Search Results for “Unstable” – Page 2

Replies to Notes & Comments

Posted on 4 December 2020 by David Merkel

Photo Credit: Andrew Steele || 42 (with apologies to the late Douglas Adams)

My last post generated its share of comments. Let me respond to a few of them, and add a little more.

Yes, I live outside Baltimore. I have lived more of my life in or near Baltimore than anyplace else. Am I a critic of Baltimore? Of course, everyone near/in Baltimore is a critic of Baltimore. But Baltimore is more complex than most outsiders can understand. It is a “city of neighborhoods.” Positively, it means that if you are in a good area, you can rely on that. Negatively, it means that if you are in a bad area, you can rely on that. It is not a consistently good or bad city, and that was true when I went to Hopkins as well. I lived one year in a relatively bad area of Baltimore, and during that time worked in a different bad area of Baltimore. They are still bad, almost 40 years later, and Baltimore is no better off on the whole. What Baltimore needs is not more money, but a consistent set of directions for the police, such that they can act to the extent desired by the communities that they serve. That said, the amount of Baltimore that is unsafe is maybe 10% of the city, and everyone who lives there understands that.
Maryland has some of the best medical assets in the country, including Johns Hopkins (my alma mater), University of Maryland, and NIH. As a result, we have a large portion of the state devoted to healthcare and biotechnology. Other outstanding industries of Maryland include software, defense/intelligence, REITs, and hotel management. These are the overweighted industries of Maryland. Do I have friends in these businesses? Of course, but I have little knowledge of what they do, and I am not a defender of these industries per se.
Telling your children not to “Blame the Ump” is indeed correct. Children and adults need to respect the governing authorities, even when they are wrong in minor ways. One reason our society is weak is that we don’t have respect for authority. We respect the office, even if the person holding it is a jerk. FIghting over small matters is not a virtue. With respect to the Presidential election, I say what I always say — if there is genuine evidence, it will be undeniable. Conspiracies rarely happen. THere is too much profit to be made from disclosing a conspiracy for it to happen. Also, when there are many parties looking over the details it is hard for a conspiracy to exist.
The same logic applies to those who deny the spread of the C19 virus is not real. I have too many friends of friends who have become very sick or who have died from it for it not to be true.
On #6, my bond management strategy is twofold. One, I try to keep costs low, and because I am small, that means using ETFs and closed-end funds. Two, I focus on mispriced risks and prevailing trends. I hold a variety of short bond funds for liquidity, which is around 50% at present. I earn less than 1% on those assets. I have 25% of the assets in TSI which yields around 6%. Then there are the two ETFs invested in short foreign government bonds and emerging market sovereigns denominated in dollars. The first pays off because of US dollar deterioration. The second does well because of their relatively high yields.
The 10-year estimate for equity returns on the S&P 500 is now 1.88%/year not adjusted for inflation. We are now in the 97th percentile. Should you be concerned? Yes, particularly if you are invested in growth stocks, particularly the hot FANGMAN stocks.
Much as the US is a free market place, there is a dislike in the government for companies that become too powerful. I remember as a youth reading articles about how the US should break up GM (pitiful company that it ended up being). Often those sentiments come at or after the apex of the company — the government may not really need to act, as the “Alexander effect” may kick in — they have conquered all that they can, and there are “no more worlds left to conquer.” That may sound aggressive with respect to Apple, Amazon or Google, but that legislators or government executives are musing about breaking them up should give everyone pause — not because they will be broken up a la AT&T, but that the interest of the government is often an indicator that their market cap has outgrown their relevance.
Regarding #13, I agree with the comments of Publius left at the blog. Monetary stimulus should not affect relative prices much, but with assets, lowering financing rates will allow marginal businesses to survive so long as easy conditions continue. That makes it harder for the Fed or other central banks to easy hyper-easy policies, even though they should bite the bullet, and just let weak firms die. Creative destruction has to do its work, or we will have a slow growing economy where capital is not deployed to achieve the best returns.
On the inequality part of the comments on #13, I don’t mean to be a controversialist. I mean to tell the truth in a way that most aren’t willing to face. My long forgotten piece called Rethinking Comparable Worth is still correct. Think of the spread of income across the world as a whole. Yes, for some activities, there is more capital investment in some places than others, requiring higher educated workers than in other places, with those workers earning higher wages for now. But as technology improves, those same benefits come to those with lesser skills. That brings a slow but persistent equalization of wage rates as the technology “de-skills” skilled workers. Who benefits? Lesser skilled workers, and the creators of technology. As wage levels equalize for occupations over the world, the world becomes more equal, but for the lower skilled in the developed world, it leads to losses for them. That leads to the nationalism that is rampant in Europe and the US — why are our relative incomes suffering?! They suffer because what they are doing is in excess supply, and they should retrain for something better rather than carping to the government. No one owes you a living. Plan ahead, and look for something better rather than imagining that the government has your back. It doesn’t.
Though I agree with Lacy Hunt and Gary Shilling regarding deflation, where I am a little different is what might change matters. QE loses potency with repeated use. There is only so much that you can lower rates, and the effect on stimulating GDP declines. Eventually the government will reach for something with more firepower, like forcing the Fed to buy new issues of government debt. Remember that central bank independence is a myth during stressful times. They are a creation of the government, and not independent from them. When things are calm, we can indulge fantasies of central bank independence as we enjoy s’mores around the campfire and let ourselves get scared as we tell each other ghost stories.
If I had to phrase it in a different way, pretend national and local governments don’t exist. That is the way the global economy is heading regardless of government policies. Positively, one thing that it has changed (temporarily reversed by C19) is that the worst poverty in the world is being reversed by the triumph of capitalism. There are genuinely fewer people in such grinding poverty. Fewer people with hunger problems, aside from those that self-cause their problems.
Immigration to the US mostly does not absorb existing jobs, but performs jobs that most Americans don’t want to take on, like picking produce. They take on the hard work but low pay positions. Do any of you want that? Maybe the children of immigrants will compete with the children of “natives” but in general most immigrants don’t compete with existing Americans for their jobs. Yes there are some technologically skilled that get hired in the US, but that is because we don’t produce enough technologically skilled young people from the “natives.”
Not all of my children listened to me. The ones that listened to me are doing well, and ones that didn’t are not. (A few of them are in-between.) I say the same to all those who read me. Pursue skills that are differentiated, and are not easily obsoleted. Anything that can be replaced by technology or offshored is not a safe place to be.
One last comment, which I posted in response to a LinkedIn post by Christof Leisinger, who I have some respect for. Here is the response:

It is a future risk when the ECB and Fed intervene in the repo funding markets, that the markets would become dependent on the Central Banks. It would be difficult to wean the repo markets off their assistance, but in one sense it makes sense for the Central Banks to do it permanently if you are going to have repo markets.
Repo markets are inherently unstable because you are financing long-term assets with short-term liabilities, and accounting for them as a short-term loan. It works fine until you have a crisis in the long asset, with prices falling hard, and the scam is exposed.
Now, the bad thing about the Central Banks taking over the repo markets is that it removes one more price out of the free markets, and will allow repo markets to balloon as they become riskless to outsiders. This is the same as people not paying much attention to bank deposits because of the existence of the FDIC.
I realize we are in the “brave new world” where Central Banks are imagined to be omnipotent, but if there is a significant financial crisis that the ECB or Fed feels that it has to bail out amid rising consumer price inflation, the creation of additional credit at that time will prove toxic.
LinkedI n Post

To my readers: I ask that you interact with my posts civilly and pertinently. I keep comments open on my blog, and I have done so for 13 years, amid a general closing down of comments across the web. Don’t abuse the freedom I offer here by going off-topic, or being abusive in your speech.

WIth that, let me say that appreciate my readers and commenters. Thanks for your efforts, and let’s keep things constructive.

Full Disclosure: Long TSI for my clients and me

Too Much Debt

Posted on 24 March 2020 by David Merkel

Photo Credit: Steve Rotman || As Simon and Garfunkel sang, “The words of the prophets are written on the subway walls…”

Debt-based economies are unstable. Economies with a lot of short-term debt are more unstable. The Fed is like Johnny One-Note, or Fat Freddie with a hammer. They only know one tool, and it will solve all problems.

Are there problems from too much debt? More debt will solve the problem. Shift debts from the private to the public sector. Don’t let the private market solve this on its own.

Though the bed debt is not in the same place as the last crisis, we are once again trying to play favorites through the Federal Reserve and rescue entities that took too much risk.

My view is let them fail. The whole system is not at risk, and the COVID-19 crisis will pass in two weeks. The great risk is not from the disease, but from the ham-handed response from policymakers who are short-sighted, and highly risk averse to the point of not wanting to cross the street for fear of dying.

Have we become like the Chinese, who bail out their banks and non-banks regularly? Who can’t bear to see any significant institution fail?

(Yes, I know they are getting more willing to see entities fail in China, but why are we getting less that way in the US? Let market discipline teach companies to not have so much debt.)

Here are three things to consider:

Bond ETFs Flash Warning Signs of Growing Mismatch — The Fed now think its purview extends to managing the discounts of bond ETFs? Let the system work, and let profit seeking institutions and individuals benefit from artificially high yields. Let insurance companies do what I did: purchase a cheap package of bonds in an ETF, and convert it into the constituent bonds, and sell those that you don’t want for a profit. (Losses from ETFs premiums and discounts are normal, and it is why the dollar weighted returns are lower than the time-weighted returns.)
The same applies to repo markets. As I have said before, the accounting rules need to be changed. Repo transactions should not be treated as a short-term asset, but as a long asset with a short-term liability, because that is what it is. With Residential Mortgage-Backed SecurIties in trouble, the market should be allowed to fail, to teach those who take too much risk to not do that. This failure will not cascade.
The same applies to the crony of Donald Trump — Tom Barrack. He pleads his own interest, seeking for the Fed or the Treasury to bail him out, and those who are like him. Let him fail, and those who are like him.

Market participants need to know that they are responsible for their own actions, particularly in a small and short-lived crisis as this one. COVID-19 as a systemic crisis will be gone within weeks.

My statement to all of those listening is “When will we set up a more rational system that discourages debt?” We could made dividends tax-exempt, and deny interest deductions for non-financial corporations, including financial subsidiaries of non-financial corporations. Of course we would grandfather prior obligations.

Are we going to wait for the grand crisis, where the Fed will continue to extend credit amid roaring inflation, or where extend no credit amid a tanking economy? This is what eventually faces us — there is no free lunch. The Fed can’t create prosperity via loose monetary policy, and Congress cannot create prosperity via loose fiscal policy.

The bills eventually come due. The USA might get the bill last after the failure of China, Japan, and the EU, but it will eventually get the bill.

As such, consider what you will do as governments can’t deal with the economic and political costs of financing the losses of the financial system.

The Sirens’ Call

Posted on 16 November 2019 by David Merkel

Photo Credit: Miles Nicholls || Actually, the bells get rung at the top, and quite frequently for the duration of the process. People hear it and they decide not to listen. Too many false alarms.

The stock market model is projecting a 3.06%/year return over the next ten years as of the close on 11/15/2019. That’s near where a 10-year mid-single-A rated bond would trade. That’s not offering a lot of compensation for putting your money at risk.

I’m planning on reducing my total risk level by 15% or so, moving my equity allocation from around 70% to 55%. That will be the lowest it has been in two decades. I’m not running to do this. I am still working out the details.

The Fundamentals of Equity Market Tops

You might recall an old piece of mine that I wrote for RealMoney back in January 2004 — The Fundamentals of Market Tops. In it, I gave a non-technical analysis approach to analyzing whether we might be near a market top. In 2004, I concluded that we were NOT near a market top. (This article also served as a partial template for the article at RealMoney in May 2005, which said that YES we were near a market top for Residential Real Estate. Two good calls.)

The article is longer than most, should not fit in the TL;DR bucket for most investors. I’m not going to reconstruct the article here, but just give some brief points that fit the frame of the article. Here I go:

Value investors have been sidelined. Growth is winning handily.
Valuation-sensitive investors are raising cash. Buffett sitting on $130 billion is quite statement. He’s not alone. More on that below.
Momentum is working.
There has been a decline in IPO quality.
Lots of money is getting attracted to private equity.
Corporate leverage is high, and covenants are weak.
Non-GAAP accounting gets more attention than it deserves.
Defined benefit plans are net sellers of stock, but not for the reasons I posit in my article — they are doing it to move to private equity and alternatives, and bonds as a part of liability-driven investing.

Cutting against my thesis:

More companies are committing to paying dividends, and growing them. I’m impressed with the degree that corporations are thinking through their use of free cash flow, even as they lever up.
Actual volatility isn’t that high.
The Fed is supportive.

On net, these conditions give some confirmation to what my quantitative model is saying… the market is near a top. Could it go higher still? You bet, with an emphasis on the word “bet.” The S&P 500 at 4500 would be where valuations were during the dot-com bubble.

Asset-Liability Management and Market Tops

I want to emphasize one point, and then I am done. I wrote another article called Look to the Liabilities to Understand the Assets. There are a few more like it at this blog.

The main idea as applied to the present is this: when you have “strong hands” (those with long time horizons and strong balance sheets) raising cash levels and those with “weak hands” (those with shorter time horizons and weaker balance sheets) staying highly invested in risk assets, it is a situation that is unstable. Those that have capability to “buy and hold” are sitting on their hands, whereas those who have to get returns or they will suffer (typically municipal defined benefit plans and older retail investor who didn’t save enough) are risking a great deal, and have little additional buying power.

This is unstable. This situation typically exists at market tops. Remember, it is what investors DO that is the consensus, not what they SAY.

With that, consider your risk positions, and if you think you should act, do so. If you are uncertain, you could ask an intelligent friend or do half.

How to Invest Carefully for Mom

Posted on 21 September 2017 by David Merkel

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Just a note before I begin. My piece called “Where Money Goes to Die” was an abnormal piece for me, and it received abnormal attention. ?The responses came in many languages aside from English, including Spanish, Turkish and Russian. ?It was interesting to note the level of distortion of my positions among those writing articles. ?That was less true of writing responses here.

My main point is this: if something either has no value or can’t be valued, it can’t be an investment. ?Speculations that have strong upward price momentum, like penny stocks during a promotion, are dangerous to speculate in. ?Howard Marks, Jamie Dimon and Ray Dalio seem to agree with that. ?That’s all.

Now for Q&A:

Greetings and salutations. ?:)

Hope all is well with you and the family!

Just have what I believe is a quick question. I already know [my husband’s] answer to this (Vanguard index funds – it his default answer to all things investment), but this is for my Mom, so it is important that she get it right (no wiggle room for losing money in an unstable market), hence my asking you. My Mom inherited money and doesn’t know what to do with it. a quarter of it was already in index funds/mutual funds and she kept it there. The rest came from the sale of real estate in the form of a check. That is the part that she doesn’t know what she should do with. She wanted to stick it in a CD until she saw how low the interest rates are. She works intermittently (handyman kind of work – it is demand-dependent), but doesn’t have any money saved in a retirement account or anything like that, so she needs this money get her though the rest of her life (she is almost 60). What would you recommend? What would you tell [name of my wife] to do if she were in this position? BTW, it is approx $ZZZ, if that makes a difference. Any advice you can give would be very much appreciated!

Vanguard funds are almost always a good choice. ?The question here is which Vanguard funds? ?To answer that, we have to think about asset allocation. ?My thoughts on asset allocation is that it is a marriage of two concepts:

When will you need to spend the money? and
Where is there the opportunity for good returns?

Your mom is the same age as my wife. ?A major difference between the two of them is that your mom doesn’t have a lot of investable assets, and my wife does. ?We have to be more careful with your mom. ?If your mom is only going to draw on these assets in retirement, say at age 67, and will draw them down over the rest of her life, say until age 87, then the horizon she is investing over is long, and should have stocks and longer-term bonds for investments.

But there is a problem here. ?Drawing on an earlier article of mine, investors today face a big problem:

The biggest problem for investors is low future returns. ?Bonds have low rates of returns, and equities have high valuations. ?You?ll see more about equity valuations in my next post.

This is a real problem for those wanting to fund retirements. ?Stocks are priced to return around 4%/year over the next ten years, and investment-grade longer bonds are around 3%. ?There are some pockets of better opportunity and so I suggest the following:

Invest more in foreign and emerging market stocks. ?The rest of the world is cheaper than the US. ?Particularly in an era where the US is trying to decouple from the rest of the world, foreign stocks may provide better returns than US stocks for a while.
Invest your US stocks in a traditional “value” style. ?Admittedly, this is not popular now, as value has underperformed for a record eight years versus growth investing. ?The value/growth cycle will turn, as it did back in 2000, and it will give your mom better returns over the next ten years.
Split your bond allocation into two components: long US high-quality bonds (Treasuries and Investment Grade corporates), and very short bonds or a money market fund. ?The long bonds are there as a deflation hedge, and the short bonds are there for liquidity. ?If the market falls precipitously, the liquidity is there for future investments.

I would split the investments 25%, 35%, 20%, 20% in the order that I listed them, or something near that. ?Try to sell your mom on the idea of setting the asset allocation, and not sweating the short-term results. ?Revisit the strategy every three years or so, and rebalance annually. ?If assets are needed prematurely, liquidate the assets that have done relatively well, and are above their target weights.

I know you love your mom, but the amount of assets isn’t that big. ?It will be a help to her, but it ultimately will be a supplement to Social Security for her. ?Her children, including you and your dear husband may ultimately prove to be a greater help for her than the assets, especially if the markets don’t do well. ?The asset allocation I gave you is a balance of offense and defense in an otherwise poor environment. ?The above advice also mirrors what I am doing for my own assets, and the assets of my clients, though I am not using Vanguard.

Overvaluation is NOT Due to Passive Investing

Posted on 22 July 2017 by David Merkel

Photo Credit: Hagens_world || I want to buy 1% of all of the items there in one nice neat package! 😉

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There’s been a lot of words thrown around lately saying that indexing has been leading to overvaluation of the US stock market. ?I’m here to tell you that is wrong. ?I have two reasons for that:

1) Active managers have been pseudo-indexing for a long time. ?The moment they get benchmarked to an index they do one of two things:

a) accept it, gain funds for mandates that are like the index, and then they constrain their investing so that they are never too different from the index, and hopefully not in the fourth quartile of performance, so they don’t lose assets. ?This is the action of the majority.

b) Ignore it, get less fund flows, and don’t let the index affect your investment decisions. ?The assets should be stickier over time if you explain to clients what you are doing, and why. ?Only a minority do this.

This has been my opinion since my days of writing for RealMoney. All of the active managers out there add up to something close to a passive benchmark, less fees. ?It can’t be otherwise.

The one exception of any size would be stocks excluded from indexes because they don’t have enough free float available for non-insiders to own/trade. ?Even that is not very big — it might be 5% of the total stock market, though this is just a wild guess.

2) If you want to talk about valuation issues, you really want to talk about the trade-off between stocks and bonds, or stocks and cash. ?Stock valuations are never absolute — it is always a question of the other assets you are measuring the stocks against, and how you desirable those other assets will be in the future, and how sustainable the profitability of stocks will be over time. ?I broke apart some of these issues in my piece?The Dead Model. ?Desirability of stock investing can be broken into three components: maturity risk, credit risk and business risk. ?At present, the first two are getting thinner. ?The last one is thicker, and at least at present, there is no great rush to encourage people to trade slack cash for newly issued shares of stock. ?If anything, stock is getting retired on net. ?(Just a guess.)

Part of this stems from demographics: the Baby Boomers and others still sock away money so that they can get payments in the future, when they are too old to work much. ?That’s the maturity risk that I mentioned above, and the reward from that is low because so many are trying to do it. ?Flat yield curve and low overall yields are the cause of a lot of worries for investors. ?The same thing applies to credit spreads: people are searching for yield, and it leads them far afield — that said, I don’t see a lot of obvious places where credit metrics look bad, aside from auto loans, student loans, and overleveraged governments.

The demographic effect means that nothing looks safe and cheap. ?Yields are low, and price/earnings multiples are high. ?The question is what could lead those to change. ?When the markets are pricing in something like continued perfection, sometimes it doesn’t take much to jolt them out of what is an unstable equilibrium. (Note: contrary to neoclassical economics, most economic equilibria are unstable.)

Profit margins could fall, but most of the factors underpinning high profit margins look pretty strong — using technology to make labor more productive, ability to shift work globally to talented people who are paid less, and clever uses of accounting to reduce taxable income and tax rates seem intact, if not growing.

That said, remember my saying:

Governments are smaller than markets; markets are smaller than cultures.

There is always the possibility of a shock happening that no one expects:

War, even if undeclared
Cultural unrest leading to political change: remember the partial nationalization of Amazon and Google that took place in 2030? ?They got broken up and parts were turned into utilities by the US government because they were so pervasive, and then foreign governments expropriated their local assets, and banned them in their countries.
Another example could be a type of Luddite behavior that attempted to force corporations to hire people proportionate to the profits.
Hyperinflation in Japan, or somewhere else big.
China has a bigger credit crisis than its last one, leading to drops in commodity prices, and further global deflation.

Point 2 was a joke, but meant to illustrate how cultural systems abhor entities that get too powerful.

Closing

I do think stock valuations are high, but the best way to see that is in my quarterly post on stock valuations. ?It takes into account the changing preferences economic actors have regarding what assets they hold — this is one indicator that explicitly reflects actual changes in stock and bond issuance and retirement, as well as changes induced by the Fed in creating more cash and credit, or, destroying it.

Passive investing is a sideshow as far as stock valuations go. ?Pay attention to the supply and demand for stock on the whole, and the factors that might lead supply and demand to change.

The Best of the Aleph Blog, Part 28

Posted on 1 April 20172 April 2017 by David Merkel

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In my view, these were my best posts written between November 2013?and January?2014:

Advice For Would-be Bloggers

Be regular (I need that advice myself), write on what you care about, start small. ?Not that much different than this recent interview of me regarding blogging.

What Life Insurance to Buy?

Depends on whether you need it for protection or as part of a tax shelter or estate plan.

Protect Your Older Family & Friends

Remember that older folks are very tempting targets for fraudsters, and very nice people delivering subpar service at a high price.

Where to Find Data

I give you my favorite sources. ?Most are free.

An Internship at a Hedge Fund

Advice on what to do if you get such an opportunity.

On Position Sizing in Equity Long-Short Hedge Funds

It’s not an easy question, particularly when it comes to shorting or being levered long, but I do offer some ideas that are better than things I have read.

Risks, not Risk, Again

It is better to model the individual risks and manage them, than to rely on an academic-derived model with unstable parameters.

Unconstrained Will Get Overdone

As in any management style, typically the best managers get there first, followed by less talented wannabes.

What are Safe Assets?

It depends on your time horizon(s)

Two Good Questions

How to sort though multiple factors in investing, and is investment in the insurance industry overdone?

Two More Good Questions

On weighting position sizes by expected returns, and?What are the tests I?use to check if accounting is fair?

On Understanding and Valuing Financial Companies

A compendium piece to the way I reason through investing in financial companies.

Why Great CEOs Look at their Stock Price Every Now and Then

It aids in managing the capital of the company wisely, especially when doing M&A.

When to Worry ? An Asset-Liability Management Perspective on Financial Macroeconomics

When those that hold risk assets predominantly have weak balance sheets, with short-dated funding/horizons, it is time to reduce risk.

Systemic Risk Stems from Asset-Liability Mismatches

More on the foolishness of the FSOC and attempts to look for systemic risk where there is none.

Lower the Cap Rate, Not

Rising stock prices does not mean that monetary policy or any other government policy is necessarily good.

A Preview of the Future in Local Government Financing

Not everything is going to fail, but the the worst 1-3% will. ?Avoid municipalities under severe stress.

Equality, and its After-Effects

What do you do when the whole world becomes more competitive, and compensation in your industry comes under pressure?

Give Them a Small Bank

How could we make banking regulators more intelligent about the industry that they watch over? ?Give them experience in managing a small bank.

The Rules, Part LXII

Posted on 17 December 201621 December 2016 by David Merkel

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Well, I didn’t think I would do any more “Rules” posts, but here one is:

In markets, “what is true” works in the long run. “What people are growing to believe is true” works in the short run.

This is a more general variant of Ben Graham’s dictum:

?In the short run, the market is a voting machine but in the long run, it is a weighing machine.?

Not that I will ever surpass the elegance of Ben Graham, but I think there are aspects of my saying that work better. ?Ben Graham lived in a time where capital was mostly physical, and he invested that way. ?He found undervalued net assets and bought them, sometimes fighting to realize value, and sometimes waiting to realize value, while all of the while enjoying the arts as a bon vivant. ?In one sense, Graham kept the peas and carrots of life on separate sides of the plate. ?There is the tangible (a cheap set of assets, easily measured), and the intangible — artistic expression, whether in painting, music, acting, etc. (where values are not only relative, but contradictory — except perhaps for Keynes’ beauty contest).

Voting and weighing are discrete actions. ?Neither has a lot of complexity on one level, though deciding who to vote for can have its challenges. (That said, that may be true in the US for 10% of the electorate. ?Most of us act like we are party hacks. 😉 )

What drives asset?prices? ?New information? ?Often, but new information is only part of it. It stems from changes in expectations. ?Expectations change when:

Earnings get announced (or pre-announced)
Economic data gets released.
Important people like the President, Cabinet members, Fed governors, etc., give speeches.
Acts of God occur — earthquakes, hurricanes, wars, terrorist attacks, etc.
A pundit releases a report, whether that person is a short, a long-only manager, hedge fund manager, financial journalist, sell-side analyst, etc. ?(I’ve even budged the market occasionally on some illiquid stocks…)
Asset prices move and some people mimic to intensify the move because they feel they are missing out.
Holdings reports get released.
New scientific discoveries are announced
Mergers or acquisitions or new issues are announced.
The solvency of a firm is questioned, or a firm of questionable solvency has an event.
And more… nowadays even a “tweet” can move the market

In the short run, it doesn’t matter whether the news is true. ?What matters is that people believe it enough to act on it. ?Their expectation change. ?Now, that may not be enough to create a permanent move in the price — kind of like people buying stocks that Cramer says he likes on TV, and the Street shorts those stocks from the inflated levels. ?(Street 1, Retail 0)

But if the news seems to have permanent validity, the price will adjust to a higher or lower level. ?It will then take new data to move the price of the asset, and the dance of information and prices goes on and on. ?Asset prices are always in an unstable equilibrium that takes account of the many views of what the world will be like over various time horizons. ?They are more volatile than most theories would predict because people are not rational in the sense that economists posit — they do not think as much as imitate and extrapolate.

Read the news, whether on paper or the web — “XXX is dead,” “YYY is the future.” ?Horrible overstatements most of the time — sure, certain products or industries may shrink or grow due to changes in technology or preferences, but with a few exceptions, a new temporary unstable equilibrium is reached which is larger or smaller than before. ?(How many times has radio died?)

“Stocks rallied because the Fed cut interest rates.”

“Stocks rallied because the Fed tightened interest rates, showing a strong economy.”

“Stocks rallied just because this market wants to go up.”

“Stocks rallied and I can’t tell you why even though you are interviewing me live.”

Okay, the last one is fake — we have to give reasons after the fact of a market move, even anthropomorphizing the market, or we would feel uncomfortable.

We like our answers big and definite. ?Often, those big, definite answers that seem right at 5PM will look ridiculous in hindsight — especially when considering what was said near turning points. ?The tremendous growth that everyone expected to last forever is a farce. ?The world did not end; every firm did not go bankrupt.

So, expectations matter a lot, and changes in expectations matter even more in the short-run, but who can lift up their head and look into the distance and say, “This is crazy.” ?Even more, who can do that precisely at the turning points?

No one.

There are few if any people who can both look at the short-term information and the long-term information and use them both well. ?Value investors are almost always early. ?If they do it neglecting the margin of safety, they may not survive to make it to the long-run, where they would have been right. ?Shorts predicting the end often develop a mindset that keeps them from seeing that things have stopped getting worse, and they stubbornly die in their bearishness. ?Vice-versa, for bullish Pollyannas.

Financially, only two things matter — cash flows, the cost of financing cash flows, and how they change with time. ?Amid the noise and news, we often forget that there are businesses going on, quietly meeting human needs in exchange for a profit. ?The businessmen are frequently more rational than the markets, and attentive to the underlying business processes producing products and services that people value.

As with most things I write about, the basic ideas are easy, but they work out in hard ways. ?We may not live long enough to see what was true or false in our market judgments. ?There comes a time for everyone to hang up their spurs if they don’t die in the saddle. ?Some of the most notable businessmen and market savants, who in their time were indispensable people, will eventually leave the playing field, leaving others to play the game, while they go to the grave. ?Keynes, the great value investor that he was, said, “In the long run we are all dead.” ?The truth remains — omnipresent and elusive, inscrutable and unchangeable like a giant cube of gold in a baseball infield.

As it was, Ben Graham left the game, but never left the theory of value investing. ?Changes in expectations drive prices, and unless you are clever enough to divine the future, perhaps the best you can do is search for places where those expectations are too low, and tuck some of those assets away for a better day. ?That better day may be slow in coming, but diversification and the margin of safety embedded in those assets there will help compensate for the lack of clairvoyance.

After all, in the end, the truth measures us.

Ten Investing Books to Consider

Posted on 5 December 20156 December 2015 by David Merkel

Recently I got asked for a list of investment books that I would recommend. These aren’t all pure investment books — some of them will teach you how markets operate in general, but they do so in a clever way. I have also reviewed all of them, which limited my choices a little. Most economics, finance, investment books that I have really liked I have reviewed at Aleph Blog, so that is not a big limit.

This post was also prompted by a post by another blogger of sorts publishing at LinkedIn. ?I liked his post in a broad sense, but felt that most books by or about traders are too hard for average people to implement. ?The successful traders seem to have systems that go beyond the simple systems that they write about. ?If that weren’t true, we’d see a lot of people prosper at trading for a time, until the trades got too crowded, and the systems failed. ?That’s why the books I am mentioning are longer-term investment books.

General Books on Value Investing

The Intelligent Investor?(Ben Graham)
The Aggressive Conservative Investor?(Marty Whitman)
Margin of Safety?(Seth Klarman)
Accounting for Value?(Stephen Penman)

Don’t get me wrong. ?I like many books on value investing, but the first?three are classic. ?Graham is the simplest to understand, and Klarman is relatively easy as well. ?Like Buffett, Klarman recognizes that we live in a new world now, and the simplistic modes of value investing would work if we could find a lot of stocks as cheap as in Graham’s era — but that is no longer so. ?But even Ben Graham recognized that value investing needed to change at the end of his life.

Whitman takes more of a private equity approach, and aims for safe and cheap. ?Can you find mispriced assets inside a corporation or elsewhere where the value would be higher?if placed in a different context? ?Whitman is a natural professor on issues like these, though in practice, the?stocks he owned during the financial crisis were not safe enough. ?Many business models that were seemingly bulletproof for years were no longer so when asset prices fell hard, especially those connected to housing. ?This should tell us to think more broadly, and not trust rules of thumb, but instead think like Buffett, who said something like, “We’re paid to think about the things that seemingly can’t happen.”

The last book is mostly unknown, but I think it is useful. ?Penman?takes apart GAAP accounting to make it more useful for decision-making. ?In the process, he ends up showing that very basic forms of quantitative value investing work well.

Books that will help you Understand Markets Better

The first link is two books on the life of George Soros. ?Soros teaches you about the nonlinearity of markets — why they overshoot and undershoot. ?Why is there momentum? ?Why is the tendency for price to converge to value weak? ?What do markets look and feel like as they are peaking, troughing, etc? ?Expectations are a huge part of the game, and they affect the behavior of your fellow market participants. ?Market movements as a result become self-reinforcing, until the cash flows can by no means support valuations, or are so rich that businessmen buy and hold.

Consider what things are like now as people justify high equity valuations. ?At every turning point, you find people defending vociferously why the trend will go further. ?Who is willing to think differently at the opportune time?

Triumph of the Optimists is another classic which should teach us to be slightly biased toward risk-taking, because it tends to win over time. ?They pile up data from around 20 nations over the 20th century, and show that stock markets have done very well through a wide number of environments, beating bonds?by a little and cash by a lot.

For those of us that tend to be bearish, it is a useful reminder to invest most of the time, because you will ordinarily make good money over the long haul.

Books on Managing Risk

The Crisis of Crowding?(Chincarini)
Pandora?s Risk?(Osband)
Risk and the Smart Investor?(Martin) also?The Nature of Risk?(also Martin)
The Hedge Fund Mirage?(Lack)

After the financial crisis, we need to understand better what risk is. ?Risk is the likelihood and severity of loss, which is not constant, and cannot be easily compressed into simple figure. ?We need to think about risk ecologically — how is an asset priced relative to its future prospects, and is there any possibility that it is significantly misfinanced either internally or by its holders. ?For the latter, think of the Chinese using too much margin to carry stocks. ?For the former, think of Fannie Mae and Freddie Mac. ?They took risks that forced them into insolvency, even though over the long run they would have been solvent institutions. ?(You can drown in a river with an average depth of six inches. ?Averages reveal; they also conceal.)

Hot money has a short attention span. ?It needs to make money NOW, or it will leave. ?When an asset is owned primarily by hot money, it is an unstable situation, where the trade is “crowded.” ?So it was with housing-related assets and a variety of arbitrage trades in the decade of the mid-2000s. ?Momentum blinded people to the economic reality, and made them justify and buy into absurdly priced assets.

As for the last book, hedge funds as a group are a dominant form of hot money. ?They have grown too large for the pool that they fish in, and as a result, their returns are poor as a group. ?With any individual hedge fund, your mileage may vary, there are some good ones.

These books as a whole will teach you about risk in a way that helps you understand the crisis in a systemic way. ?Most people did not understand the situation that way before the crisis, and if you talk to most politicians and bureaucrats, they still don’t get it. ?A few simple changes have been made, along with a bunch of ineffectual complex changes. ?The financial system is a little better as a result, but could still go through a crisis like the last one — we would need a lot more development of explicit and implicit debts to get there though.

An aside: the book The Nature of Risk is simple, short and cute, and can probably reach just about anyone who can grasp the similarities between a forest ecology under threat of fire, and a financial system.

Summary

I chose some good books here, some of which are less well-known. ?They will help understand the markets and investing, and make you a bigger-picture thinker… which makes me think, I forgot the second level thinking of?The Most Important Thing, by Howard Marks. ?Oops, also great, and all for now.

PS — you can probably get Klarman’s book through interlibrary loan, or via some torrent on the internet. ?You can figure that out for yourselves. ?Just don’t spend the $1600 necessary to buy it — you will prove you aren’t a value investor in the process.

The Incredible Chain of Lending

Posted on 19 August 201519 August 2015 by David Merkel

Photo Credit: Vinoth Chandar || Do you control the elephant, or does the elephant control you?

I’m currently reading a book about the life of Jesse Livermore. ?Part of the book describes how Livermore made a fortune shorting stocks just before the panic of 1907 hit. ?He had one key insight: the loans of lesser brokers were being funded by the large brokers, and the large brokers were losing confidence in the creditworthiness of the lesser brokers, and banks were now funding the borrowings by the lesser brokers.

What Livermore didn’t know was that the same set of affairs existed with the banks toward trust companies and smaller banks. ?Most financial players were playing with tight balance sheets that did not have a lot of incremental borrowing power, even considering the lax lending standards of the day, and the high level of the stock market. ?Remember, in those days, margin loans required only 10% initial equity, not the 50% required today. ?A modest move down in the stock market could create a self-reinforcing panic.

All the same, he was in the right place at the right time, and repeated the performance in 1929 (I’m not that far in the book yet). ?In both cases you had a mix of:

High leverage
Short lending terms with long-term assets (stocks) as collateral.
Chains of lending where party A lends to party B who lends to party C who lends to party D, etc., with each one trying to make some profit off the deal.
Inflated asset values on the stock collateral.
Inadequate loan underwriting standards at many trusts and banks
Inadequate solvency standards for regulated financials.
A culture of greed ruled the day.

Now, this is not much different than what happened to Japan in the late 1980s, the US in the mid-2000s, and China today. ?The assets vary, and so does the degree and nature of the lending chains, but the overleverage, inflated assets, etc. were similar.

In all of these cases, you had some institutions that were leaders in the nuttiness that went belly-up, or had significant problems in advance of the crisis, but they were dismissed as one-time events, or mere liquidity and not solvency problems — not something that was indicative of the system as a whole.

Those were the warnings — from the recent financial crisis we had Bear Stearns, the failures in short-term lending (SIVs, auction rate preferreds, ABCP, etc.), Bank of America, Citigroup, credit problems at subprime lenders, etc.

I’m not suggesting a credit crisis now, but it is useful to keep a list of areas where caution is being thrown to the wind — I can think of a few areas: student loans, agricultural loans, energy loans, lending to certain weak governments with large liabilities and no independent monetary policy… there may be more — can you think of any? ?Leave a comment.

Subprime lending is returning also, though not in housing yet…

Parting Thoughts

I’ve been toying with the idea that maybe there would be a way to create a crisis model off of the financial sector and its clients, working off of a “how much slack capital exists across the system” basis. ?Since risky?borrowers vary over time, and some lenders are more prudent than others, the model would have to reflect the different links, and dodgy borrowers in each era. ?There would be some art to this. ?A raw leverage ratio, or fixed charges ratio?in?the financial sector wouldn’t be a bad idea, but it probably wouldn’t be enough. ?The constraint that bind varies over time as well — regulators, rating agencies, general prudence, etc…)

In a highly leveraged situation with chains of lending, confidence becomes crucial. ?Indeed, at the time, you will hear the improvident squeal that they “don’t have a solvency crisis, but just a liquidity crisis! We just need to restore confidence!” ?The truth is that they put themselves in an unstable situation where a small change in cash flows and collateral values will be the difference between life and death. ?Confidence only deserves to exist among balance sheets that are conservative.

That’s all for now. ?Again, if you can think of other areas where debt has grown too quickly, or lending standards are poor, please e-mail me, or leave a message in the comments. Thanks.

Have Your Cake, Eat It Too, And End Up With Only Crumbs

Posted on 11 December 201411 December 2014 by David Merkel

Beware when the geniuses show up in finance. “I can make your money work harder!” some may say, and the simple-minded say, “Make the money sweat, man! ?We have retirements to fund, and precious little time to do it!”

Those that have read me for a while will know that I am an advocate for simplicity, and against debt. ?Why? ?The two are related because some of us tend toward overconfidence. ?We often overestimate the good the complexity will bring, while underestimating the illiquidity that it will impose on finances. ?We overestimate the value of the goods or assets that we buy, particularly if funded by debt that has no obligation to make any payments in the short run, but a vague possibility of immediate repayment.

The topic of the evening is margin loans, and is prompted by Josh Brown’s article here. ?Margin loans are a means of borrowing against securities in a brokerage account. ?Margin debt can either be for the purpose of buying more securities, or “non-purpose lending,” where the proceeds of the loan are used to buy assets outside of brokerage accounts, or goods,?or?services. ?Josh’s article was about non-purpose lending; this article is applicable to all margin borrowing.

Margin loans seem less burdensome than other types of borrowing because:

Interest rates are sometimes low.
They are easy to get, if you have liquid securities.
They are a quick way of?getting cash.
There is almost never any scheduled principal repayment or maturity date for the loan.
Interest either quietly accrues, or is paid periodically.
You don’t have to liquidate securities to get the cash you think you need.
There is no taxable event, at least not immediately.
Better than second-lien or unsecured debt in most ways.

But, what does a margin loan say about the borrower?

He?needs money now
He?doesn’t want to liquidate assets
He wants lending terms that are easy in the short run
He doesn’t have a lot of liquidity at present.

So what’s the risk??If the ratio of the value of assets in the portfolio versus accrued loan value falls enough, the broker will ask the borrower to either:

Pay back some of the loan, or
Liquidate some of the assets in the portfolio.

And, if the borrower can’t do that, the broker will liquidate portfolio assets for them to restore the safety of the account for the broker who made the loan.

Now, it’s one thing when there isn’t much margin debt, because the margin debt won’t influence the likelihood or severity of a crisis. ?But when there is a lot of margin debt, that’s a problem. ?As I like to say, markets abhor free riders. ?When there is a lot of liquid/short-dated liabilities financing long-dated assets, it is an unstable situation, inviting, nay, daring the crisis to come. ?And come it will, like a?heat seeking missile.

Before the margin desks must act, some account holders will manage their own risk, bite the bullet, and sell into a falling market, exacerbating the action. ?But when the margin desks act, because asset values have fallen enough, they will mercilessly sell out positions, and force the prices of the assets that they sell lower, lower, lower.

A surfeit of margin debt can turn a low severity crisis into a high severity crisis, both individually and corporately, the same way too much debt applied to housing created the crisis in the housing markets.

I would again encourage you to read Josh’s excellent piece, which includes gems like:

Skeptics from the independent side of the wealth management industry would ask, rhetorically, whether or not most of these loans would be made with such frequency if the advisors themselves were not sharing in the fees. The answer is that, no, of course they wouldn’t.

He is correct that the incentives are perverse for the advisors who receive compensation for encouraging their clients to borrow and take huge risks in the process. ?It’s another reason not to take out those loans.

Remember, Wall Street wants easy profits from margin lending. ?They don’t care if they encourage you to take too much risk, just as they didn’t care if you borrowed too much to buy housing.

The Free Advice that Embraces Humility

Just say no to margin debt. ?Live smaller; enjoy the security of the unlevered life, and be ready for the day when the mass liquidation of margin accounts will offer up the bargains of a lifetime.

If you have margin loans out now, start planning to reduce them (before you have to). ?You’ve had a nice bull market, don’t spoil it by staying levered until the bear market comes to make you return your?assets to their rightful owners.

Wisdom is almost always on the side of humility, so simplify your life and finances while conditions favor doing so. ?If you must borrow, do it in a way where you won’t run much risk of losing control of your finances.

And after all that… enjoy your sleep, even amid crises.