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The Longer View, Part 4

The Longer View, Part 4

Posted on by David Merkel

In my continuing series where I try to look beyond the current furor of the markets, here are a number of interesting items I have run into on the web:

 

1) Asset Allocation

 

  • Many people who want to stress the importance of their asset allocation services will tell you that asset allocation is responsible for 90% of all returns, so ignore other issues.? An article on the web reminded me of this debate.? The correct answer to the question, as pointed out by this paper, is that asset allocation explains 90% of the variability of the returns of a given fund across time, but only explains only 40% of the variability of a fund versus other funds.? Security selection matters.
  • Two interesting papers on asset class correlation.? Main upshots: historical correlations are not fully reliable, because risky assets tend to trade similarly in a crisis.? Value tends to march to its own drummer more than other equity styles in a crisis.? The effects on correlation in crises vary by crisis; no two are alike.? Natural resources and globa bonds tend to be good diversifiers.
  • In bull markets, risky asset classes all tend to do well.? Vice-versa in the bear markets.? My reason for this correlation is that you have institutional asset buyers all focusing on asset classes that were previously under-recognized, and are now investing in them, which raises the correlation level, not because the economics have changed, but becuase the buyers have very similar objectives.
  • There are a few good states, but by and large, public pensions are a morass.? Most are underfunded, and rely on future taxation increases to support them.? When a public system realizes that it is behind, the temptation is to take more investment risk by purchasing alternative asset classes that might give higher returns.? This will end badly, as I have commented before… I suspect that some state pension plans are the dumping grounds for a lot of overpriced risk that Wall Street could not offload elsewhere.

 

2) Insurance

 

 

3) Investment Abuse of the Elderly

 

It’s all too common, I’m afraid.? Senior citizens get convinced to buy inappropriate investments.? Even the SEC is looking into it.? This applies to annuities as well, mainly deferred annuities, which I generally do not recommend, particularly for seniors.? The comment that a CEO doesn’t fully understand his own annuity products is telling.

 

Now fixed immediate annuities are another thing, and I recommend them highly as a bond substitute for those in retirement, particularly for seniors who are healthy.

 

The only real cure for these deceptive practices is to watch out for the seniors that you care for, and tell them to be skeptics, and to run all major investment decisions by you, or another trusted soul for a second opinion.

 

4) Accounting

 

  • I am against the elimination of the IFRS to GAAP reconciliation for foreign firms.? What is FASB’s main goal in life — to destroy comparability of financial statements?? We may lose more foreign firms listed in the US, which I won’t like, but a consistent accounting basis is critical for smaller investors.
  • Congress moves from one ditch to the other.? This time it’s sale of subprime loans.? Too many modifications, and sale treatment is at risk, so Congress tries to soften the blow for the housing market.? Let auditors be auditors, and if you want the accounting rules changed, then let Congress do the job of the FASB, so that they can be blamed for their incompetence at a complex task.
  • As I’ve said before, I don’t like SFAS 159.? It will lead to more distortions in financial statements, because managements will tend to err in favor of higher asset and lower liability values, where they have the freedom to set assumptions.

 

5) Volatility

 

  • Earn 40%/year from naked put selling?? Possible, but with a lot of tail risk.? I remember how a lot of naked put sellers got smashed back in October 1987.? That said, it looks like you can make up the loss with persistence, that is, until too many people do it.
  • Here’s an interesting graph of the various VIX phases over the past 20 years.? Interesting how the phases are multiyear in nature.? Makes me think higher implied volatility is coming.
  • I don’t think a VIX replicating ETF would be a good idea; I’m not sure it would work.? If we want to have a volatility ETF, maybe it would be better to use variance swaps or a fund that buys long delta-neutral straddles, and rebalances when the absolute value of delta gets too high.

 

That’s all for now.? More coming in the next part of this series.

My 9/11 Experience

My 9/11 Experience

Posted on by David Merkel

Six years ago, I was a neophyte (2 months) corporate bond manager, also doing mortgage bonds, and nominally Chief Investment Officer of a medium-sized life insurance company. I was leading our asset management team through a merger with another firm as well. On 9/11, I was going to have a meeting with my new bosses and the management of our one and only life insurance client.

I was running a little late, so I got to the office as the first tower fell. I talked with a few of my brokers, and concluded that nothing would be trading today. After the second tower fell, our offices were crowded from people in the insurance company watching the spectacle on CNBC. I told my staff to prepare a broad threat report, describing what parts of our portfolio would be harmed by the events; after that, they could go home and grieve. (Our KBW coverage died that day; he was a good fellow.) I went to the meeting, where we canceled our agenda, and I gave a brief threat report, and told them they would have full threat report every day at 4PM until the markets normalized. Aside from owning part of a mortgage on a building near the World Trade Center (One Liberty Plaza) which was rumored to be leaning (not true), the problems were pretty light; liquidity was adequate.

That evening I showed my family video clips from the Internet, and explained what had happened. We’re a pretty matter of fact bunch, so they took it in stride, and realized that the world had changed for the worse.
Because of the merger, the portfolio was relatively high quality. Good thing, too. The markets were closed for the whole week, and reopened the next week. Bond markets are networks, and so, they come back proportionally to the square of the nodes. After one week, the bond market was half functional. After two weeks, 80% functional. After three weeks, 100% functional. We started trading sooner than most, and offered liquidity in exchange for good deals. When our merger closed on 9/30, was began a massive down-in-credit trade, buying bonds in sectors most affected by the disaster. Our logic was that the terrorist event was a “one off” matter where the highjackers got really lucky, and that the odds of a second event were nil, now that the US was on alert.

When I went to a Chief investment Officer’s forum in October, there was a “closed door” meeting with “peer companies” to discuss problems and strategies. One of the early questions was how investment strategy had changed since 9/11. I was the odd man out. We were the only one in the room taking more risk. Everyone else was running up-in-credit trades, and avoiding affected sectors. Not only did I get a “you’re weird” look from the other participants, but I got the “you’re irresponsible” look as well. Not fun.

We continued the down-in-credit trade for another month until we had gone as far as we thought prudent. Then our client came to us and said that the ratings agency heard what we were doing, and told us to knock it off, or face a downgrade. We were done, so we agreed. By this time, it was mid-November. By December, a little more willingness to take risk took hold, and by the first quarter of 2002, there was a full-fledged scramble for yield. We sold into it, doing a massive up-in-credit trade that left the portfolio higher quality than it was prior to 9/11, and giving us room for the upset that would happen as Worldcom went down, and the corporate bond markets doing a double dip in late July and early October. We played the risk cycle very well.


There are four investment points here:

  • Don’t follow the crowds during panics.
  • Don’t follow the crowds during manias.
  • Know your limits. No matter how good an idea will work out eventually, don’t overplay it, because the market can be crazy longer than you can stay solvent.
  • After a panic event, analyze what has truly changed, and ask what things will be like when the next steady state comes, and how long it will likely take to get there.

It was not a consensus view at the time, but the idea that not much had changed permanently proved to be a valuable idea. Capitalist economies tend to be resilient, bending but not breaking. With that, guard your emotions, and try to be analytical toward investing, even when times are abnormal, and people think you are nuts.

The Longer View, Part 3

The Longer View, Part 3

Posted on by David Merkel
  1. August wasn’t all that bad of a month… so why were investors squealing? The volatility, I guess… since people hurt three times as much from losses as they feel good from gains, I suppose market-neutral high volatility will always leave people with perceived pain.
  2. Need a reason for optimism? Look at the insiders. They see more value at current levels.
  3. Need another good investor to follow? Consider Jean-Marie Eveillard. I’ve only met him once, and I can tell you that if you get the chance to hear him speak, jump at it. He is practically wise at a high level. It is a pity that Bill Miller wasn’t there that day; he could have learned a few things. Value investing involves a margin of safety; ignoring that is a recipe for underperformance.
  4. Call me a skeptic on 10-year P/E ratios. I think it’s more effective to look at a weighted average of past earnings, giving more weight to current earnings, and declining weights as one goes further into the past. It only makes sense; older data deserves lower weights, because business is constantly changing, and older data is less informative about future profitability, usually.
  5. I found these two posts on the VIX uncompelling. Simple comparisons of the VIX versus the market often lead to cloudy conclusions. I prefer what I wrote on the topic last month. When the S&P 500 is below the trendline, and the VIX is relatively high, it is usually a good time to buy stocks.
  6. What does a pension manager want? He wwants returns that allow him to beat the actuarial funding target over the lifetime of the pension liabilities. If long-term high quality bonds allowed him to do that, then he would buy them. Unfortunately, the yield is too low, so the concept of absolute return strategies becomes attractive. Well, after the upset of the past six weeks, that ardor is diminished. As I have said before, to the extent that hedge funds seek stable, above average returns, they engage in yield-seeking behavior which prospers as credit spreads and implied volatilities fall, and fail when they rise. Eventually pension managers will realize that hedge fund returns cannot provide returns over the full length of the pension liability, in the same way that you can’t invest more than a certain amount of the pension assets in junk bonds.
  7. Is productivity growth slowing? Probably. What may deserve more notice, is that we have larger cohorts entering the workforce for maybe the next ten years, and larger cohorts exiting as well, which will decrease overall productivity. Younger workers are less productive, middle-aged most productive, and older-aged in-between. With the Baby Boomers graying, productivity should fall in aggregate.
  8. This is just a good post on sector data from VIX and More. It’s worth looking at the websites listed.
  9. Economic weakness in the US doesn’t make oil prices fall? Perhaps it is because the US is important to the global economy, but not as important as it used to be. It’s not hard to see why: China and India are growing. Trade is growing outside of the US at a rapid pace. The US consumer is no longer the global consumer of last resort. Now we get to find out where the real resource shortages are, if the whole world is capitalist in one form or another.
  10. Calendar anomalies might be due to greater macroeconomic news flow? Neat idea, and it seems to fit with when we get the most negative data.
  11. Is investing a form of gambling? I get asked that question a lot, and my answer is in aggregate no, because the economy is a positive-sum game, but some investors do gamble as they invest, while others treat it like a business. Much depends on the attitude of the investor in question, including the time horizon and return goals that they have.
  12. Massachusetts vs. the laws of economics. Beyond the difficulty of what to do with expensive cohorts in a public insurance system, I’ve heard that they are having difficulties that will make the system untenable in the long run… most of which boil down to antiselection, and inability to fight the force of aging Baby Boomers.
  13. Rationality is one of those shibboleths that economists can’t abandon, or their mathematical models can’t be calculated. Bubbles are irrational, therefore they can’t happen. Welcome to the real world, gentlemen. People are limitedly rational, and often base their view of what is a good idea, off of what their neighbor thinks is a good idea, because it is a lot of work to think independently. Because it is a lot of work, people conserve on hard thinking, since it is a negative good. They maximize utility where utility includes not thinking too hard. Any surprise why we end up with bubbles? Groupthink is a lot easier than thinking for yourself, particularly when the crowd seems to be right.
  14. Is China like the US with 120 years of delay? No, China has access to better technology. No, China does not have the same sense of liberty and degree of tolerance of difference. Its culture is far more uniform from an ethnic point of view. It also does not have the same degree of unused resources as the US did in the 1880s. Their government is in principle totalitarian, and allows little true freedom of religious expression, which is critical to a healthy economy, because people work for more than money/goods, but to express themselves and their ideals.
  15. As I have stated before, prices are rising in China, and that is a big threat to global stability. China can’t continue to keep selling goods without receive goods back that their workers can buy.
  16. The US needs more skilled immigrants. Firms will keep looking for clever ways to get them into the US, if the functions can’t be outsourced abroad.
  17. It’s my view that dictators like Chavez possess less power than commonly imagined. They spend excess resources on their pet projects, while denying aid to the people whom they claim to rule for their benefit. With inflation running hard, hard currencies like the dollar in high demand, and the corruption of his cronies, I can’t imagine that Chavez will be around ten years from now.
  18. Makes me want to buy Plum Creek, Potlach, or Rayonier. The pine beetle is eating its fill of Canadian pines, and then some, with difficult intermediate-term implications. More wood will come onto the market in the short run, depressing prices, but in the intermediate term, less wood will come to market. Watch the prices, and buy when the price of lumber is cheap, and prices of timber REITs depressed.
  19. Pax Romana. Pax Americana. One went decadent and broke, the other is well on its way. I love my country, but our policies are not good for us, or the world as a whole. We intrude in areas of the world that are not our own, and neglect the proper fiscal and moral management of our own country.
  20. Finally, it makes sense for economic commentators to make bold predictions, because there’s no such thing as bad publicity. Sad, but true, particularly when the audience has a short attention span. So where does that leave me? Puzzled, because I enjoy writing, but hate leading people the wrong way. I want to stay “low hype” even if it means fewer people read me. At least those who read me will be better informed, even if it means that the correct view of the world is ambiguous.

Tickers mentioned: PCH PCL RYN

The Longer View, Part 2

The Longer View, Part 2

Posted on by David Merkel

When the market gets wonky, I write more about current events.? I prefer to write about longer-dated topics, because the posts will have validity for a longer time, and I think there is more money to be made off of the longer trends.? Before I go there tonight, I would like to say that at present the Fed says that it is ready to act, but it hasn’t done much yet.? As for the Bush Administration, and Congress, they have done nothing so far, and the few credible promises are small in nature.? My counsel: don’t be surprised if the markets stay rough for a while.

Onto longer-dated topics:

  1. Perhaps this should go into my “too many vultures” file, but conservative players like Annaly can take advantage of bargains produced by the crisis.? My suspicion is that they will succeed in their usual modest conservative way.
  2. Falling rates?? Falling equity prices?? Pension funding declines.? This issue has not gone away in the UK, and here in the US, the PBGC is still struggling.? As it is, FASB is facing the issue head on (finally), and the result will likely be a diminution of shareholders’ equity for most companies with defined benefit plans.
  3. China is a capitalist country?? Eminent domain can be quite aggressive there.? At least now they are promising compensation, but who knows whether the government really follows through.
  4. Any strategy, like quant funds, can become overcrowded.? As a strategy goes from little known to crowded, total returns rise and then flatten.? Prospective returns only fall as more and more compete for scarce excess returns.? As the blowout occurs, total returns go negative, and more so for the most leveraged.? Prospective returns rise as capital exits the trade.? Smart quants measure prospective return, and begin liquidating as prospective returns get too low.? Not many do that for institutional imperative reasons (investor: what do you mean cash is building up?? What am I paying you for?), but it is the right strategy regardless.
  5. This is a useful graph of sector weights in the S&P 500.? If nothing else, it is worth knowing what one is underweighting and overweighting.? I am overweight Energy, Basic Materials, Staples, Utilities, and (urk) Financials, and underweight the rest.? My portfolio, right or wrong, never looks like the market.
  6. I’ve written about SFAS 159 before.? Well, we may have a new poster child for why I don’t like it, Wells Fargo.? Mark-to-model is impossible to escape in fixed income, but I would treat gains resulting from changes in model assumptions as very low quality.? Watch SFAS 159 disclosures closely with complex financial companies.? If we wanted to repeat the late 90s headache from gain on sale accounting, we may have created the conditions to repeat the experience in a related way.
  7. How dishonest is the P&C insurance industry?? It varies, as in most industries.? Insurance is a bag of complex promises, which leaves it more open to abuse.? This article goes into some of that abuse, and teaches us to evaluate a company’s claims paying record.? You may have to pay more to get Chubb or Stancorp, but they almost always pay.
  8. China’s financial system is maturing slowly; one example of that is reduced reliance on bank finance, and issuing bonds directly.
  9. I don’t care what regulations get put into place, capitalist economies are unstable, and that’s a good thing.? There are always information asymmetries, and always crowd behavior, such that risk preferences change precipitously.? That’s the nature of the system.? The only true protection is to be aware of this reality, and adjust your behavior before things get crazy.
  10. A firm I was with had an early opportunity to invest in LSV and we didn’t do it.? The two members of our committee that read academic research thought we ought to (I was one), but the practical men of the committee objected to investing with unproven academics.? Oh, well, win some, lose some.
  11. Speaking of academic research, here’s a non-mathematical piece on cognitive biases.? Economists believe that man is economically rational not because of evidence, but because it simplifies the models enough to allow calculations to be made.? They would rather be precisely wrong than approximately right.
  12. Bit by bit, the efficient markets hypothesis get chipped away.? Here we have a piece indicating persistence of excess returns of the best individual investors.? For those of us that have done well, and continue to plug away in the markets, this is an encouragement.? It’s not luck.

I have enough for two more pieces on longer dated data.? It will have to come later.

Tickers Mentioned: NLY WFC CB SFG

More Slick VIX Tricks

More Slick VIX Tricks

Posted on by David Merkel

Tonight’s article will be less mathematical, and more qualitative than last night’s article. Last night I did say:

The relationship of the VIX to the S&P 500 is an interesting one, one that I have studied for the past nine years. Over that time, I have used the relationships to:

  • Design investment strategies for insurance companies selling Equity Indexed Annuities.
  • Estimate the betas of common stocks. (Not that I believe in MPT?)
  • Trade corporate bonds.
  • Gauge the overall risk cycle, in concert with other indicators.

Investing to Back Equity Indexed Annuities

Let me talk about these applications. Equity indexed annuities [EIAs] are tricky to design an investment strategy for. Typically they contain long guarantees, say ten years or so, where the minimum payoff must be guaranteed. That payoff is typically 90% of the initial premium plus 3% compound interest. The optimal strategy invests 80% or so of the money to immunize that guarantee, while using the other 20% to invest short to pay for option premiums that match the payoff pattern promised in the EIA.

But here’s the problem. The forward market for 1-year implied volatility doesn’t exist in any deep way, so the insurance company decides that it will have to take its chances, and assume that volatility will mean revert over longer periods of time. Also, they try to build in enough policy flexibility that they can less favorable option terms to policyholders during times of high volatility (at the risk of higher lapsation). Certain bits of actuarial smoothing in the reserves can also be useful in assuming mean reversion. But what happens if volatility rises high and stays there a while? Unfortunately, that tends to be the same time when credit spreads are wide, because option implied volatility is positively correlated with credit spreads. So, at the time that the strategy needs the most help, option costs are high (or payouts are chintzy and lapse rates go up), and corporate bond prcies sag due to wider spreads.
If the insurance company can handle the lack of incremental income, investing in higher credit quality instruments in tight spread low implied volatility environments can mitigate the risks. The benefit to such a strategy is that in a higher spread and implied volatility environment, you can do a down-in-credit trade (lower credit quality) at the time that it is being rewarded. This takes real courage and foresight on the part of the insurance management team to manage this way, but it pays off in the long run. (Which is why the strategy doesn’t usually get used…)


Corporate Bonds Generally

On my monitor screens, I keep three things front and center: the S&P 500, the long bond, and the VIX. This served me well in 2001-2003 when I was a corporate bond manager. After 9/11, we did a massive down-in-credit trade, buying all of the industries that were out of favor because of fears of terrorism. This is the only time I can remember when our client, who never said “no” to incremental yield, told us to hold back. We were almost done anyway, but in the depths of November 2001, we questioned our own sanity. Then, as implied volatility fell, credit spreads did as well, and the prices of our bonds rose, so in the spring of 2002, we reversed the trade and then some. We were in great position for the double bottoms that happened in July and October of 2002. We played the risk cycle well. Following equity volatility aided structural management of the corporate bonds.
When implied volatility was so high, and volatile, I would use the S&P 500 and the VIX to aid the timing of my trades. When the S&P was falling, and the VIX rising, and the long (Treasury) bond rising in price and falling in yield, I would wait until the S&P 500 would level off, and the VIX begin to fall a little. Then I would buy the corporates that I had been targeting. I would get good executions because of the dourness of the day, but more often than not, the market would turn an hour after I bought as corporate spreads would begin to tighten in response to the better tone from the equity markets and implied volatility.Though we were a qualitative credit analysis shop, I would have analysts review companies when their stock price had fallen by more than 30% since the purchase of the bond, and where the equity’s implied volatility had risen by more than 30%. This test flagged Enron, and others, before they collapsed. Not everything that fits those parameters is a sell, but they are all to be reviewed.

One aspect of the bond market that outsiders don’t know about is that when it gets frothy, deals come and go rapidly. Some get announced and close in as little as seven minutes. Speed is critical at such times, but so is judgment on how fairly the deal is priced. When the market is that hot, a corporate bond manager does not have time to ask the credit analyst what he thinks about a given company. I developed what I called the one-minute drill, which when I explained it to my analysts, fascinated them. Using a Bloomberg terminal, I would check the equity price movement over the last twelve months (red flag — down a lot), equity implied volatility (red flag — up a lot), balance sheet (how much leverage, and what is the trend?), income statement (red flag — losing money), cash flow statement (red flag — negative cash flow from operations), and the credit ratings and their outlooks. I can do that in 30 seconds to a minute at most, giving me ample time to place an order, even if the deal closes seven minutes from its announcement. I told my analysts that I trusted their opinions, but in the few weeks that we might hold the bonds while they were working out their opinion, if I didn’t have any red flags, it was safe to hold the bonds for a month off of the one minute drill. If the analyst didn’t like the bonds, typically I would kick them out for a small gain.
For those with access to RealMoney, I recommend my articles on bonds and implied volatility. Changes in Corporate Bonds, Part 1 , and Changes in Corporate Bonds, Part 2.


Estimating Beta

You can estimate beta using the VIX. Here’s how: start with the Capital Asset Pricing Model (ugh), and apply a variance operator to each side. After simplification, the eventual result will be (math available on request):
BetaWhat this means is that the actual volatility of the individual stock is equal to the square of its beta times the actual volatility of the market portfolio, plus the firm-specific variance. Now, one can estimate this relationship using a non-linear optimizer (Solver in Excel can do it), regressing actual market volatility on the volatility of the individual firm, allowing for no intercept term, and constraining the errors to be positive, because firm specific variance can’t be negative. In place of actual volatility, implied volatility can be used, because the two are closely related.
I played around with this relationship and found that it yielded estimates of beta that I thought were reasonable. It’s a lot more work than the ordinary calculation, though. The estimate might be more stable than that from using returns.

Gauging the Overall Risk Cycle

When I look at systemic risk, the VIX plays a big role. Other option volatilities are valuable as well, bond volatilities, swaption volatilities, currency volatilities, etc. Also playing a role are credit spreads in the fixed income markets. Together, these help me analyze how much risk is being perceived in the market as a whole. I don’t have a single summary measure at present; different variables are important at different points in the cycle.


Profitable Trading Rules

I think that there are no lack of profitable trading rules for the S&P 500 from the VIX. But you have to choose your poison. Absolute rules tend to have few signals, and require holding for some time, but are quite profitable. Here’s an example: Buy the S&P 500 when the VIX goes over 40, and sell when it drops below 15. Relative rules tend to have more signals, and don’t require long holding periods, but are modestly profitable on average, with more losing trades. Example: buy when the VIX is over its 50-day moving average by 50%, and sell when it is less than the 50-day moving average.

I don’t use any of those rules for my investing, but I do watch the VIX out of the corner of my eye to help me decide when conditions are are more or less favorable to put on more risk. Along with my other variables for tracking the risk cycle, it can aid your investment performance as well.

Speculation Away From Subprime, Part 2

Speculation Away From Subprime, Part 2

Posted on by David Merkel

What a week, huh? Even with all of my cash on hand, I did a little worse than the S&P 500. One house keeping note before I get started, the file problem from my last insurance post is fixed. On to speculation:

  1. When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.
  2. We lost our NYSE feed on Bloomberg for the last 25 minutes of the trading day. Anyone else have a similar outage? I know Cramer is outraged over the break in the tape around 3PM, and how the lack of specialists exacerbated the move. Can’t say that I disagree; it may cost a little more to have an intermediated market, but if the specialist does his job (and many don’t), volatility is reduced, and panics are more slow to occur.
  3. Perhaps Babak at Trader’s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
  4. The bond market on the whole responded rationally last week. There was a flight to quality. High yield spreads continued to move wider, and the more junky, the more widening. Less noticed: the yields on safe debt, high quality governments, agencies, mortgages, industrials and utilities fell, as the flight to quality benefitted high quality borrowers. Here’s another summary of the action on Thursday, though it should be noted that Treasury yields fell more than investment grade debt spreads rose.
  5. Shhhhh. I’m not sure I should say this, but maybe the investment banks are cheap here. I’ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.
  6. Comparisons to October 1987? My friend Aaron Pressman makes a bold effort, but I have to give the most serious difference between then and now. At the beginning of October 1987, BBB bonds yielded 7.05% more than the S&P 500 earnings yield. Today, that figure is closer to 0.40%. In October 1987, bonds were cheap to stocks; today it is the reverse.
  7. Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
  8. Now, a trailing indicator is mutual fund flows. Selling equities and high yield? No surprise. Most retail investors shut the barn door after the cow has run off.
  9. Deals get scrapped, at least for now, and the overall risk tenor of the market shifts because player come to their senses, realizing that the risk is higher than the reward. El-Erian of Harvard may suggest that we have hit upon a regime change, but I would argue that such a judgment is premature. We have too many bright people looking for turning points, which may make a turning point less likely.
  10. Are we really going to have credit difficulties with prime loans? I have suggested as much at RealMoney over the past two years, to much disbelief. Falling house prices will have negative impacts everywhere in housing. Still, it more likely that Alt-A loans get negative results, given the lower underwriting standards involved.

We’re going to have to end it here. Part 3 will come Monday evening.

Blog Notes

Blog Notes

Posted on by David Merkel
  1. If anyone is having difficulty registering to use the site, just e-mail me, and I can set you up manually.
  2. I have added a few more categories for my posts. One category will be best posts at The Aleph Blog. I have my own ideas, but you can nominate articles if you like.
  3. I have an article on the VIX coming in the next week or so, also a short piece on a subsegment of the life insurance business, and one summary piece on the “Fed model.”
  4. Longer term, there should be articles digging into mistakes in academic finance, rescuing capitalism from capitalists, flexibility vs. discipline, traffic analogies to investing, hidden correlations, and asset allocation.

Suggestions? E-mail me as well, or just comment below. Generally, I try to respond to comments within a week if I can.

One last late addition… I am republishing this because I added one more feature, the “bizz buzz” button at the bottom of each post. It appears on each post’s distinct page, as opposed to the blog’s front page.? You can get to it from the front page by clicking on the permalink, or the post’s title.? If you particularly liked one of my posts, click on the “bizz buzz” bee icon, and that will recommend the story to others at the “Best way to Invest” website.? Thanks for all of your support as readers!

Quantitative Analysis is not Trivial — The Case of PB-ROE

Quantitative Analysis is not Trivial — The Case of PB-ROE

Posted on by David Merkel

I debated on whether to post on this topic or not. I try to be a gentleman, so I don’t want to be too rough on those I criticize. Let me start out by saying that those I criticize have honorable intentions. They want to make investing simple for investors. Noble and laudable; the trouble comes when one over-simplifies, and errors get introduced as a result.

I am both a quantitative and a qualitative analyst, which makes me a little unusual. It also means that I am not as good as the best qualitative or quantitative analysts. To be the best, it takes dedication that would squeeze out spending too much time on the other skill. I have always tried to stay balanced, which helps me as a businessman, actuary and investor. Good problem solving requires looking at a problem from many angles, and then choosing the right analogy/tool to do the job.

One of my readers, Steve Milos, forwarded to me a piece from Merrill Lynch’s life insurance analyst suggesting that Price-to-Book — Return on Equity [PB-ROE] analyses were simply low P/E investing in disguise. I tossed back a comment “The Merrill analyst doesn’t understand what he is talking about. PB-ROE analyses are richer than low PE, though in a few environments, like the present, they are similar.”, prompting Steve to say, “LOL, I love that ? now tell me what you really think!”

I decided to let the matter drop until Zach Maxfield, one of the analysts from Bankstocks.com, posted a laudatory article on Ed Spehar’s piece. I didn’t learn what I am about to write in a day, so let me take you on a journey explaining how I came to learn that PB-ROE analyses are valuable.

Back in 1982, I was a graduate teaching assistant at UC-Davis. The professor that I worked for used regression analysis in financial analysis to try to separate out effects that might be more complex than current modeling would admit. I did not get a chance to use the idea though, until 1992, when I began value investing, after my Mom gave me a copy of Ben Graham’s “The Intelligent Investor.” As I began investing, I noted that some stocks seemed better valued using book, others by earnings, and some by other metrics. Initially I began doing rule-of-thumb tradeoffs like Price to (book plus 5 times earnings). Eventually I wondered whether I had the right tradeoff or not, and how I might work in other metrics like dividends, sales, cash from operations [CFO], and free cash flow [FCF].

I’m not sure when it hit me, but I decided to run a regression of price versus earnings, book, sales, FCF, and CFO. Reasoning that sectors have different economic models, I did separate runs by sector. Truly, I should have done it by industry, or subindustry, as I do it today, but my initial attempts still found promising inexpensive stocks.

It was not until 1998 that I ran into PB-ROE analysis for the first time. Morgan Stanley was marketing a derivative instrument that would reduce book, turn it into earnings, and reduce taxes at the same time. I became the external expert on that derivative instrument, while hating its sliminess. (The whole story is a hoot, but it would take too long, and isn’t relevant here. Suffice it to say that the EITF and the IRS killed it six months after the first transaction got done.)

For those who believed PB-ROE analysis, the derivative was a godsend — less book, more earnings. With my more general model, I said, “So what, give up book, get “earnings,” which come back to book value anyway. These are just accounting shenanigans.” I didn’t see the value of PB-ROE then.

By 2001, I was a corporate bond manager. The Society of Actuaries Investment Section recommended the book, “Investing by the Numbers” by Jarrod Wilcox. An excellent book, I learned a lot from it, and he explained the PB-ROE model to me for the first time. To the best of my knowledge, it is the only place where I have seen it explained.

Where does the PB-ROE model come from? It is a simplification of the dividend discount model. In 2004, I gave a talk to the Southeastern Actuaries Conference. The relevant pages are 5-11, where I go through an example of a PB-ROE analysis, and give the limitations of the analysis. There are several limitations, here they are:

 

  1. Encourages maximization of ROE in the short run, rather than the long run
  2. Revenue growth is often equated with earnings growth in practice
  3. ?Run rate earnings? is adjusted (operating) GAAP earnings, versus distributable earnings (free cash flow)
  4. Implicit assumption of constant earnings growth, required return, and dividend policy in the Price to Book versus ROE metric
  5. The model assumes that capital is the scarce resource needed to produce more earnings.
  6. ROA is more critical than ROE; it?s harder to achieve. In bull markets, anyone can add leverage.

 

Items 4 & 5 are the only problems intrinsic to the PB-ROE model; the rest are problems with how the model gets abused by practitioners. I don’t think that any industry fits those conditions perfectly, but I usually think that the are good enough for a first pass, and after that I make adjustments for different expected growth rates, excess capital, earnings quality and more.

 

PB-ROE is equivalent to low P/E investing when the regression line comes close to going through the origin (0,0). From my experience, that rarely happens. For my nine insurance subgroups (bigger than Mr. Spehar’s analysis — I cover them all), almost all of the intercept terms are different than zero with statistical significance. Or, as a colleague of mine said to me recently, “Thanks for teaching me how to do PB-ROE analysis,it really helped with my analyses on Japanese banks and US investment banks.”

 

Now, there is a seventh problem with PB-ROE, but it is more complex. So you run he regression and get the tradeoff of P/B versus ROE that the market is currently pricing. Is that the right tradeoff in the intermediate term, or are investors overvaluing or undervaluing ROE? Hard to tell, but when the regression line is flat or downward sloping (it happens every now and then), one has to question whether the market’s judgment is right or not.

 

In some environments, PB-ROE and low P/E investing will be similar, but that will not always be true. Do not accept a false simplification, even though it may be true at present. The PB-ROE model is richer, and works in more environments, after adjusting for the limitations listed above. PB-ROE is a very useful tool, and not “gobbledygook.”

Eleven Articles on Residential Real Estate

Eleven Articles on Residential Real Estate

Posted on by David Merkel

Those who have read me at RealMoney know that I have been bearish on residential real estate for the last 2-3 years, and on commercial real estate for the last year.? I have found it fascinating to see both markets move to situations where current income is exceeded by what can be earned in Treasury securities, much less mortgage funding costs.? Take it as a rule, when one must depend on rental growth and property appreciation to make a profit, it’s time to sell.? Anyway, here are the articles:

  1. I guess I have to start with Bear Stearns’ hedge funds.? An ugly situation where Bear might have to tap $3.2 billion of liquidity to stem the crisis.? Bear can afford the money, but it might bite into their credit rating, and their ability to earn money off of their spare capital.? As I commented on RealMoney yesterday, it is not likely, but possible that this turns into a wider crisis.
  2. Though this article is about Collateralized Debt Obligations [CDOs] generally, much of the excess yield that allowed the CDOs to be sold came from subprime CDOs.? Now who holds the risk?? From what I can tell, a bunch of hedge funds, hedge fund-of-funds, and pension plans.? The lure of easy yield beings out the worst in institutional investors stretching to make a certain total return target.? The low-paid managers of public funds are particularly drawn to these investments because of the political pressure to keep taxes low.

    As an aside, the principal-protected versions are a sham; it is the same as investing a small amount in the volatile stuff, and a large amount in Treasuries.? That one can’t lose money on the package is meaningless; look at the two investments separately, and ask if they both make sense.? Lesson: don’t but investments that you don’t fully understand.

  3. Little of the current troubles in residential real estate could have gone on without optimistic appraisals.? That’s putting it kindly; before the end of this crisis the appraisers are going to face some degree of additional regulation.? Will it be the right solution?? Probably not, but read the article, and watch a profession in need of tough ethical requirements, or perhaps, means of eliminating shady operators.
  4. I’m not sure how one can rent out credit scores.? It would be fraud if done without the consent of the one whose score is borrowed.? With consent, it would be a stupid form of co-signing a loan.? I never recommend co-signing.? You have more protections loaning the person the money yourself, even if you have to take out a loan to do it.
  5. I’ve followed this statistic for a while.? With a few conservative assumptions, it means that the average indebted homeowner has only 30% equity in his home.? Not a safe place to be.
  6. Buying foreclosures?? Wait a year, okay?? Look, foreclosure, and other forms of distressed investing only work when the ratio of vultures to carrion is low.? It’s not low now.? Let the dumb vultures overspend now; come back when you hear of former vultures having to raise liquidity.
  7. Barry Ritholtz and I have long been on the same page on residential real estate investing.? This article has some of the best charts I have seen in some time.
  8. Here’s an alternative view of residential real estate pricing.? Rather than listen to the shills at the NAR, this might be a fairer take on the market.? Note that it has been lower and higher than NAR forecasts; I like that, because reality is almost aways more volatile than we would admit.
  9. My view of the residential real estate markets is bifurcated.? The Midwest and the South suffered the worst initial foreclosures because housing prices did not rise much there, and refinancing was not an option.

    ? Tight finances + bad event = default.

    But the pain will shift to the formerly hotter coastal markets, where subprime financing was more prevalent, as the ARM resets hit, and now prices are falling, and interest rates rising.

  10. Excess supply is the rule; we have a little less than one year’s supply of housing vacant and ready to sell at present.? That is a record by almost double the long term average.? This will take years to clear up, particularly with the builders still constructing homes.? Perhaps we can solve the problem by selling all the excess homes to wealthy foreigners.? Kill two birds with one stone; fund the current account deficit, and reduce the the housing supply overhang in one fell swoop.
  11. Interest rates are the silent killer here.? It would be wise for many people to refinance to prime fixed-rate loans, but with interest rates rising, the bar is getting raised for even creditworthy borrowers.

We are stopping at a butcher’s dozen here.? Not a great time to own residential real estate on leverage.? When I went to work for the hedge funds that employ me, I paid off my mortgage because my earnings would be less certain than what ai earned as a bond manager for an insurance company.? Would that more people were conservative with their finances in the same way.? As it is, I expect the residential real estate price slump to persist into 2009.

Bottom Left Hand Drawer Issues

Bottom Left Hand Drawer Issues

Posted on by David Merkel

Back in the saddle.? I have a lot to write about, but not so much time.? The insights developed over vacation will be spread out over the next week or so.

Just a quick one to get started.? In general, I think insurance companies with more than $100 million in assets should have their own investment departments, and not outsource the management of assets.? (Note: to any insurance CEOs reading this — would you like a chief investment officer with experience in all major fixed income classes, equity, and derivatives, and a knowledge of the actuarial side of investing as well?? E-mail me, and we can talk.)

I only know one insurance asset outsourcing larger than this, but Safeco has outsourced their asset management to Blackrock.? I think that it is a mistake.? Why?

  1. Insurance companies excel at creating tailored liabilities, taking individual risks away, and pooling them.? The same should be done with assets.? Anyone can hire Blackrock (a very good firm), but an intelligent management will take the time and effort to develop in-house expertise, which is usually cheaper than most third party solutions.? It gives up what should be a profit center for the enterprise as a whole.
  2. Third-party arrangements miss what I call “The Bottom Left Hand Drawer” issues.? I worked in insurance for 17 years, and I grew to love the competent but uncelebrated people in the company that did excellent work, but management thought were expendable.? Third-party relationships lack the freedom for customization that in-house management allows for.? Often because accounting systems don’t get it quite right, human intervention is needed.? Someone makes an adjustment off of a schedule that they keep in their bottom left hand drawer once a year, and that keeps the system running right.? In a third party solution, those issues can get lost; I have personally seen it fail.
  3. Penny wise, pound foolish.? The explicit expense savings are easy to see, but the implicit losses from not having someone managing the investments that is totally on your side is hard to measure.? Though I can’t prove it, the soft costs are large.

If I served an insurance company again as an asset manager, I would want to serve that company only, and not run a third-party asset management shop.? The work of an insurance company is important enough that it deserves the undivided attention of professionals on staff.

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