The Aleph Blog – Page 121 – Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control

Cato Institute 30th Annual Monetary Conference, Part 2

Posted on 15 November 2012 by David Merkel

Moderator: Zanny Minton Beddoes
Economics Editor, The Economist

Thomas Hoenig
Vice Chairman, Federal Deposit Insurance Corporation

Tells us to be skeptical of changes in financial regulation.? Incentives have not changed to favor increased leverage in financial institutions.? Protecting big banks has further worsened incentives.

Safety net started w/FDIC — insuring bank deposits makes payments system safe.? Investment banking, more volatile stays outside.? As commercial and investing banks were made to compete, the safety net expands, de facto.

1) Banks should spin out their investment arms into separate entities.

Lehman had a short-financed balance sheet, and relied on the government to protect them.

2) Need to rethink the capital approach.? Dump Basel.? Simplify, it is too easy to game.? Increase capital levels.? (DM: As I say, dumb regulation is good regulation.)? Need a simple tangible capital ratio.? Need to negotiate a tangible capital ratio, and a transition period.

Tangible capital during unregulated periods 13-16%.

3) Re-establish bank supervision as a tool to uncover risk.? Real supervision would find risks, and raise capital when needed.? (DM: how do we get mean regulators back.)

Jeffrey A. Miron
Senior Fellow, Cato Institute, and Director of Undergraduate Studies in Economics, Harvard University

Should we try to avoid market crises?

1) Avoiding crises is not a main goal of policy.

Policy in his view is maximizing economic growth.? Growth was not materially affected by crises 1790-1915.? (DM: his log graph hides the real panics.)

Great Depression and 2008-2012 are unique events.? Criticizes Bernanke view of the Great Depression, where bank failures happened near the bottom of the cycle.

Reinhart & Rogoff — recoveries after panics are slow.? Happens because debts have to be reconciled.? (Has a variety of less realistic reasons for the slowness.)

2) Policies to stop crises may hurt more than help.

Policy should be neutral to the sectors of the economy.? Bernanke’s policies are not neutral, aiding housing.

People want to reduce volatility, but that could hurt more than help.

He argues that we should promote freedom and growth.? Reduce government, etc.

Lawrence H. White
Professor of Economics, George Mason University

Create an anti-fragile banking system, a la Taleb.? Anti-fragile: gets stronger from small problems.

Suggests reducing deposit guarantees, and eliminating central banking, because they increase fragility.

Banking is not naturally fragile, White says. (Lots of hand waving, and looking at foreign examples where small failures did not impair the system.)

Suggests that pledging not to bail out banks will make everyone more careful.

We have a less-diversified financial ecology where many are pursuing a single strategy.? Heuristics of having a high tangible capital ratio would aid regulation.? Basel III is the wrong idea — too complicated, and Basel I & II did not help.

Robert L. Hetzel
Senior Economist, Federal Reserve Bank of Richmond

What do central banks control, and how do they control it?? Macro models turn correlation into causation, and obscures the the buildup in debt, which eventually collapses.

If you want to understand causation, you have to have models.? Uses an example from the 1812-1820 period, where small Treasury notes expand the monetary base, leading to inflation, a run for gold, and later a collapse.

Runs out of time.? Suggests we need more intelligence regarding what central banks can and can’t do.

Q&A

Hoenig: Unlimited liability would be good, but you will politically never get there.

White: Banks arbitrage risk weights.? Zero risk weight for government debts were a fail.

Poole Q: Economics not hard, but the politics are hard.? Eliminating bailout support is impossible — in a crisis, bailouts happen, unless you eliminate the authority, or narrow the banking institutions.

Did existence of the FDIC cause the crisis? Risk-based insurance premiums?? Hoenig: we do risk-weight in some ways… but could you create a bank run from that?

Hoenig: FDIC has a reinsurer, the US Treasury.? White: clearinghouse model worked pre-Fed.

Hoenig: Sweden increasing capital standards above Basel.

I asked my question on asset-liability mismatch — the answer was the usual that you can’t end maturity transformation, and that taking duration risk is a risk like any other.

Cato Institute 30th Annual Monetary Conference, Part 1

Posted on 15 November 2012 by David Merkel

Note to readers: these are my notes from the conference, as such, they will be rough.

Keynote: Vernon L. Smith, Professor of Economics, Chapman University, and Nobel Laureate in Economics

Main points: 1) we get bubbles because we misfinance long-term assets, typically housing.? We borrow short to finance a long-term asset.? Examples: Great Depression and now.

Other housing distortions: waiving capital gains taxes, deduction for interest, offering credits to buy mortgages, GSE financing, etc.

Housing is the largest part of the growth in debt.

2) Leverage cuts far deeper on the downside than on the upside.? That’s because it is easier to buy a house than to liquidate an inverted debt.

If incomes do not grow to meet the need to finance incremental debts incurred, you set up a debt financing crisis.

Bernanke cut rates 8/2007-9/2008 in the midst of a solvency problem as opposed to a liquidity problem.? Cutting rates would/did not work.

Financing was short-term for housing in the Great Depression.

If you want to separate underwriting and investing, make incentives to underwriters proportionate to principal repayment.

3) How to fix a debt deflation slump:

WWII did not end the Great Depression — many debts compromised, paid off by 1941.

a) must pay off and compromise bad debts.

b) banks mark assets to market, some fail.? Alternative is Japan, where there is no recovery.

Without significant defaults, there is no way to eliminate a debt deflation.

The Rules, Part XXXVI

Posted on 15 November 201221 May 2013 by David Merkel

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

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

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

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

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

Don’t be a Fool

Posted on 14 November 201214 November 2012 by David Merkel

When I wrote for RealMoney, I would often write things critical of others, but not identify my target.? Why?

I didn’t want to get kicked out, or have a fight that would discredit RealMoney.
But I did want to teach general principles.

I maintain that practice to this day.? Typically, I don’t name names.? Again, two reasons:

I don’t want to get sued.
But I do want my readers to understand what are shoddy practices, so they can avoid them.

Recently, a large investment website has been loosening up their standards for who they will allow to advertise via e-mail.? Here is one redacted advertisement:

A New Strategy With Startling Results

Dear Investor,

A small group of XXX clients are making 20% to 40% in trading profits…PER DAY.

They call it ?Exploiting the Banker?s Market.?

Their trading methodology is unlike anything you?ll find in today?s financial marketplace.

And best of all, their newsletter is totally free.

Honestly, this is the only investing newsletter worth your time.

?Sign up for free now. [link removed for your protection]

Sincerely,

XXX Investing Team

P.S. By exploiting the banker?s market, they just hit winners on 19 out of 22 trades, including gains of 45%, 48%, 56%, and 78%.

Prior to this, they took gains on 30 out of 33 trades. You can achieve these same returns. It’s simple.

As long as the bankers remain in control of the markets (and now that Obama got re-elected, you know they will), this unique trading methodology offers you a safe and consistent way to profit.

If you?re interested in profiting day after day ? even if the bankers and the Fed are working against you ? then do not miss these unique trading strategies.

It?s all revealed to you in this free newsletter. [link removed for your protection]

YYY
30 Forest Ave
Naperville, IL 60540

Note that YYY is a penny stock promoter.? XXX may be decent enough, aside from their willingness to employ YYY.? Investing in options is a ticket to the poor house for most, because the market is not very liquid.? It is very hard to make money trading options.? Most lose money doing so.

But here is another from the same e-mail list:

Dear Investor,

Where were you on August 13, 2012, when tech-stock guru WWW gave the green light on EZchip Semiconductor (EZCH), then trading at $28.36?

Well, maybe it doesn?t matter because very few investors had ever even heard of this red-hot networking chip company.

But on November 8, EZchip reported a huge earnings beat and rallied an incredible 15% to $34.80 in one day, delivering a 23% gain for ZZZ subscribers [link removed for your protection] who bought alongside Sean at the $28 level.

So we?ll ask you some simple questions?

Do you want to make money off of hot technology trends that have nothing to do with how the US Fiscal Cliff and European drama play out?

Would you like to get in on the hot storage play at which Facebook (FB) and Apple (AAPL) are throwing money?

Or the semiconductor producer that is printing money on the global transition to 4G/LTE smartphones?

How about the left-for-dead social-media play that is about to rise like a phoenix?

If you answered yes, then we’ve got an offer for you.

We?re giving you an exclusive 30% discount on an annual subscription to ZZZ [link removed for your protection] , WWW?s exclusive money-making tech stock newsletter that will help you do all of the above and more.

For just $447 (a savings of nearly $200!), you?ll receive:

? ? ? ? ?

? ? ? Exclusive access to WWW?s hand-picked portfolio of technology stocks ?

? ? ? ? ?

? ? ? Instant e-mail updates whenever WWW makes a trade or initiates new coverage ?

? ? ? ? ?

? ? ? Expert analysis of the most important tech-industry news ?

? ? ? ? ?

? ? ? Access to quarterly webcasts, where WWW delivers in-depth analysis of the technology industry ?

? ? ? ? ?

? ? ? WWW?s special report: 5 Stocks That Will Gain 50% From Apple TV ?

? ? ? ? ?

But most importantly, with a ZZZ subscription, you will get direct access to Sean, who stands by ready to answer any and all reader questions through our regular mailbag feature.

Sean?s goal is simple: to have your ZZZ subscription pay for itself many times over through winning trades while keeping you up to date on everything that?s hot in tech.

So, do you want in? [link removed for your protection]

Advertisements like this appeal to dopes.? There is no easy money in the market.? Anyone can cherry-pick a record of risky calls and show a bunch of wins.? What of the losses? How many and how severe were they?? Why don’t you show the results of an audited real money portfolio that you managed?? What, you didn’t put any real money behind? these calls?

Look, when advertised results are too high, they usually aren’t real.? Get smart.? Avoid websites that propagate such nonsense.? Anyone willing to sully their reputation for a bunch of cheap advertising revenues is not worth your time.? I get about 10 advertising proposals per week, and I turn almost all of them down.

If it seems too good to be true, it is false.? Avoid reaching for the rare exception, and you will be much better off.

The Rules, Part XXXV

Posted on 10 November 201213 November 2012 by David Merkel

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

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

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

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

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

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

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

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

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

Sorted Weekly Tweets

Posted on 10 November 2012 by David Merkel

Politics

California Democrats seize super majorities in both houses of Legislature http://t.co/Wp2cVYTF CA businesses plan exit strategies $$ Nov 08, 2012
Harsher energy regulations coming in Obama’s second term http://t.co/JHDKAhok Fracking, chemical emissions, & more $$ -losing green energy Nov 08, 2012
US crop insurance a post-election target, farm bill elusive http://t.co/9OdbRVjy W/Ag doing so well over last 5 yrs, this should b ez, not Nov 08, 2012
Ethanol Going Ugly Turns Bush Plan Into Obama Test http://t.co/Pe6ixxc1 Should b a no-brainer, but Congress ag state politics r ugly $$ Nov 08, 2012
Could This Be End of Evil Filibuster? http://t.co/t72aR3OR Limit filibusters to actual votes & require physical presence on the floor $$ Nov 08, 2012
Obama Win Means Health Overhaul to Move Ahead in States http://t.co/ybXggsLt Destroy health care 2 replace it w/single-payer system $$ Nov 08, 2012
Yep, There Have Been Problems With Email Voting in New Jersey http://t.co/lZjzVNrG In general, probability of fraud in voting is rising $$ Nov 07, 2012
Defense Fund Rockets to Four-Year High: Romney Rally? http://t.co/3fzUDRTH Discounting Obama’s change of heart after election $$ 😉 Nov 06, 2012
Romney Threatens Pimco?s Gross With Bernanke-Dumping Plan http://t.co/xO6Tm0aF 2 many links in the chain of reasoning; low prob correct $$ Nov 06, 2012
Southfield Twp. voter appears to die, then asks ‘Did I vote?’ http://t.co/2ZwRgotp I found his words to his wife 2b touching in many ways $$ Nov 06, 2012
Tuesday Is Election Night, Be Careful What You Tweet http://t.co/UdPPMYiJ Measure twice, cut once, tweeps. & bring a dose of skepticism $$ Nov 05, 2012
Three Men Make a Tiger http://t.co/eX1PziJK John Mauldin predicts Romney as victor; piece is mostly about eliminating confirmation bias $$ Nov 05, 2012

China

China: Worse Than You Ever Imagined http://t.co/Kp69IC1n 40MM+ people were killed during the “Great Leap Forward.” Mao deserves derision $$ Nov 08, 2012
China’s leadership challenge in new era: douse “inequality volcano” http://t.co/pJiAksUl Widespread poverty in China scares Communist Party Nov 08, 2012
A Cheerleader for Mao’s Cultural Revolution http://t.co/d3RhdV95 Lied about Cultural Revolution & The Great Leap Forward. Millions died. Nov 08, 2012
The Chinese Credit Bubble – Full Frontal http://t.co/MDZn1jCs As I have argued for some time, total debt in China is quite high $$ #danger Nov 07, 2012

Companies

Peltz Takes Stake in Danone http://t.co/P1AdRe9G Danone $DANOY is a French firm, will be difficult to encourage change $$ Nov 08, 2012
Prudential Records $618 Million Loss on Derivatives http://t.co/6ZQK1Uk5 I worry about life industry; the acctg 4 secondary gtees: yuck $$ Nov 08, 2012
Nucor Galvanizes Gas Hopes http://t.co/NmfZ9fmJ $NUE provides capital 4 development of gas resources of $ECA -Gets 50% stake in wells $$ Nov 08, 2012
Office Depot-OfficeMax Deal Seen Rescuing Value http://t.co/bNsFKuJU The failure of office retailers as the non-profit $AMZN undercuts $$ Nov 07, 2012
SapuraKencana Agrees 2 Buy Seadrill Tender Rigs http://t.co/XXrAsjFj Interesting deal, clever investor; expands Malaysia exposure $SDRL $$ Nov 05, 2012
Sharp blunted, and it?s not alone http://t.co/5jTHzKuN Argues that Japanese electronics mfg & exports r getting killed by strong yen $$ Nov 04, 2012

Federal Reserve

Inflation, QE and forcing the banks to lend http://t.co/XuPgRPJm I’ve subscribed 2 The Economist for 25 years; they r getting dumber $$ Nov 04, 2012
Casting Dual Roles, at Treasury & the Fed http://t.co/kIwpAzZ3 Bernanke’s Last Supper & The Return Of Larry Summershttp://bit.ly/Sp9PBZ $$ Nov 04, 2012
Off of the last tweet, it would be nice 2c Bernanke retire; he really may b tired of the abuse. His prob was he thought he knew what 2 do $$ Nov 04, 2012
& as a result, could not c that Neoclassical macro does not work with an overindebted economy. We need fewer economists at the Fed & Tsy $$ Nov 04, 2012
Wrong: Seth Klarman Goes Nuts On The Fed In His Latest Investor Letter http://t.co/G6gAkMfU Y I think value investors should run the Fed $$ Nov 04, 2012
Seth Klarman, like most value investors, is farsighted & not just thinking about how to goose GDP for the next year. Klarman 4 Fed chair $$ Nov 04, 2012

Eurozone

Convergence between the core and the periphery economies in the Eurozone http://t.co/2oD2exeV Drowning PIIGS pull Germany & France under $$ Nov 08, 2012
ECB & Fed: Worlds Apart http://t.co/zZuaFiXU Axel Merk praises the ECB & disses the Fed. Argues that ECB has not gone fiscal as the Fed has Nov 08, 2012
Unsteady Greek Coalition Faces More Strikes http://t.co/dxQJYzmw Suspect they make it through; Greeks don’t want 2 leave Eurozone yet $$ Nov 05, 2012
The peripheral threat to France http://t.co/0atOAKZq Many of the PIIGS r getting more competitive relative 2 France. No E-zone w/o France Nov 04, 2012

Rest of the World

Old People Versus Babies, In One Graph http://t.co/Erk2Mu8z Global demographic crisis in one very easy to manipulate graphic $$ Nov 08, 2012
Iceland Sees Mortgage Bubble Threat From Foreign Cash http://t.co/djtYZDxw The problems of capital controls start to bite $$ #nofreelunch Nov 06, 2012
Turning Trash Into Tidy Profit http://t.co/FvM32C3a Optimistic story on turning trash into durable building materials in Senegal $$ Nov 05, 2012

Sandy and Disaster

Frederick County teen wins regional science competition http://t.co/F72thGx3 The software can read a picture & tell where it is. $$ Nov 08, 2012
Sandy’s Aftermath: Samuel Pritt Develops Geolocation Software http://t.co/InnwZaGe Young friend won Siemens US Science Competition $$ Nov 08, 2012
Insurance divides haves from have-nots after Sandy http://t.co/NngZdchm Insurance is for catastrophes; scrimp on frequency, not severity $$ Nov 04, 2012
Reserved Buoyancy, Down-Flooding, and Living Off the Grid http://t.co/TXxn9f6e The value of slack in physical systems, especially boats $$ Nov 03, 2012

Market Dynamics

FIRE IN THE DISCO! http://t.co/YComOnGA @reformedbroker warns us that a recession is coming, & talks about a decline in corporate profits $$ Nov 08, 2012
Even 6.75% is too high. Looking at the Q-ratio, CAPE10, & long high quality bond yields would make 4% more realistic http://t.co/vjP0X7y1 $$ Nov 06, 2012
Lightening the Pension Load http://t.co/bi2j6cdJ Never thought I’d c terminal funding return; can b bad 4 annuitants if insurer fails $$ Nov 06, 2012
Fitting Factors Into the Formula http://t.co/35speWwR Bob Arnott& Cliff Asness discuss quantitative investing; long article worth reading $$ Nov 06, 2012
TAGP expiration will put downward pressure on short-term yields http://t.co/YgwmR2bu Once guarantee goes, much S-T $$ will look 4a home $$ Nov 06, 2012
Cash as Trash, Cash as King, and Cash as a Weapon http://t.co/fWS1TOTl In different environments & hands, cash has different properties $$ Nov 06, 2012
Wrong: Is Your Manager Skillful?or Just Lucky? http://t.co/vJu2tTrd Bill Miller neglected “margin of safety” & reaped bad results $$ Nov 05, 2012
http://t.co/VRj1k4Vg They didn’t read paper closely. Performance of anomalies diminished, not destroyed, by publishing academic research $$ Nov 05, 2012
For John Maynard Keynes, Economic Theory Was a Sideline http://t.co/IVdB6Gyc He was a better investor than he was an economist $$ Nov 05, 2012
It?s the Earnings, Stupid: ?Atrocious? Q3 Turns Josh Brown Cautious http://t.co/a2ChJKTL Time 2b cautious says @reformedbroker. Calendar? Nov 05, 2012
“All I know: The next bankruptcy cycle, whether in 2 or 3 or 4 years, is going to be one for the ages. Count on it.” http://t.co/xtHy7lqj $$ Nov 03, 2012

Policy

A New Idea of How to Fix the Ratings Agencies http://t.co/fTEECPUP by @carney | My response: http://t.co/3dWFo2Pv $$ Nov 06, 2012
Investors won?t read the fine print http://t.co/t2W8Nrk9 Even many institutional investors become overworked, lazy, etc. & don’t read $$ Nov 06, 2012
Hero of the day, CPDO edition http://t.co/wIxyPo2T I remember 2006 when @alea_ @interfluidity & I (@ Realmoney) were criticizing CPDOs $$ Nov 05, 2012
Health-Care Law Spurs Shift to Part-Time Workers http://t.co/0ui2LGvm Law of unintended consequences: How 29-hr workweek got created $$ Nov 05, 2012
10 things walk-in clinics won?t tell you http://t.co/qKPj3D3R Major factor is the loss of continuity u have w/doctor who knows u $$ Nov 05, 2012
After Bailout, Giants Allowed to Dominate the Mortgage Business http://t.co/K9HZZWDu “Is this what we saved [the financial system] for?” $$ Nov 04, 2012

Retweets

Can say that again RT @bespokeinvest: Wow, big selloff in the last couple minutes of trading. Dow down 430 points since Tuesday’s close. $$ Nov 08, 2012
Some gift RT @pdacosta: Gift that keeps on taking: France, Belgium agree to pump 5.5B euros into bailed-out Dexia http://t.co/qgq8PI6R Nov 08, 2012
RT @ReformedBroker: This Greek austerity bill is the equivalent of slapping a Kick Me sign on the Troika’s back. Gives us one day’s peac … Nov 07, 2012
Rupert goes back to sleep $$ RT @felixsalmon: RT @dansabbagh: Pearson says FT is not for sale. “This particular Bloomberg story is wrong. ” Nov 06, 2012
RT @SimoneFoxman: you’ve got to be kidding me. — Southfield Twp. voter appears to die, then asks ?Did I vote?? http://t.co/2ZwRgotp Nov 06, 2012
First of many 2 come RT @FrancesDenmark: Indiana is the first state to drop its pension return expectations below 7.0% http://t.co/ir8anqN4 Nov 06, 2012
Murdoch would b interested $$ RT @ReformedBroker: The Financial Slides RT @TheStalwart: Who will buy the FT? Maybe BI in a reverse merger? Nov 06, 2012
Bite your tongue 🙂 Janet Yellen has exceeded the Peter Principle $$ RT @fundmyfund: precious metals say = janet yellen here we come Nov 06, 2012
Easy 2 talk tough, hard 2 not repay $$ RT @munilass: So much for cities standing up to Calpers http://t.co/xWIciI4C Nov 06, 2012
marriage changes u $$ RT @moorehn Surprising: single & married women are further apart politically than men & women r http://t.co/b4adY1pc Nov 06, 2012
Probably priced in $$ RT @kyles09: isn’t the exp of TAG a negative for the big bank stocks or do you think it is already priced in? Nov 06, 2012
I was just looking forward to the end of the political season, sigh RT @jfahmy: Hillary Clinton listed as current 2016 favorite (6:1 odds). Nov 05, 2012
Dog bites man RT @TheStalwart: National Review endorses Mitt Romney http://t.co/ZBAptg8Q Nov 05, 2012
Wow $$ RT @businessinsider: New York Magazine’s Breathtaking Cover Shows Manhattan From Up In The Sky by @KimBhasin http://t.co/FaTgCqA1 Nov 03, 2012

Replies

@valuewalk Thanks. $DANOY might do what they can to improve margins, but might play badly in France. Has mgmt been s/h-friendly in past? $$ Nov 08, 2012
@Frank_McG Very cool. We homeschool — only 4 left, 1 senior, 2 freshmen & a 5th grader. My wife is having a blast. $$ Nov 08, 2012
@TheOneDave You’re welcome — you do some great stuff Nov 07, 2012
@TheOneDave Hey, Dave, don’t see where we can get the Chart… Nov 07, 2012
@amacker Floating NAV, hehe Nov 07, 2012
@TheStalwart My friend and former boss Eric Hovde would have beaten Baldwin, and handily… Nov 07, 2012
@kyles09 My actuarial conservatism, and knowing that God can do whatever he wants with me Nov 07, 2012
@carney I hear you: I’m going to write a piece where I take my “eliminate the rating agencies model” and clarify it http://t.co/x4WsWaj3 $$ Nov 06, 2012
@PragCapitalist Thanks, Cullen. I applied that idea to corporate board elections when writing 4 Realmoney, Shame it didn’t get traction $$ Nov 06, 2012
@michaelroston Yes, but there is a lot of $$ on both sides, and the phones ring. WV & PA gambling firms & Christians vs MD gambling firms Nov 06, 2012
@michaelroston However, if you live in MD all u hear about is 7, the ballot measure expanding gambling. Other measures: <crickets> $$ Nov 06, 2012
@BradErvin1 That’s what I am saying — they r taking consensus risks $$ Nov 05, 2012
@BradErvin1 But my point about the balanced funds is this: in the selection he could invest in, they r all taking the same broad risks Nov 05, 2012
@BradErvin1 57, Married, one kid at home, significant assets good job, wife w/good health, 52, he not so healthy, has saved aggressively Nov 05, 2012
@FriedrichHayek I knew that Keynes got bailed out once (or was it twice?), but he learned from his losses, & was far better at the end $$ Nov 05, 2012
@MarketIntegrity @CFAInstitute @CFAcareers @CFAevents You might want to get different logos; it makes you look like u r RT-ing yourself $$ Nov 05, 2012
@japhychron Bingo. You got it. Nov 04, 2012
@TeamHeadwaters Forgot about that.. those are some of the best limestone deposits in the world, in an area ideal 4 potato farming, right? Nov 04, 2012
@nelson3748 That seems correct, but doesn’t S. Korea have the same issues w/the Chaebol, & they r functioning ok, seemingly… Nov 04, 2012
@munilass Thanks. I put it on my wish list. We discussed mishedging in the finance markets, Soros, &c. Nice of him 2 spend time w/little me. Nov 03, 2012
@munilass What’s the title of the book? I spent about ten minutes talking with him in early 2000 at a Complexity Theory conf @ Columbia U Nov 03, 2012

Comments

I suspect that Obama ends up winning the popular vote as well, and maybe surpasses 50%, fwiw, which isn’t much… $$ Nov 07, 2012
Best thing about elections: they’re over. Second best: gridlock continues. Worst: Four more years of Bush-clone Obama. $$ Nov 07, 2012
“Stocks aren’t GDP futures, so its not a lock that they immediately fall during the recession?” ? David_Merkel http://t.co/CdH1CNuP Nov 08, 2012
Last pres election, took oldest child 2 vote. This time, took child #5 2 vote. If I live, next time will be kids 6 & 7. Time after, kid 8 $$ Nov 06, 2012
“Josh, the article is worth a read, but the Chronicle of Higher Education misreported on it. The?” ? David_Merkel http://t.co/BFGqCw04 $$ Nov 06, 2012
“People easily forget that the stocks of commodity producers are very different than buying the?” ? David_Merkel http://t.co/dDlMNxIY $$ Nov 05, 2012
Helping a client w/his 401(k). Common balanced fund risk factors chosen: Low Duration, Medium credit quality, Large Cap Blend Equities $$ Nov 05, 2012
The benchmark changes added jobs that were created at an unknown earlier point in time. If they were… http://t.co/TmRLG1vg Nov 03, 2012

Eliminating the Rating Agencies, Part 3

Posted on 9 November 2012 by David Merkel

There’s one thing that is a little odd about me: occasionally as I am waking in the morning, something that I have been thinking about comes crashing in on me, and I get a moment of clarity where everything seems obvious for a complex question.

So to begin, I would like to say that I was utterly wrong in part 1 and part 2 of this series.? It won’t work.? Here’s why:

When is it safest to buy high yield bonds — when spreads are tight, or when spreads are wide?? Of course, when spreads are wide.? When spreads are tight, it is risky to buy corporates.? But my method for allocating capital would do the reverse: it would force a lot of capital to be allocated when spreads are high, and little when spreads are low.? That’s the wrong way to do it.

Second, most bond defaults occur because the borrower chokes on an interest payment, not a principal payment.? If you can make the interest payments, under normal circumstances, you can refinance the principal.? That indicates that the risk of a bond will grow less than linearly with maturity.? It may even be flat.

The upshot of this, is that you would want to assign capital counter-cyclically if you could, but no one would go for that, it doesn’t fit human nature.? So maybe a compromise works where there is a fixed amount of capital assigned across the cycle, and not varying by maturity.? So how do you make adjustments for variable riskiness?

For corporate bonds that have a public stock trading, a contingent claims model can yield good results.? Egan-Jones does that, though many of the major raters have similar models, that they watch as a check on their fundamental reasoning.

But many bonds have no publicly traded equity to give them estimates of value and volatility.? Whether private corporates or securitized debts, there is no way to accurately estimate risks, unless you have a cash flow database of the underlying properties/assets, and aside from CMBS, that would be hard to get.

That brings us back to the rating agencies.? Much as they failed on rating novel types of debt that the regulators should not have allowed regulated entities to invest in, the rating agencies did a good job in rating seasoned corporate bonds, both private and public, incorporating private data to sharpen their estimates of creditworthiness.

I know that Dodd-Frank has required Federal Regulations to eliminate the use of credit ratings.? What have they substituted? Management judgement, simplistic statistical tests, nothing, and the ability to use quantitative rating schemes.? My view is this: there will be a series of scandals out of this, and there will be a return to the rating agencies, where human judgment takes in the factors that can’t be crunched into an equation.

Thus I return to my opinions expressed in: In Defense of the Rating Agencies ? V (summary, and hopefully final). You can’t live with them, but you can’t live without them.

Eliminating the Rating Agencies, Part 2

Posted on 8 November 2012 by David Merkel

After writing Eliminating the Rating Agencies, I felt there was room for improvement.? Part of that stems from reading critiques of the rating agencies that really don’t understand why ratings exist.? Ratings don’t exist to help average people, they exist to allow regulators to evaluate the credit risks of financial institutions.

The beauty of my prior proposal is that it can be applied to any credit instrument, even private placements for which there is no market.? Let me give an example.? In mid-2002 with the ten-year Treasury yielding 4.5% an investment banker approached me with a private bond deal — $50 million in total to finance the owner of real estate where the US Government had old computers that would be difficult to do away with.? The yield offered was 8% for 10 years, and S&P shadow-rated it “A.”? We bought 20% of the deal.? We were the biggest holder at $10 million.

Following my procedure in the prior article, the amount of capital that would have to be put up would be almost $2.2 million.? Now, that is likely too severe, but maybe the regulators would choose a percentage of that amount as the right amount for all fixed income securities.? Other securities that are not hedges would be considered deductions from capital.

Is the bond illiquid?? More spread -> more capital required.? The beauty of this system is that it does not care where the excess spread is coming from.? It just measures the present value of the uncertain spread, and realizes that it is a very good proxy for credit risk.? It can be applied to any bond, preferred stock, etc. fairly easily.

There would have to an additional analysis for asset-liability mismatch, but existing methods for measuring that are adequate.? In any case, the rating agencies would no longer be needed for measuring credit risk.? Regulators would simply review the calculations of the actuaries/quants, as they file their annual/quarterly statements.? The value of the uncertain portion of the fixed income assets would be the proxy for the total credit risk of the firm.? No rating agency needed to calculate that.

Industry Ranks November 2012

Posted on 7 November 20127 November 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, 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.

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 Noncyclicals

What I find fascinating about the red momentum zone now, is that it is laden with noncyclical companies.? That said, it has been recently noted in a few places how cyclicals are trading at a discount to noncyclicals at present.

So, as I considered the green and red zones, I chose areas that I thought would be interesting.? In the red zone, I picked IT services and beverages.? Stable industries.

In the green zone, I picked most of the industries.? If the companies are sufficiently well-capitalized, and the valuation is low, it can still be an rewarding place to do due diligence.

That said, it is tough when noncyclical companies are relatively expensive to cyclicals in a weak economy. Choose your poison: high valuations, or growth that may disappoint.

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, VLO, TOT, TEL, INTC, CSCO, VOD

An Actuarial Question

Posted on 6 November 2012 by David Merkel

Here is a question from a reader:

Hi Mr. Merkel,

?My name is XXXXXXX and I rcently started my ASA modules. I am considering pursuing a Chartered Enterprise Risk Analyst designation from the SOA. I was curious if, based on your experience in both the financial and actuarial world, you had any thoughts on the CERA designation? I have

2.5 years of experience and work for a pension consulting firm, but would like to broaden my skill set. I really enjoy The Aleph Blog, especially the book reviews. Keep up the good work.

?Thanks,

?XXXX

My response:

Dear XXXX,

I don’t have an opinion on the CERA designation.? In my opinion, the SOA is in the midst of an existential crisis.? How do they survive, prosper, and maybe even grow the SOA?? Outside of their core industries, insurance and employee benefits, they have strong competition.? Many organizations that do something like them are larger than the SOA.

Ideas:

1) Put a gun to the head of the CAS by offering a casualty track.

2) CERA competing against other risk management credentials

3) Make an effort to create new “actuarial” tracks off of the experiences of nontraditional actuaries, most of whom are a lot more entrepreneurial than other actuaries.? Investing, big data, etc.? Look for all the things that involve the intersection of the Law of large numbers and durational discount…

4) Try to cooperate with the CFA Institute — how that will work, I have no idea, and I am reminded of the limerick about the young lady from Niger.

http://allpoetry.com/poem/8518887-Limerick_There_was_a_Young_Lady_of_Niger-by-William_Cosmo_Monkhouse

5) Attempt to merge all actuarial organizations in the US & Canada into one organization — try to go global, like the CFA Institute.? (The rewards of being global are far smaller than imagined.)

Think hard about what you want to do, and analyze which credential will get you there.? Then pursue it with all your strength, and pick up adjacent/tangential skills to differentiate yourself.? That last part is important, and it is what has made my career very different than most actuaries.

It’s kind of like violating the semi-strong form efficient markets hypothesis — in order to do better than the market, you need an edge.? Find that edge, because regardless of what credential you get, you will need to know more than that to excel.

Best wishes,

David

And his response:

Hi David,

Thank you very much for the thoughtful response. I had not considered the size of the SOA in relation to other competing organizations. As you said, I will have to do some hard thinking about what I want to do and pursue the my designations accordingly.

Thanks again,

XXXX

Thee is an article waiting to be written about credentialing in investments, and how the credentials are not worth much.? It is a lot harder to get an FSA from the Society of Actuaries than it is to get a CFA credential from the CFA Institute.? But the CFA offers a lot more with respect to investing than an FSA does.

Now, those are two strong credentials that are worthy of trust.? There are many more credentials out there, and most are not worthy of trust.? Be careful.? Many put initials after their names, and they aren’t worth a lot.? Be careful.