Value Investing – Page 63

Tickers for the Latest Portfolio Reshaping

Posted on 4 September 20094 September 2009 by David Merkel

Fortunately my portfolio management methods don’t revolve around? frequent trading.? One of my kids came up to me recently and said, “What did you do today, Dad?”? I said, “I made one trade, and I did a bunch of research.”? He then asked, “How often do you trade?”? I answered, “That was my first trade in a week, and I haven’t traded much in the last two months, but that’s not normal.? There is no normal for me. When the market is really volatile, I trade a lot more, selling when stocks are rising, and buying when they are selling off.? When the market is relatively placid, I don’t do much.” He looked at me, kind of smiled, and moved on.? Information overload from Dad.

Most people and investment managers trade too often.? They sell their winners too rapidly, and panic too soon on their losers.? Now, I’m not advocating “buy and forget,” or Buffett’s statement, “Our favorite holding period is forever.”? Buffett has had a huge opportunity loss on many of his “permanent” holdings.? Granted, when you are managing that much money, it is tough, so I give him a pass, not that he needs it from me.? (Rather, I am the needy one.? If you ever read me, Mr. Buffett, sir, would you send me an e-mail?? I have one favor to ask.)

Measure twice, cut once.? Risk control is best done on the front end, analyzing what you will buy, rather than having strict sell rules that limit losses.? Many who have strict sell rules die the death of a thousand cuts.? Careful selection matters more, in my opinion.? What should you aim for at present?

A strong balance sheet
Cheap price versus earnings and book
An industry that is needed even in bad times.
Earnings quality — low earnings from accrual entries.

Well, at least that is what I am aiming for.? The following tickers are my working list of buy candidates.? If you have other ideas for me or readers, please post them in the comments.? Thanks.

ABC ACE ACGL ACN ACS AEE AEP AGL AHL ALE AMGN APA APC ATI AWH BAX BCR BDX BG BHP BOBE BP CAH CB CNQ COO COV CPWR CSC CSL CTAS CVG CVS D DST DUK ECA ED EE EFX EIX ELNK EME ENH ETP EXC FE FIC FISV HELE HES HI HON HPQ HSC IMO IVC JNJ KCI MCK MDT MGEE MRO MUR NJR NOC NOK NPK NST NTRI OCR OGE PCG PCP PDCO RIG RLI SCG SJM SNPS SO SPR SPW SRE STJ SWY SYK T TCK TFX TGI TLM TOT TRV TYC UGI UL VAR VOD VZ WEC WGL WW XEL ZMH

Full disclosure: I don’t any of the above tickers, I am not short them either.

Book Review: Finding Alpha

Posted on 3 September 2009 by David Merkel

I found this book both easy and hard to review.? Easy, because it adopts two of my biases: Modern portfolio theory doesn’t work, and the equity premium is near zero.? Hard, because the book needed a better editor, and plods in the middle.? I don’t ordinarily do this, but I felt the reviews at Amazon were valuable, particularly the most critical one, which still liked the book.? I liked the book, despite its weaknesses.

One core idea of the book is that risk is not rewarded on net.? It doesn’t matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds).? Junk underperforms investment grade bonds on average.? Lower beta and standard deviation stocks overperform on average.

A second core idea is that some people are so risk averse that they only accept the safest investments, which leaves investment opportunities for those that are willing to compromise a little with credit quality or maturity.? Moving from money markets to one year out is an almost riskless move for most, and usually adds a lot of excess return.? Bond ladders do the same thing, though Falkenstein does not discuss those.

Also, the move from high investment grade to low investment grade does not involve a lot more investment risk, but it does offer more yield on a risk adjusted basis.

A third core idea is that equities, though more risky than high quality bonds, have not returned that much more than bonds when the returns are measured properly.? See this post for more details.

A fourth core idea is that people are more willing to take risks to be wealthy than theory would admit.? Most of those risks lose money on average , but people still pursue them.

A fifth core idea is that alpha is hard to define.? Helpfully, Falkenstein defines alpha as comparative advantage.? Focus on what you can do better than anyone else.

A sixth core idea is that leverage, however obtained, does not add alpha of itself.? This should be obvious, but people like to try to hit home runs.

A seventh core idea is that when an alpha generation technique becomes well-known, it loses its potency.

An eighth core idea is that people are more envious than greedy; they care more about their relative position in this world than their absolute well-being.

One idea he could have developed more fully is that retail investors are easily deluded by yield.? They underestimate the amount of yield needed to compensate for illiquidity, optionality, and default.? Wall Street makes money out of jamming retail with yieldy investments that deliver capital losses.

Another idea he he could have developed is that strategies that lose their potency lose investors, and tend to become less efficiently priced, leading to new opportunities.? Investment ideas go in and out of fashion, leading to overshooting and washouts.

How one achieves alpha is not defined — Falkenstein leaves that blank, because there is no simple formula, and I respect him for that.? He encourages readers to devise their own methods in areas where there is not a lot of competition.? Alpha? comes from being better than your competition.

Summary

What this all says to me is that investors are too hopeful.? They look for the big wins and ignore smaller ways to make extra money.? They swing for the fences and get an “out,” rather than blooping singles with some regularity.? I like blooping singles with regularity.

I recommend this book for quantitative investors who can find a way to buy it for less than $40.? The sticker price is $95, though it can be obtained for less than $60.? Try to find a way to borrow the book, through interlibrary loan if necessary — that was how I read Margin of Safety by Seth Klarman.? Klarman’s book is not worth $1000.? Falkenstein’s book is not worth $95.? Falkenstein’s very good blog will give you much of what you need to know for free, and even more than he has covered in his book.

This book would also be valuable for academics and asset allocators wedded to Modern Portfolio Theory and a large value for the equity premium, though some would snipe at aspects of the presentation.? Parts of the book are more rigorous than others.

If you still want to buy the book at the non-discounted price, you can buy it here: Finding Alpha: The Search for Alpha When Risk and Return Break Down (Wiley Finance)

PS: Unless I state otherwise, I read the books cover-to-cover, unlike most book reviewers.? The books are often different from what the PR flacks encourage reviewers to think.? If you enter Amazon through my site and buy anything, I get a small commission.

Animal Spririts Eating Green Shoots

Posted on 1 September 2009 by David Merkel

I have never liked Keynes concept of “animal spirits.” (I reread that piece, and though it is long, I think it is worth another read.? I try not to say that about my own stuff too often.)? Businessmen are generally rational, and take opportunities when they see them.? As for those that invest in the stock market, perhaps the opposite is true — panicking near bottoms, and buying near tops.

Most businessmen are risk-averse.? They do what they can to avoid insolvency.? But debt capital is cheap during the boom phase of an economic cycle, and businessmen load up on it then.? During the bear phase of the cycle, overly indebted businessmen pull in their horns and try to survive.? At bottoms, deals are too attractive for businessmen with spare cash to ignore — businessmen are rational, and seek deals that offer profitability with reasonable probability.

Unlike this article, I’m not convinced that the news does that much to affect behavior.? Movements in asset values are self-reinforcing not because of crowd opinion, but because of the accumulation and decumulation of debt and other financial claims.? As businessmen get closer to insolvency, they trim activity.? As their financial constraints get looser, they are willing to consider more investments with free cash.

As for the current situation, I am less confident of the “green shoots.”? Yes, inventory decumulation has slowed down.? So has the increase in unemployment, maybe.? Yes, financing rates have fallen.? We still face a situation where China is force feeding loans for non-economic reasons into its economy, and where the financial sector of the US is still weak due to commercial real estate loans, bank loans to corporations, and weak financial entities propped up by the US government.? Even residential real estate is not done, because of the number of properties that are inverted, and the increase in unemployment, which I think is likely to get worse.

Applications: I think it is more likely than not that there will be another crisis with the banks, and another round of monetary rescue from the government.? I also think that many speculative names like AIG have overshot, and the advantage now rests with the shorts for a little while.? Real money selling is overcoming day traders.

Be cautious in this environment.? After I put out my nine-year equity management track record, the next project is to dig deeper in the risks in my own portfolio, and make some changes.

Avoid Risk; Make Money.

Posted on 29 August 200930 August 2009 by David Merkel

Sometimes a single article can change my direction for publishing for an evening.? So it was for this article, Hedge Fund Keeps Reins on Risk.? I had not heard of Graham Capital Management until today, but given what I read, I like what they do — they focus on risk.

I am currently reading Eric Falkenstein’s book, Finding Alpha, and I am a little less than half through it, but he makes the point quite ably that the way to make money is to avoid risk, and that those that do avoid risk tend to do better than those that take a lot of risk.? I know that this is tough to understand for those that have bee indoctrinated by Modern Portfolio Theory, but I will phrase it my own way.? Take risk when you are paid to take it; avoid undercompensated risks.

Here’s the money quote from the WSJ story:

The firm’s risk manager Bill Pertusi leads a meeting at 9:30 a.m. each day in a large room in Graham’s 93-year-old Irish Tudor mansion. There, a group of seven or so people — always including Messrs. Tropin and Pertusi — discusses all aspects of risk: market risks, risks in individual traders’ portfolios and how they have changed since the day before, risks to the way the firm is investing its cash, counterparty risk — or risk that the firm on another side of a trade will fail, even evaluations of whether traders’ are in positions that are “crowded” with other hedge funds.

“I’m not aware of anyone who has a daily meeting just to talk about risk in the absence of talking about opportunity,” according to Leslie Rahl, managing partner of risk-management firm Capital Market Risk Advisors.

Graham requires managers of some of its funds to fill in a survey every Friday, answering the question: “How much money would we lose if you had to completely liquidate your portfolio in one, three or five days, in both normal and stressed environments?”

Risks are multi-dimensional, and a wise manager thinks through all aspects of his risks.

How creditworthy are my counterparties?
How readily can I convert my portfolio to cash if I had to?
What are my competitors doing?? Are my positions in strong hands or weak hands?? How many are making the same bet that I am?
Have the fundamentals of my positions changed?? Have the views of other major players in the market changed?
Has the time horizon of other investors alongside of me changed?
What cash flow yield am I likely to get, and how might that vary?
What should we do about major moves in the markets that we trade — go with the trend, or resist it, or ignore the move?
Am I implicitly taking the same bet through seemingly different? areas of my portfolio?

Limit the downside, and the upside will provide for you.? I am not saying to avoid risk, but to take prudent risks.

Now, I try to avoid making a lot of market calls, because those who do make a lot of calls are incautious at best.? I do believe that this is a time for caution with respect to the equity markets and the corporate bond markets.? I agree with Jason Zweig here, it is a time to trim risk positions.

On another front, consider illiquidity.? Taking on illiquid investments is a bet the the future will be very good; there will be no reason to liquidate funds.? This is why there should be a substantial yield or likely return premium for investing where there is no liquid public market.? The university endowments have stumbled here; they needed more liquidity than they thought.?? So have pension plans, who aimed for high returns at the worst possible moment.

That said, some pension plans are taking money off the table in stocks in the present environment.? Good move, I think.? Even the venerable Value Line is recommending lower commitments to common stocks.

Human nature does not change, and that is what makes behavioral finance and value investing stronger.? As the market moves up, shorts cover, but greed and envy drive people to invest more in the hot sectors.

This is not limited to retail investors, though.? Even investment banks are getting into the act.? Add to the leverage and let’s take some sweet bets!? Devil take the hindmost!

I get it, and I don’t get it.? This is a time to decrease risk, even though I might be early.? The troubles of our financial sector are not solved.? Our consumers are still overleveraged.? I don’t see how we get sustainable decent returns on capital in the present environment, aside from stable sectors of the global economy.? Avoid risk; make money.

Predicting Corporate Events

Posted on 31 July 2009 by David Merkel

A client called yesterday, and asked one of my colleagues whether I could create a model that predicted corporate events.? Corporate events are typically purchases and sales of assets or subsidiaries that change the nature of a company, or wholesale change in the capital structure of a company on the whole.

My comment to my colleague was on the order of, “So, another client asking for the impossible again?? It’s one thing to try to do risk arbitrage after deal announcements; it quite another to try to predict deals.? Most of the successful risk arbs stick to confirmed, announced deals.? The guys who try to predict deals, or work with unconfirmed deals have tended to not do so well.”

Then I thought about my old Master’s Thesis, and how it predicted stock splits (another corporate event) with reasonable accuracy.? What worked?? Momentum, valuation, and maybe a few other oddities like insider trading.? Perhaps the same would be true of other corporate events.? After all, highly valued companies use their stock as currency to buy stocks with lesser valuations, and stocks with low valuations tend to buy back stock or increase dividends.

But then I thought about my series, “If you get to Talk to Management.”? Management teams tend not to change over their tenures, unless a change process has been designed in the hearts of a company.? Those few companies that have the change process have a lot of corporate events, and that is built into the stock price.? Those companies can be found by a general search of EDGAR, looking for the most filings reflecting capital changes.? I’m not sure it would be of much use, because they regularly do this; the markets are used to it.

For most companies, given the laziness of managements to do wholesale changes of strategy, it takes a replacement of a significant amount of the management team, i.e., the CEO and/or the CFO to create a lot of corporate events.? Why is this?? Most management teams implicitly assume that there is one way to get business done, and have a limited number of variables to which they are ready to respond. They are also more reputationally and emotionally invested in the mistakes of the past.? It takes real humility to admit to errors and move in a different direction.

As an aside — Perhaps that gives me a good Rumsfeld-esque nonsense question for asking a management team, “What risks are out there that you haven’t considered yet?”? ;)? But better to ask a bunch of companies, “What risks are you ready for that most of your competititors are not ready for?”

Ergo, it often takes a new management team to achieve large changes.? So, tracking management changes could be a leading indicator of corporate actions, and perhaps, excess returns, if combined with a little analysis for undervalution of the assets of the company.

I don’t want to overplay this one.? There are a lot of links in the chain here; I’m not trying to minimize the difficulties here, which include:

Successfully setting up news retreival sources that sort through the news for major companies, catching the significant news while not getting a lot of unwanted news that doesn’t fit the paradigm.
Being able to sense the significance of the management change.
Analyzing the potential increase in value of assets used differently than before, and/or changes in financing.

This doesn’t promise to be easy, but maybe it will surface some promising ideas — I’ve made money on turnarounds before; perhaps this will help with the future.

Book Review: Mr. Market Miscalculates

Posted on 29 July 200920 June 2017 by David Merkel

Since the first time I read him, I have been a fan of James Grant.? He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.? Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.? When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”? For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.? This book followed the same format, reprinting the best of old columns, with modest commentary.? In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?? Isn’t that a waste of time? That depends.? Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?? Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

How does monetary policy affect the financial economy?
Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
Why do value (and other) investors need to be extra careful when investing in leveraged firms?
What is risk?? Variation of total return or likelihood of loss and its severity?
Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
Why great technologies may make lousy investments.
Why does neoclassical economics fail us when trying to understand the financial economy?
How does one recognize a speculative mania?
And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.? Being too early means you eventually get disregarded.? The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.? That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.? You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

Those that have assumed that neoclassical economics adequately explains the way our economy works.
Those that want to understand how monetary policy really works, or doesn’t.
Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,? but your costs don’t go up.?? Also, thanks to Axios Press for the free review copy.? I read the whole thing, and enjoyed it all.

Industry Ranks

Posted on 18 July 2009 by David Merkel

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.? The first part of this is industry analysis.

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.”

Now, as a bonus to Aleph Blog readers, I’ll share with you my second industry rotation model, which I put out weekly to clients.? This model looks at the S&P 1500 Supercomposite, and using price momentum, among other factors, encourages the purchase of equities that have done well over the past? year.? Comparing it to the first model, this report always works in the red zone, because price momentum tends to persist in the short run.? This is a short term model.

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 wth more potential over the next 1-5 years.

Anyway, consider this, and if you have more good ideas on industries, share them with the group.? I can always learn more.

Book Review: The Myth of the Rational Market

Posted on 14 July 200914 July 2009 by David Merkel

There are few books that I read that leave me feeling as if I have taken a trip down memory lane.? The Myth of the Rational Market was that for me.

In my junior year at Johns Hopkins, I wrote my senior thesis on predicting splits in the stock market.? I had to do it in my junior year because I had applied to do a combined BA/MA in political economy in my senior year.

My thesis, springing from what I had learned in Dr. Carl Christ’s class on financial economics (which in itself was an anomaly in the political economy department), forced me to analyze the then-fresh literature on event studies on efficient markets, including the famous paper by Fama, Fisher, Jensen, and Roll on how it was impossible to make money off of stock market splits.

That paper was important, because prior research was not agreed on the topic, and it was an example of something not all that significant that could be a signal of greater things — that managements would only split the stock when they had confidence.

Young David, having been raised in a home where his self-trained mother had regularly beaten the market, found the efficient markets hypothesis less than compelling.? Like his mother, he felt that superior analysis of fundamentals should outperform.

But here was a situation where it was obvious that stocks that split outperformed before they split.? My thesis asked, “Could splits be predicted?”

Going through the literature, I came up with some variables that could be useful — some were valuation-based, some were technical (price, volume), and some were anomalies (insider trading).? I ended up finding that stock splits could be predicted more often than not, but more importantly, that the variables that correlated with stock splits were more generally correlated with outperformance (in the 7%/yr region).? Those variables included valuation, momentum, and insider trading — which for a paper written in 1982 was notable.? I concluded that the Efficient Markets Hypothesis was flawed, also notable for its time.

Wait — this is a book review.? As I read Justin Fox’s work, I admired its ambition.? This attempts to cover financial markets efficiency, with some efforts toward economic efficiency generally.? It covers a lot of ground — all of the major players in the efficiency of financial markets debate are featured, and written about in simple language — there are no equations to wade through as I once did.? This book is comprehensive, and touches on many of the more obscure critics of the Efficient Markets Hypothesis.? Bright men who are tangential to the Financial Economics profession get their play — Kahneman, Tversky, Minsky, Mandelbrot, and more

Many of these men that questioned market efficiency went down the same trail that I did; they were led by the data, which conflicted with neoclassical economic theory.? Many of them came to my view that the market is pretty efficient, but not perfectly so.? Efforts at finding inefficiency promote market efficiency.? Efficient markets make people lazy, which leads to inefficiencies that can be profited from.

I liked this book a great deal.? It gets a bit thin at the end when it tries to incorporate the current crisis into its framework.? More broadly, it is at its weakest where it merely touches on a significant contribution, but does not dig deeper.? That said, a book of 500 pages would be far less readable than one of 300+.

Who would benefit from this book:

Those who are too certain about their positions on market efficiency.
Those that assume that the market is always or rarely right.
Those that select asset managers, because there is a lot of volatility around investment returns.? What is luck? What is skill?? We know less here than we imagine.
Academics in economics that are not familiar with the finance literature, because this would give an outline of the questions involved.

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When I do book reviews, I actually read the books.? In the few cases where I scan a book, I reveal that in the review.? I also offer the easy ability to buy books through Amazon.com, and if you want to buy this book click here:? The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Full disclosure: if you buy anything through Amazon after entering through my site, I get a small commission, but your costs do not go up.

Some Practical Thoughts on Asset Allocation

Posted on 12 July 2009 by David Merkel

When I think about asset allocation, I typically begin with my model that chooses between BBB corporate bonds and common stocks.? The model still favors corporate bonds.? After that, I look at the bond market, and ask myself where I think risks have more than adequate compensation.? I look at the following factors:

Duration (Average Maturity is similar, sort of) — do we get fair compensation for lending long?
Convexity — does the bond benefit or get hurt by interest rate volatility?
Credit — are we getting decent compensation for credit risk?
Structure — Structured notes always trade cheap to rating, but how cheap?
Collateral/Sectors — Are there any collateral classes or sectors that are trading cheap to their fundamentals?
Illiquidity — are illiquid issues trading stupidly cheap?
Taxes — How are munis trading relative to tax rates and creditworthiness?
Inflation — is the CPI expected to accelerate?
Foreign currency — if nothing looks good on the above (or few things look good), perhaps it is time to buy non-dollar denominated notes.? My view is buy foreign currencies when nothing else looks good, because foreigners will do the same.

At present, I am not crazy about corporate credit relative to other bonds.? I would move up in quality.

We are getting decent compensation for duration risks, so I would buy some amount of long Treasuries.? I would also hold some cash, running a barbell.

On convexity, I would be market weight in conforming mortgages.? If I had an edge in analyzing non-conforming mortgages, I would buy highly rated tranches of seasoned deals (2005 and before).

I would do a lot of analysis, and buy seasoned CMBS (2005 and before) — there are real risks, but the seniors should not get killed.

Munis offer promise for taxable accounts — the difficulty is doing the credit analysis on long bonds.

On inflation — I am not a fan of TIPS right now.? I would rather buy foreign bonds.? The actions of foreign nations lend themselves to dollar depreciation.

So, where would I go with a portfolio that has an intermediate horizon, say, 5-10 years out?

30% global equities — half US, half foreign (emphasize value, but not financials)
15% long Treasuries
15% residential mortgages — seniors, conforming
10% CMBS seniors
15% cash
15% foreign bonds

Yeah, I know this seems conservative, but I am not a believer in the current rally in stocks or corporate debt.? This is a time to preserve capital, not hunt for yield.

Toward a New Concept of Asset Allocation

Posted on 10 July 2009 by David Merkel

To my readers: thanks for your responses to yesterday’s article.? I will do a follow up piece soon.? If you have more comments please make them — they will help me with the piece.? Main new concepts coming — need for a deliverable, speculators can’t trade with speculators, only hedgers.

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Longtime readers know that I am not a fan of modern portfolio theory.? It is a failure for many reasons:

It assumes there is one type of risk, the occurence of which is random.
It assumes that this risk can be approximated by volatility (variance of returns), rather than probability of loss, and the likely severity thereof.
Mean return estimates, volatility estimates, and correlation coefficient estimates aren’t stable.
In crises, correlations head to 1 or -1.? Assets divide into safe and “not safe.”
Problem: some assets always fall into the “not safe” bucket, but what falls into the safe bucket can vary.? Long Treasuries and commodities could be examples of assets that vary during a crisis, depending on the type of crisis.
It does not recognize multiple time horizons easily.? Bonds held to maturity have a different risk profile than a constantly rebalanced portfolio.
Risk is the same for all people, and their decision-making time horizons are the same as well.
And more…

I’m still playing around with the elements of what would make up a new asset allocation model, but a new model has to disaggregate risk into risks, and ask some basic questions:

Where am I getting paid to take risk?
Where am I getting paid to avoid risk?
What aspects of the financial landscape offer the potential for a change in behavior, even if it might take a while to get there?? What major imbalances exist?? Where are dumb people making money?
Where options are available, how is implied volatility relative to long-term averages?
What asset classes have momentum to their total returns?

One good example of an approach like this is Jeremy Grantham at GMO.? Asset allocation begins by measuring likely cash flow yields on asset classes, together with the likelihood of obtaining those estimates.? With domestic bonds, the estimates are relatively easy.? Look at the current yield, with a haircut for defaults and optionality.? Still there is room to add value in bonds, looking at what sectors are cheap.

Are corporate spreads narrow or wide?
How are residential mortgage bonds priced relative to agency bonds, after adjusting for negative optionality?
How steep is the yield curve, and where is Fed policy?
What is the speculative feel of the market now?? Bold? Scared? Normal?
Related, how are illiquid issues doing?? Are they permafrost, or are molasses not in January?
If every risk factor in domestic bonds looks lousy, it is time to make a larger allocation to foreign bonds.
Cash is underrated, and it is safe.

Understanding bonds is an aid to understanding the rest of the market.? The risk factors in play in the bond market are more transparent than elsewhere, but the rest of the markets eventually adjust to them.

With stocks and commodities, the answer is tougher — we have to estimate future demand and supply for commodities.? Tough.? With stocks, we need to estimate future earnings, and apply a P/E multiple that is consistent with the future yield on BBB corporate bonds.? There is some degree of mean-reversion that can help our estimates, but I would not rely on that too heavily.

There is one more aspect to layer in here: illiquidity of equity investments.? With limited partnerships of any sort, whether they are hedge funds, venture capital, private equity, etc., one has to analyze a few factors:

Where is the sector in its speculative cycle?? Where are secondary interests being sold?
How much capacity do you have for such investments?? How much of your liability structure is near-permanent?? Is the same true of peer institutions?
Is the public equity market overvalued or undervalued?? Public and private tend to track each other.

Beyond that we get to the structure and goals of the entity neding the assets allocated.? Time horizon, skittishness, and understanding levels are key for making a reasonable allocation.

This is just my initial brain dump.? It was spurred by this article in the WSJ, on how asset allocation had failed.? Add in the article on immediate annuities, which are a great aid in personal retirement planning.? For those that think that immediate annuities reduce the inheritance to the children, I would simply say that it is longevity insurance.? If the annuitant lives a long time, he might run out of assets, and might rely on his children for help.? The immediate annuity would be there to kick in something.

Why did asset allocation fail in 2008?? All risk assets failed.? Stocks, corporate bonds, venture capital, private equity, CMBS, RMBS, ABS… nothing held up.? There were just varying degress of loss.? Oh, add in Real Estate, and REITs.? Destroyed.? Destroyed…

When the system as a whole has too much leverage, all risky asset classes get affected.? That’s what happened in 2008, as speculators got their heads handed to them, including many who did not realize that they were speculators.