $$ Aug 09, 2012
@PlanMaestro I have a friend who is a $PRU agent. One day he showed me his hottest-selling VA product, and ask me how I liked it. $$ + Aug 09, 2012
@PlanMaestro Acctg can get really screwy if you hedge NPV or FMV; gets really noisy because the results pile up in the current year $$ Aug 09, 2012
@PlanMaestro hedging long-dated options, w/complex contingencies built into them. Do you hedge next few years, or NPV sensitivity? $$ + Aug 09, 2012
@PlanMaestro I was an ALM actuary for many years, typically we hedged partial durations; fixed income hedging is easy, what’s hard is $$ + Aug 09, 2012
@PlanMaestro many exposures are impossible to hedge b/c the contracts r long-term, and hedge instruments r usually far shorter $$ Aug 09, 2012
@PlanMaestro That’s one of my concerns about the life industry; secondary guarantees r virtually impossible to reserve, getting big now $$ Aug 09, 2012

Insurance Industry

@ReformedBroker Good post, same thing happens with young life insurance agents to a degree http://t.co/LbMyo48G $$ Aug 10, 2012
@Bonfire_Sherman P&C – P/TB vs ROTE, adjusted 4 business mix, reserve life & conservatism, mgmt quality, U/W cycle, never premiums $$ Aug 09, 2012
@Bonfire_Sherman Most of it is change in required capital. Life actuaries typically calculate “distibutable earnings” reflting stat & RBC $$ Aug 09, 2012
Anytime anyone talks about Financial Cos & tells u about Free Cash Flow, ask how they did the calc. C if they mention chg in req capital $$ Aug 09, 2012
Wrong: 3 Life Insurance Stocks Undervalued By Levered Free Cash Flows http://t.co/gF5HYRZb GAAP financials don’t have data4 FCF calcs $$ Aug 09, 2012
Aviva profits fall as it cuts the value of its US unit http://t.co/t816IjAZ Amerus IR was annoyed @ me 4saying the orignal deal expensive $$ Aug 09, 2012
@PlanMaestro HIG is next on my list Aug 09, 2012
@PlanMaestro Thanks, I know where to get them, but I have enough GNW on my plate for now, I took me two weeks to write my AIG piece. $$ Aug 09, 2012
@PlanMaestro Have not looked at HIG, after I am done with GNW may take a look. If u r looking at stat acctg, look @ pg 5 indiv annuities $$ Aug 09, 2012
@PlanMaestro That’s the thing, like AIG prior to the crisis, and Scottish Re, they are capital constrained; things have 2go right 4 them $$ Aug 09, 2012
@PlanMaestro & not so sure about the rest if investing for more than five years. $$ Aug 09, 2012
@PlanMaestro Aye, agreed. Oddly, my interest stemmed from a reader who asked me if I would invest in GNW bonds. Yes 4 GIC-MTNs + Aug 09, 2012
@PlanMaestro I’m going to write a broad piece about it, but follow it up, with a narrow piece focusing on the specific problems. $$ Aug 09, 2012
@PlanMaestro Intercompany surplus notes and preferred stock too. Aug 09, 2012
@PlanMaestro There’s a ton. Underreserving, capital stacking, capital interlacing, intercompany reinsurance, & I’ve ony been looking 2 hours Aug 09, 2012
@Bonfire_Sherman Good guess, I need to look at the life co stmts someday, esp. page 5 for Indiv annuities Aug 09, 2012
Ding! We have a winner! RT @RennieScinto: @AlephBlog gnw? Aug 09, 2012
I’m a fun guy, looking @ statutory statements of a major US insurer, though AIG in 2008 looked worse, this company doesn’t look good $$ Who? Aug 09, 2012
Online Dating for Homes Stumps Insurers http://t.co/R2fmztPa Y not have both deposit $$ w/the insurer plus a premium payment? #wouldwork Aug 08, 2012
Regulators Probe ‘Captives’ http://t.co/xbXQ5aYO How to bend life insurance reserves. Catch my comment: http://t.co/9WQWYZ3W $$ Aug 06, 2012
Berkshire Trims Municipal-Debt Bet http://t.co/9zhhbdtD Meredith Whitney, no. Buffett, yes. But even he is only selectively reducing $$ Aug 05, 2012

Poway School District

Article near issuance of Poway School District CAB http://t.co/kxAWCNxT Letter from CA AG: http://t.co/UiZM0j3K cc: @munilass @jamessaft $$ Aug 06, 2012
@jamessaft I’m not a muni expert like @munilass, but no, I would try to find another way to refinance prior debts. $$ Aug 06, 2012
Ideal buyer4the preceding bond would b Buffett, or a P&C company w/long-tail liabilities. Prospectus 4 wonks only http://t.co/nIKJvJje $$ Aug 06, 2012
Where Borrowing $105 Million Will Cost $1 Billion: Poway Schools http://t.co/IPaABoXY Paying 7.6% IRR at a duration of 25. Astounding! $$ Aug 06, 2012
@munilass Also, I found the prospectus here: http://t.co/nIKJvJje Last Q: Do county tax levies into a sinking fund ever fail to work? $$ Aug 06, 2012
@munilass I get the holder taxes now. Poway was structured as a series of zero coupon notes, followed by 2 series of long lottery bonds $$ Aug 06, 2012
@munilass Used to be an asset-liability manager, so I look for that. 1 question: do you know how holders are taxed on a deal like that? Aug 06, 2012
@munilass This is just a crude estimate, but the IRR on the Poway deal is around 7.7%, and is nonrefinancable. Duration estimate 25 years $$ Aug 06, 2012

Rest of the World

China Export Growth Slides as World Recovery Slows http://t.co/u4YEUPQB China sneezes & the world catches a cold? no, important anyway $$ Aug 10, 2012
India?s Biggest Corporate Loss Shows Singh?s Dilemma on Deficit http://t.co/6xl7lsZD Force oil company to lose $$, eventually lose oil co. Aug 10, 2012
Housewives With Frying Pans Protest Japan Tax Hike as Debt Soars http://t.co/z3aeqjEv Taxes to double; can’t keep borrowing 4ever $$ Aug 10, 2012
Virus found in Mideast can spy on finance transactions http://t.co/V2GgyjpV Can spy on financial transactions, email & social networking $$ Aug 09, 2012
Toronto Condo ?Roller Coaster? Peaks as Flaherty Acts http://t.co/c6sJ0CqE Is Canadian housing a basketball (sss) or a bubble (pop)? $$ Aug 08, 2012
Iran?s Big Crisis: The Price of Chicken http://t.co/WXlUIIdL Describes some the economic difficulties of Iran under sanctions $$ Aug 08, 2012
Article makes a good point. The industries where China has overcapacity are power-intensive & are shrinking. Simple. http://t.co/IzyV0Bxe Aug 08, 2012
China’s answer to subprime bets: the “Golden Elephant” http://t.co/MP7LviwT Illiquid investments touting high returns w/lousy business $$ Aug 07, 2012
RE: Things are getting less equal in the US, because we allow more freedom here.? Globally, things are getting more e? http://t.co/WeGEEJF9 Aug 07, 2012
Presidential candidate up by 15%+ in August will win. If merely ahead, 9 times out of 12 he will win the Presidency http://t.co/soCj7Kf9 Aug 08, 2012
Swiss Banks Face Slow Death as Taxman Chases Assets http://t.co/13I9NkiQ Life’s tough when u can no longer help people cheat the taxman $$ Aug 06, 2012
Germany has the most to lose from a meltdown http://t.co/9JTwRfii Basically encourages an inflationary “solution.” Prob won’t work $$ Aug 06, 2012
If policymakers are worried about this, they are worried about the wrong thing. EU does not have that big… http://t.co/eCBlZg5I Aug 06, 2012
Summary: greater structural unity, mutualization of sovereign debts and a weak euro $$ Tough order for the… http://t.co/KN9pc0Pt Aug 06, 2012
Rogoff Sees World Wishing It?s America Year After S&P Downgrade http://t.co/MpStm7ww Relative flexibility pays off $$ Aug 06, 2012

Fixed Income

Lending in the offshore markets developed because of bad regulations here. It is outside US control & we should not m? http://t.co/C8y9rVFw Aug 10, 2012
In hunt for yield, hybrids flourish anew http://t.co/GCugG6A6 Credit rally revsup ppl grab yield in exchange 4 higher poss loss severity $$ Aug 09, 2012
Please, no $$ RT @CapitalCityIFR: In hunt for yield, hybrids flourish anew http://t.co/ZWbdRRl5 Aug 09, 2012
For a bad 30-yr Tsy auction, nice rally since then $$ Aug 09, 2012
A Greek banker, the Shah and the birth of Libor http://t.co/ibvVs9mE ht: @alea_ Started w/a loan 2 the Shah. Inauspicious start 4a big # $$ Aug 09, 2012
Definitely a weak auction, surprised long end not selling off $$ RT @ritholtz: 30 yr bond auction weak as well http://t.co/1gU89HMb $$ Aug 09, 2012
“Credit default swaps are easily manipulated. Rather, watch the bond market; it’s much bigger. $$” ? David_Merkel http://t.co/tESmTJsK Aug 09, 2012

Politics

The Neocon War Against Robert Zoellick http://t.co/vZreHf1n If Romney wins, pragmatic Zoellick could be influential on foreign policy $$ Aug 11, 2012
Christie Does Tenure http://t.co/J8krPlim Tenure is one of those sacred cows that hides the intellectually weak from consequences $$ Aug 10, 2012
In New York City, Microsoft Really Is Watching You http://t.co/trNOkU2d Interesting partnership w/NYC & $MSFT Civil liberties? $$ Aug 09, 2012
Postal Service $1 Million-an-Hour Loss Puts Abyss in View http://t.co/FVXMn5Di Raise stamp prices & costs 2 $FDX & $UPS $$ #simple Aug 09, 2012
Here’s The Real Reason The Feds Are Furious At The NY Regulator Going After Standard Chartered http://t.co/OmpwBILH Made Feds look dumb $$ Aug 08, 2012
RE: @bloombergview Dream, the Republicans will block this because it favors blue states over Red. $$ http://www.bloom? http://t.co/jT7EmSS0 Aug 08, 2012
I think it is a fair tradeoff to lose 2% of GDP in 2013 in order to get the economy growing. I agree with… http://t.co/mwuvnogX Aug 07, 2012
The Numbers Inside a Hot-Button Issue http://t.co/Fwois4YN Something to make everyone unhappy. Me: Don’t focus on rates, but deferral $$ Aug 07, 2012

Pensions & Endowments

State Pensions Get High Fees, Low Profits-Study http://t.co/3LRIL23c Add to that the lack of adequate funding &you have a serious crisis $$ Aug 10, 2012
Cornell, MIT Scale Back Aid Even as Endowments Rise http://t.co/WUoWDLLB Endowments provide less when rates r low, future cashflows smallr Aug 10, 2012
Defined contribution assets hit all-time high despite conservative shift http://t.co/7s9Stabd Amazing 2c bond alloc rising w/low rates $$ Aug 06, 2012
U can say that again $$ RT @e_d_sanders: @AlephBlog now this is an issue I know something about. Public pensions for execs are a nightmare Aug 05, 2012
Police Chief?s $204,000 Pension Shows How Cities Crashed http://t.co/ZorpuSjX Sloppy pension negotiating leads2 L-T cash flow crises. $$ Aug 05, 2012

Energy

Let the market decide.? If people want to pay a lot for gas, let them.? Why is Obama discouraging consumer spending? http://t.co/VT8xCyU0 Aug 10, 2012
Refiners Awash in Shale Oil Offer 10 Times Exxon Returns http://t.co/IIw9xXlb Buy cheap shale oil, ship to coasts, refine, sell & make $$ Aug 10, 2012
Louisiana sinkhole roils local natural gas network http://t.co/IkZxHLAs Now, who could have seen that coming? Risk is pervasive. $$ #sloorp Aug 09, 2012
Coal stocks typically have a lot of debt, beware $$ RT @MKTWBurton: Don?t mine this coal stock – Chuck Jaffe – http://t.co/nCQWfYzQ Aug 09, 2012

Other

Passed 10,000 tweets today. I quit Twitter after my first month, but came back to it after I saw its usefulness. Thanks 4 reading me $$ Aug 10, 2012
Heavy rain in Baltimore w/sleet and sunshine. Really weird weather. Sleet is neat, is hard to beat & will repeat, to make me tweet. $$ #ugh Aug 09, 2012
After Moods & Markets, Bailout is my next book to review. http://t.co/zkioUQ5N Aug 09, 2012
5 Questions Great Job Candidates Ask http://t.co/JpnpVWtu Questions show initiative, intelligence, & give u good jump pts 2 sell yrself $$ Aug 09, 2012
Novel Cure for Ailing Hearts http://t.co/RAiv4FYj Nanotech combines w/vascular endothelial growth factor to grow new heart muscle $$ Aug 09, 2012
Wrong: Business Is Booming in Empirical Economics http://t.co/aTNu4qfu U might get cute papers out of it, but nothing that generalizes $$ Aug 07, 2012

Companies

Yahoo Reviewing Business Strategy, Alibaba Proceeds; Shares Tumble http://t.co/ikk3dpeC Marissa Mayer has plans, & they require $$ Aug 09, 2012
Why Honda?s New Accord Looks Like the Old One http://t.co/6Ez8uL5i FD: + $HMC Designers tire of their designs long b4 users do $$ Aug 09, 2012
The WARN Act dilemma http://t.co/ilbxFsXD Defense, Fiscal cliff, DOL Guidance Letter saying ignore WARN act on 11/1, & elections $$ Aug 09, 2012
Hewlett-Packard?s Whitman Dismantles Hurd-Era Empire http://t.co/ySeeVM9w FD: + $HPQ She seems 2b evaluating each biz separately $$ #good Aug 09, 2012
The New York Times Is About to Say Goodbye to About,com http://t.co/frzrVlUq gives more details on the lossesv$$ Aug 08, 2012
New York Times Shares Rise on Deal to Sell About,com http://t.co/k5GarxXV Amazing how much $NYT lost on it, capital losses, neg income $$ Aug 08, 2012
Judge in Google, Oracle case seeks names of paid reporters, bloggers http://t.co/7vhmK5N3 Fascinating 4bloggers 2b paid $$ by corps quietly Aug 08, 2012
I do not get how http://t.co/ROsNYak3 could be worth $270M. What’s the revenue model? Ads? $$ http://t.co/n1ddWxvU Aug 08, 2012
Wrong: The PC looks like it’s dying http://t.co/IqeVAbi6 Like most tech, when it matures, it finds & stays there. Think of “dead” radio $$ Aug 07, 2012
Amazon Is No Wal-Mart…Yet http://t.co/cmEjPHHu Relatively neutral article on $AMZN by Martin Sosnoff; prob: treats AMZN as retailer $$ Aug 07, 2012
Why FedEx and UPS Want the Postal Service to Survive http://t.co/MAaCfOXQ Solution: raise stamp prices, and prices to $FDX and $UPS $$ #easy Aug 05, 2012

Monetary Policy

Fisher Says More Stimulus May Overburden Central Banks http://t.co/5ZMlKO5G 3-time winner of coveted “FOMC loose cannon award” speaks $$ Aug 08, 2012
Economic Musings – Fed eyeing a new kind of twist? http://t.co/aUezU2XE $$ Extending duration in MBS; creating larger losses later $$ Aug 08, 2012
RE: @bondtrader83 That’s not all that much different than the 1st Twist. It’s duration extension in MBS. Wait till ra? http://t.co/PrMHBSGh Aug 08, 2012
How about quantitative easing for the people? http://t.co/inHK9NF2 Would work better than current QE/Twist etc, but this frightens me. $$ Aug 08, 2012
Wrong: Bernanke to Economists: More Philosophy, Please http://t.co/9638QlHo Been down this road; utility theory doesn’t explain mankind $$ Aug 07, 2012

Housing & Related

Public-Housing Parking Lots Make Everyone Poorer http://t.co/2gensCd8 Set rates to achieve 15% vacancy; Rather than lots, have garages $$ Aug 08, 2012
Home Prices Climb as Supply Dwindles http://t.co/hMoZBsNZ Good news for the low end of the market, high end will take time $$ Aug 08, 2012
Fannie Mae profits rolled into rainy day fund http://t.co/bDWphSuE Good for Fannie & Freddie preferred, not worth anything 4 the common $$ Aug 08, 2012

Financial Companies & Markets

NYSE in talks with SEC to settle data probe http://t.co/FkxBtlbz Wow, faster data feeds 4 some special clients; level the playing field $$ Aug 09, 2012
Are Diamonds an ETF?s Best Friend? http://t.co/RHbSghCw Bad things happen when you take something illiquid and try to make it liquid $$ Aug 08, 2012
Richest Family Offices Seeing Fastest Growth as Firms Oust Banks http://t.co/NqY9650P UberWealthy get $$ talent; tax savings >> costs Aug 07, 2012
4 ETF Lessons From Knight http://t.co/st6wbNgR Lead Market Makers matter, Markets Work, Settlement Works, Illiquid ETFs Need Helpers $$ Aug 06, 2012
Other problem: active etf gives away trading information it might rather not divulge, leading to front-running. $$ http://t.co/q4XXZwRv Aug 06, 2012
A Tale of Two Fund Giants: American Funds vs Vanguard http://t.co/46rFsL9e Key advantage for Vanguard was embracing ETFs early $$ Aug 06, 2012

Repos

Banks? Liquidity Hinges on Risky Assets http://t.co/45Iw5Dz9 Repo lending is subject2runs during credit panics which depress collateral $$ Aug 08, 2012
Good one $$ RT @pdacosta: Watch out for the grim repo-er RT @cate_long Banks? liquidity hinges on risky assets http://t.co/9lk0GjA0 Aug 08, 2012
The danger of repo http://t.co/mZDG9Ocb Repo is weak financing in crisis; 3-mo T-bills would b a better index 4 Tsy floating rate notes $$ Aug 06, 2012

The Equity Premium

That would get the advantage of stocks over high quality bonds down to ~1-2%/year. Outperforms with a *lot* of noise $$ Aug 11, 2012
Bill Gross Is Wrong About Stocks: GMO http://t.co/c6gJwfUB Truth inbetween; have GMO adjust 4 $$ -weighted returns, not time-weighted Aug 11, 2012
Bonds for the Long Run http://t.co/MmkoYk3U @ritholtz nails it. Advantage of stocks over bonds is ~1%/yr over the long haul. Limited data $$ Aug 10, 2012

Comments

@LDrogen After reading this, I have more certainty that airbnb has already worked out some of the bugs http://t.co/Xx3ztVZv $$ Aug 10, 2012
@LDrogen Fine, Leigh, I hope it works. When single party lending gave way to securitization, it was unstoppable, until lending stds died. $$ Aug 10, 2012
RE: @ldrogen Multiple party economic dealings have their issues.? Consider: http://t.co/Z2rRNeTS? http://t.co/gCrEYzX2 Aug 10, 2012
‘ @TheOneDave In a word: depletion. Costs are rising to incremental barrels of oil, and ounces of gold. $$ Aug 09, 2012
@PlanMaestro $CLD LTD/E ~89%, take a look at $HNRG Hallador Energy. I’m not looking @ coal names until I see a few go BK, like steel 2002 $$ Aug 09, 2012
@PragCapitalist Depends on slope of demand curve 4 Tsys. Compare it2the former on-the-run. Jump of 6 bps high for that spot on the curve $$ Aug 08, 2012
@groditi Effective Yield series. Was trying to show that junk yields don’t compress as much when HQ-yields are low. Would have liked OAY $$ Aug 08, 2012
@PragCapitalist If it gets enough assets to survive $$ Aug 08, 2012
@footnoted …and maybe adjs for a year, but large writeoffs mean that prior earnings were overstated; testifies to bad mgmt quality $$ Aug 08, 2012
@footnoted That’s one reason why I tell investors to look at LT growth in BV + Divs rather than op income. I accept adjustments 4 a qtr + $$ Aug 08, 2012
RE: @bloombergview The single period cost to fix might be small, the continuous transfer cost would be considerably l? http://t.co/9gyFVvh4 Aug 08, 2012
RE: @bloombergview When games change from two players to three players, things get messy if no single player has most? http://t.co/TU09OZml Aug 08, 2012
Most pessimistic he’s been on China debts RT @groditi: Wow. I’m used to Pettis’ Euro-pessimism, but he’s not holding back here. U MAD, PROF? Aug 07, 2012
Always a great read RT @groditi: yaaaaaay new Pettis! Aug 07, 2012
@AnaCapMgmt Ain’t true. The foolish models of economists do not take into account political realities, and when inflation runs, no ammo. $$ Aug 05, 2012
@LisaCNBC Ask him how confident he is in India’s power grid. After that, the water supply. $$ Aug 05, 2012
‘ @pvitha Gold moves inversely to real interest rates, a.k.a. cost of carry, that’s all I know. $$ Aug 06, 2012
‘ @WTOP Romney shouldn’t worry about the Fed; they are out of ammo. QE is a joke, as is Operation Twist, and forward fed funds guidance. $$ Aug 05, 2012
+1 I like to say that 🙂 RT @BarbarianCap: “there are more debt claims than resources to pay them at par” Aug 05, 2012

On Complexity in Financials, and Insurers Specifically

Posted on 9 August 2012 by David Merkel

I’m not a fan of complexity in financial companies.? Complexity is a sign of trying to be” too clever by half,” as the British might say.? If an economic idea is good it can be executed simply.? Complex financial business stems from a desire to do accounting, regulatory, and other arbitrage.

Like my piece on AIG in 2009, I am doing low level research on an insurer using the statutory data. ?Let me give an example of what I mean.

There is no economic reason to have internal reinsurance treaties aside from sharing losses on short duration coverages.? To have large internal reinsurance credits is a sign that you are passing your reserves to the subsidiaries in domiciles with weak rules.

Also, to have a complex organization chart means that you are taking advantage of weak reserving requirements, capital requirements, except to the extent that national requirements call for a separate subsidiary.

Things are also tough when you interlace the capital of your subsidiaries, whether through equity, preferred stock, trust preferreds, or debt.? And with insurance companies, surplus notes.

That’s one reason why investment banks trade at low valuations, and might be better to be broken up.? Complexity.? “If you are not buying a Sunkist orange, you don’t know what you are eating.”? Okay, that dates me, but if the financials of a company are not transparent, in this environment, they will trade at a discount.? That is what I have said to reporters who have called me.? Complexity deserves a discount.? Level 3 assets deserve a discount.

Also, under-reserving deserves a discount, when you see significant claims arise out of prior year business.

Good financial businesses are simple and have few complexities to make them look like they are trying to scam the accounting rules.? Please remember my folly with Scottish Re, where I was a bull, and when it? got into trouble, I did a deep analysis, and turned into a bear.? When the company announced superficial changes and the price almost doubled, we sold out, though we held ~5% of the stock in a very busy day.? Where did the stock go out at? Zero.? Do I feel bad for losing money? Yes.? Do I feel good for cutting losses? Yes, and even more so.? Risk control is important.

Scottish Re was Bermuda domiciled, and so we didn’t get as much data as with a US domiciled company, but I had enough in the SEC-required documents to see the morass that Scottish Re was in, and the lack of ability for cash to flow to the publicly-traded holding company.

Financials are tough to invest in and the simpler that they are, the better.? To the degree that you can see that margins are assured, they are safe, but that is tough to assure.

Financials require extra caution.? That is most of what I am trying to say.

Retail Investors and the Stock Market

Posted on 7 August 2012 by David Merkel

I’ve seen a spate of articles lately on retail investors abandoning the stock market. Here’s a sampling:

Cult Figures — Bill Gross
Stock bulls have a beef with Bill Gross — Jonathan Burton
Why Are Investors Fleeing Equities? Hint: It?s Not the Computers — Andrew Ross Sorkin
Small investors vs high-speed traders — Felix Salmon
AMERICAN IDLE: FIVE REASONS WE HATE THE STOCK MARKET — Josh Brown

I chose these because I think they add to the discussion.? In general, I think there are a decent number of retail investors, that have left the markets, or reduced their exposure.

But I saw this back in 2002, when I saw many friends leave the stock market because of the losses they were taking.? Several said to me, “I am going to invest in what I know — I’m sticking with real estate.”? I winced and stuck with stocks, and had phenomenal performance in 2003.? I paid off my mortgage, and considered selling my house in 2005, but I realized for me, a house is not an investment — it’s a place to live.

After 2008, more people concluded the stock market was rigged.? Why?? Because they lost money, and that couldn’t be their fault.? Sorry, but retail investors, and many professionals too, give way to fear and greed, and chase trends.? They are not invested at the bottom, because they are too scared.? They are invested at the top, because it is the “thing to do if you want to make money.”

Call my point 1 this: People who don’t understand investing buy and sell at the wrong times.? They panic and get greedy.

Point 2: People don’t get that returns are lumpy.? They happen in spurts, over months, years, decades.? This is the big problem with financial planners — they assume smooth returns that will assure a retirement.? Sorry, but market moves in regimes, and is not easily predictable.? There are a few two decade periods where the market goes nowhere.? They are not anomalies; the value of companies are catching up to their prices.

Point 3: The estimates of equity outperformance sold by consultants, financial planners and naive journalists exaggerate the reality.? Here’s the reality: equities perform maybe 1% better than Baa/BBB bonds, particularly when you analyze the investments on a dollar-weighted basis.

Point 4: Everyone loves a winner.? People were spoiled by the returns of the 80s and 90s, and that validated in their minds the idea that more stocks are better; the projections of the financial planners are conservative; equities always beat bonds.

Point 5: Most ignore long-term valuation metrics, whether professionals or retail.? Whether it is the:

Q-Ratio
CAPE
Price-to-Resources Ratio
Whatever John Hussman has cooked up
Eddy Elfenbein’s view the stock market as a bond measure

they say roughly the same thing at present: equities are overvalued long-term.? Short-term is another matter: P/Es aren’t that high and momentum is running.? But how short is your horizon?? This makes sense if you are willing to play for months, not years.

Point 6: Professionals changed too.? In this market environment many professionals have started to trade more, as if we don’t trade too much already, and I think this is the wrong response.? As professionals, we need to do due diligence, and pick stocks we can be happy with for some time.? High frequency trading affects those who are not clever at trading.? Those who are clever disguise their trades making them look small like retail.

Point 7: But regardless of who holds stocks, they are still held by some entity.? They don’t disappear.? They move from weak hands to strong hands.? The trouble for retail investors is that they are weak hands on average.? They can’t handle disappointment, versus value investors who buy when there is disappointment.

Yes, I understand the frustration of average investors who do not do well; you are novices in a complex market.? Maybe you should just buy BBB bonds.? With the abnormal economic policies of our government, it is difficult to make any decision.

Personally I don’t think that retail investors are abnormally disappointed at present.? This is just market noise — we face overvaluation, but positive momentum.

Me?? I keep owning undervalued companies for myself and clients.

Forget Your Cost Basis

Posted on 31 July 2012 by David Merkel

All good investment decision-making is forward looking.? Whether you are buying or selling, it doesn’t matter where prices have been in the past.

Now, that said, price and volume charts may occasionally indicate where there is support or resistance.? That might be worthy of consideration in the short-run.? When I was an institutional bond manager, competing against few others, but larger others, that was more important.? Not sure it is so important when competitors are smaller.

My main concern is that investors focus forward.? Use your best data. and estimate future advantage.? Be aware of mean reversion, so don’t let mere changes in price affect your opinion.? Always aim for the best possible future return.

We win and lose constantly in the market.? Don’t let past successes delude you, they may be historical accidents. Instead, focus forward to try to see what opportunities and threats are in front of you.

There were two hard things I had to learn when I was a corporate bond manager: 1) learning to sell lower than my original sell. 2) Learning to buy higher than my original buy.? That meant I had to forget my original cost basis, and try to estimate the best forward value that I could.

That is a tough place to be, but it is rational.? Always look forward, and estimate where you will have the best outcomes going forward.? You will get superior results from doing that.

On Life Insurance and Life Reinsurance

Posted on 30 July 2012 by David Merkel

I get good questions from readers.? Here’s one from this post:

Is there a reason why life reinsurance companies are better positioned then life insurers?

Don?t they face the same problems that they won?t be able to generate as they roll their portfolios into lower yielding bonds going forward (since rates have come down so much)?

Basically just wondering why you think RGA is cheap at 84% of AOCI adjusted book but not the rest of the life insurance industry at 35%-75% of tangible book?

Is it mostly due to your opinion of management?

I started to leave a reply and the normally reliable software glitched, and I lost it. Dejected, I decided to make it a post.

First, life reinsurance is much less competitive than life insurance.? Globally and in the US, the top 5 life reinsurers have ~80% of the market share.? Life insurance is far more fragmented, and has a decent slug of mutual insurers who don’t have an explicit profit motive.? (Note: many of the large mutuals are exceedingly well run, which makes the competition even stiffer.

Second, life reinsurance is mostly mortality exposure-based, versus life insurers which are mostly investment spread based.? The law of large numbers favors the life reinsurers over the insurers.? Low interest rates will not affect reinsurers as much as insurers.? Hint to those who analyze life insurers and reinsurers: look in the statutory statements, which have a lot more data than the GAAP statements for odd reserves that indicate a significant chance of losses if interest rates continue to remain low.

Third, life insurers have weaknesses in reserving practices for variable products with secondary guarantees.? There is no good way to calculate what a proper reserve should be.? The implied options are odd, and have no natural hedges.

That’s why I only own one life insurance company; one that has simple products.? Aside from low interest rates, valuations are low at life insurers because of lack of certainty over reserves.

So, much as I like RGA management, they are not the main reason why I like the company.? RGA executes well, and has an excellent reputation in its industry.

Here’s another question that I received via e-mail:

Prices of financial services stocks are too cheap for me to resist these days. ?I see companies like Citigroup as being just given away by Mr. Market.

?Within insurance, my equity exposure is limited to AIG, which I consider to be well managed, misunderstood, and priced attractively enough to continue holding. ?Over the past month other insurers have started to grab my attention (HIG, MFC, MET, PRU). ?HIG stands out as being the least sensitive to the possibility of a decade of financial repression. ?Do you have any favorites that you would care to share? ?This topic could make for a timely blog posting.

I responded:

Value trap.? Focus on sustainable ROEs that will validate book value.? The accounting of AIG is a quagmire, even after their disposals.

There is a further difficulty with life insurers at present.? The GAAP accounting standards do not fairly reserve for secondary guarantees on insurance and annuity policies; truth, as a life actuary and a financial analyst, the options offered are so complex and long-dated, that I?m not sure there is a way to value them.? Over the last 10-20 years, we knew that this could be an issue, but we are now seeing the issue creep in as stock performance ebbs.

But if you disagree, consider PNX, it has all of the issues, and then some.? Be sure to get the Statutory books of the companies you buy here, because that drives dividend payments to the indebted holding company.

And one more e-mail:

Hi David,?? I have enjoyed reading your blog for many years (even before GGG recommended it)

I have two questions for you about insurance companies in general — I know you are very busy, I am just hoping you can point me to some websites where I can do my own homework.

(1) If I want to check the financials of a number of mutual insurance companies, is there a consolidated source??? Do I need to pull the annual statements of each one and are the different state accounting rules comparable?

(2) As I understand it (and I am quite new to this so I may have this wrong) — mutual insurance companies use “statutory accounting”, which is different from US GAAP.??? Is there a website or library book that explains the differences between these two methods????? Does statutory accounting differ from state to state?

Again, I am sure you are very busy and I will have to do my own research / homework.? You seem to be more knowledgeable than most about insurance accounting, and I am hoping you can point me to some documentation that will help me gain a better understanding.

My response:

1a)? Consolidated source: https://eapps.naic.org/insData/ , but most companies will send it to you if you ask.? Haven?t been turned down yet, aside from Berkshire Hathaway? and I?m working on that.

1b) Generally, you have to pull each one.? Some companies will do a combined set of schedules for their investments.? When I got AIG 3 years ago, there were 60+ books?

1c) There are slight differences by state, but most of the time you can neglect that.

2a) Mutual companies use statutory accounting, but so do stock companies for the state?s analysis of insurance subsidiary solvency.? And, though stock companies use GAAP for reporting to shareholders, many mutual companies will have an internal pseudo-GAAP basis for analyzing long-term profitability, and for management bonuses, yeh.? Statutory accounting is in some ways more critical than GAAP even for stock companies, because that determines how much cash can be distributed to the holding company, which is crucial if the holding company needs to make interest payments, or wants to make dividend payments.? This is one reason why actuaries often price products by calculating marginal distributable earnings.

2b) I have attached what I think is a short primer on GAAP vs Stat accounting.? This is a big topic, and the NAIC sells all manner of resources at high prices with all of the gory details.? This should give you a good start.? I general, the volunteers from the actuarial societies put out some good summary stuff, but you have to hunt for it.

Keep fighting the good fight.? Bloggers are the conscience of Wall Street and DC?

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Life insurance is tough because there is uncertainty on claim payment on timing, and uncertainty of investment earnings.? The latter is usually more serious, because the law of large numbers does not help.? Add in the valuation issues, and now you know why a life actuary primarily invests in P&C insurance companies, life reinsurers, and simple life companies.

Full disclosure: long RGA