The Aleph Blog – Page 42 – Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control

Learning from the Past, Part 6 [Hopefully Final, But It Won’t Be…]

Posted on 8 October 20158 October 2015 by David Merkel

Photo Credit: Tony Webster || Bridges can collapse -- so can leverage... — Photo Credit: Tony Webster || Bridges can collapse — so can leverage…

This is the last article in this series… for now. ?The advantages of the modern era… I went back through my taxes over the last eleven years through a series of PDF files and pulled out all of the remaining companies where I lost more than half of the value of what I invested, 2004-2014. ?Here’s the list:

Avon Products [AVP]
Avnet [AVT]
Charlotte Russe [Formerly CHIC — Bought out by Advent International]
Cimarex Energy [XEC]
Devon Energy [DVN]
Deerfield Triarc?[formerly DFR, now merged with?Commercial Industrial Finance Corp]
Jones Apparel Group [formerly JNY — Bought out by Sycamore Partners]
Valero Enery [VLO]
Vishay Intertechnology [VSH]
YRC Worldwide [YRCW]

The Collapse of Leverage

Take a look of the last nine of those companies. ?My?losses?all happened during the financial crisis. ?Here I was, writing for RealMoney.com, starting this blog, focused on risk control, and talking often?about rising financial leverage and overvalued housing. ?Well, goes to show you that I needed to take more of my own medicine. ?Doctor David, heal yourself?

Sigh. ?My portfolios typically hold 30-40 stocks. ?You think you’ve screened out every weak balance sheet or too much operating leverage, but a few slip through… I mean, over the last 15 years running this strategy, I’ve owned over 200 stocks.

The really bad collapses happen when there is too much debt and operations fall apart — Deerfield Triarc?was the worst of the bunch. ?Too much debt and assets with poor quality and/or repayment terms that could be adjusted in a negative way. ?YRC Worldwide — collapsing freight rates into a slowing economy with too much debt. ?(An investment is not safe if it has already fallen 80%.)

Energy prices fell at the same time as the economy slowed, and as debt came under pressure — thus the problems with Cimarex, Devon, and to a lesser extent Valero. ?Apparel concepts are fickle for women. ?Charlotte Russe and Jones Apparel executed badly in a bad stock market environment. ?That leaves Avnet and Vishay — too much debt, and falling business prospect along with the rest of the tech sector. ?Double trouble.

Really messed up badly on each one of them, not realizing that a weak market environment reveals weaknesses in companies that would go unnoticed in good or moderate times. ?As such, if you are worried about a crushing market environment in the future, you will need to stress-test to a much higher degree than looking at financial leverage only. ?Look for companies where the pricing of the product or service can reprice down — commodity prices, things that people really don’t need in the short run, intermediate goods where purchases?can be delayed for a while, and anyplace where high fixed investment needs strong volumes to keep costs per unit low.

One final note — Avon calling! ?Ding-dong. ?This was a 2015 issue. ?Really felt that management would see the writing on the wall, and change its overall strategy. ?What seemed to have stopped falling had only caught its breath for the next dive. ?Again,?an investment is not safe if it has already fallen 80%.

There is something to remembering rule number 1 — Don’t Lose Money. ?And rule 2 reminds us — Don’t forget rule number 1. ?That said, I have some things to say on the positive side of all of this.

The Bright Side

A) I did have a diversified portfolio — I still do, and I had companies that did not do badly as well as the minority of big losers. ?I also had a decent amount of cash, no debt, and other investments that were not doing so badly.

B) I used the tax losses to allow a greater degree of flexibility in investing. ?I don’t pay too much attention to tax consequences, but all concerns over?taking gains went away until 2011.

C) I reinvested in better companies, and made the losses back in reasonably short order, once again getting to pay some taxes in the process by 2011. ?Important to note: losses did not make me give up. ?I came back with vigor.

D) I learned valuable lessons in the process, which you now get to absorb for free. ?We call it market tuition, but it is a lot cheaper to learn from the mistakes of others.

Thus in closing — don’t give up. ?There will be losses. ?You will make mistakes, and you might kick yourself. ?Kick yourself a little, but only a little — it drives the lessons home, and then get up and try again, doing better.

Full disclosure: long VLO — made those losses back and then some.

Notes on the SEC’s Proposal on Mutual Fund Liquidity

Posted on 7 October 2015 by David Merkel

I’m still working through the SEC’s proposal on Mutual Fund Liquidity, which I mentioned at the end of?this article:

Q: <snip> Are you going to write anything regarding the SEC?s proposal on open end mutual funds and ETFs regarding liquidity?

A: <snip> …my main question to myself is whether I have enough time to do it justice. ?There?s their white paper on liquidity and mutual funds. ?The proposed rule is a monster at 415 pages, and I may have better things to do. ? If I do anything with it, you?ll see it here first.

These are just notes on the proposal so far. ?Here goes:

1) It’s a solution in search of a problem.

After the financial crisis, regulators got one message strongly — focus on liquidity. ?Good point with respect to banks and other depositary financials, useless with respect to everything else. ?Insurers and asset managers pose no systemic risk, unless like AIG they have a derivatives counterparty. ?Even money market funds weren’t that big of a problem — halt withdrawals for a short amount of time, and hand out losses to withdrawing unitholders.

The problem the SEC is trying to deal with seems to be that in a crisis, mutual fund holders who do not sell lose value from those who are selling because the Net Asset Value at the end of the day does not go low enough. ?In the short run, mutual fund managers tend to sell liquid assets when redemptions are spiking; the prices of illiquid assets don’t move as much as they should, and so the NAV is artificially high post-redemptions, until the prices of illiquid assets adjust.

The proposal allows for “swing pricing.” ?From the SEC release:

The Commission will consider proposed amendments to Investment Company Act rule 22c-1 that would permit, but not require, open-end funds (except money market funds or ETFs) to use ?swing pricing.??

Swing pricing is the process of reflecting in a fund?s NAV the costs associated with shareholders? trading activity in order to pass those costs on to the purchasing and redeeming shareholders.? It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks.? Pooled investment vehicles in certain foreign jurisdictions currently use forms of swing pricing.

A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund?s NAV known as the swing threshold.? The proposed amendments include factors that funds would be required to consider to determine the swing threshold and swing factor, and to annually review the swing threshold.? The fund?s board, including the independent directors, would be required to approve the fund?s swing pricing policies and procedures.

But there are simpler ways to do this. ?In the wake of the mutual fund timing scandal, mutual funds were allowed to estimate the NAV to reflect the underlying value of assets that don’t adjust rapidly. ?This just needs to be followed more aggressively in a crisis, and peg the NAV lower than they otherwise would, for the sake of those that hold on.

Perhaps better still would be provisions where exit loads are paid back to the funds, not the fund companies. ?Those are frequently used for funds where the underlying assets are less liquid. ?Those would more than compensate for any losses.

2) This disproportionately affects fixed income funds. ?One size does not fit all here. ?Fixed income funds already use matrix pricing extensively — the NAV is always an estimate because not only do the grand majority of fixed income instruments not trade each day, most of them do not have anyone publicly posting a bid or ask.

In order to get a decent yield, you have to accept some amount of lesser liquidity. ?Do you want to force bond managers to start buying instruments that are nominally more liquid, but carry more risk of loss? ?Dividend-paying common stocks are more liquid than bonds, but it is far easier to lose money in stocks than in bonds.

Liquidity risk in bonds is important, but it is not the only risk that managers face. ?it should not be made a high priority relative to credit or interest rate risks.

3) One could argue that every order affects market pricing — nothing is truly liquid. ?The calculations behind the analyses will be fraught with unprovable assumptions, and merely replace a known risk with an unknown risk.

4)?Liquidity is not as constant as you might imagine. ?Raising your bid to buy, or lowering your ask to sell are normal activities. ?Particularly with illiquid stocks and bonds, volume only picks up when someone arrives wanting to buy or sell, and then the rest of the holders and potential holders react to what he wants to do. ?It is very easy to underestimate the amount of potential liquidity in a given asset. ?As with any asset, it comes at a cost.

I spent a lot of time trading illiquid bonds. ?If I liked the creditworthiness, during times of market stress, I would buy bonds that others wanted to get rid of. ?What surprised me was how easy it was to source the bonds and sell the bonds if you weren’t in a hurry. ?Just be diffident, say you want to pick up or pose one or two?million of par value in the right context, say it to the right broker who knows the bond, and you can begin the negotiation. ?I actually found it to be a lot of fun, and it made good money for my insurance client.

5) It affects good things about mutual funds. ?Really, this regulation should have to go through a benefit-cost analysis to show that it does more good than harm. ?Illiquid assets, properly chosen, can add significant value. ?As Jason Zweig of the Wall Street Journal said:

The bad news is that the new regulations might well make most fund managers even more chicken-hearted than they already are ? and a rare few into bigger risk-takers than ever.

You want to kill off active managers, or make them even more index-like? ?This proposal will help do that.

6) Do you want funds to limit their size to comply with the rules, while the fund firm rolls out “clone” fund 2, 3, 4, 5, etc?

Summary

You will never fully get rid of pricing issues with mutual funds, but the problems are largely self-correcting, and they are not systemic. ?It would be better if the SEC just withdrew these proposed rules. ?My guess is that the costs outweigh the benefits, and by a wide margin.

Long-term Relationships and Credit Scores

Posted on 3 October 20154 October 2015 by David Merkel

Photo Credit: Vladimir Pustovit || But do they have compatible credit scores?

Unlike many commentators, I tend to think credit scores are a good thing. In a big world, it is difficult for large financial institutions to figure out the most import “C” of the four Cs of Credit — Character. ?Credit scores offer an imperfect but generally useful shortcut in what is often an anonymous world.

In my last article on the topic, I noted that in addition to lending, credit scores are used in renting, insurance, employment, and a wide number of other areas. ?One new place where credit scores could prove useful is analyzing a prospective spouse. ?An academic paper suggests the following:

Birds of a feather flock together — in general, people tend to enter into long-term relationships?those?with similar credit scores.
Relationships?with higher credit scores tend to last longer.
Those with larger gaps in the credit scores have a higher probability of the relationship ending sooner.

Though the paper is more broad than marriage, I am going to shift over to marriage for the rest of this article. ?Why? ?Every now and then, I get called in to do marriage counseling, typically along with my pastor and fellow elders. ?I’m not perfect, so my marriage isn’t perfect, but it is very good.

Marriages tend to fail because the husband and wife disagree on goals or methods for the partnership that they have entered into. ?Common disagreements and problems involve:

Money
Sex
Children — number, methods of raising
Lack of companionship — shared goals, responsibilities, etc.
Bad communication patterns
Sins that need to be repented of — anger & abuse, adultery & related, laziness, substance abuse,?disdain, lying, etc.
And more — there are more ways to get it wrong than to get it right, just as there are more wrong answers on tests than right answers.

I’m only going to handle the money issue here, though laziness, lying, bad communication, and lack of clearly specifying and agreeing to goals play a large role in money problems. ?Going back to my earlier article on credit scores, you might recall that I said that credit scores were a moderately accurate measure of moral tendency on average. ?Quoting:

Honoring agreements that you have entered into is an important indicator of your personality.? Those who do not repay are on average less moral than those that repay.? Those that are net creditors on average made efforts that net debtors did not.

Credit scores are important.? In a specific way, they measure your willingness to keep your word.? Anytime you enter into a debt contract, you make a promise to repay.? If you fulfill your promise to repay, you impress others as one of good moral character.? If you don?t repay, it is vice-versa, you appear to be of low moral character.? (Note: I am excluding those that got hoodwinked by lenders that defrauded borrowers in a variety of ways.? That said, if you can be hoodwinked, that says something else about you, and that may have an impact on your creditworthiness as well.)

Now, before I continue, these concepts work on average, and not always in particular.? I have helped some at the edge of society with gifts and loans.? In some cases there is a cascade of bad events that the most intelligent would have a hard time facing.? Being wise helps, but there are some situations that would tax the soul of anyone, and be difficult to claim that they were blameworthy; it?s just the way things happened.

The “keeping your word” part is important for marriage. ?After all, marriage begins with a simple public promise of mutual fidelity between a man and a woman. ?If you can’t keep your word in one area, i.e., paying off a debt, your ability to keep your word in another area, marital fidelity, may be less likely as well. ?As such, it shouldn’t be too surprising that those with higher credit scores tend to have longer lasting relationships on average. ?They keep their word better, and will tend to have fewer money problems, because they manage their finances well.

As for the couples that have dramatically different credit scores between the two of them, there is the possibility that the more responsible one will get fed up with the lack of discipline on the part of his/her spouse. ?Or, the one with less self-controlled spouse will grow to disdain the one trying to bring order. ?If not handled properly, it can lead to a breakup — no one wants to feel their resources are being wasted, and no one likes constant criticism.

No Determinism Here

For those that do have difficulties here, I can tell you that you can change. ?It is not a question of ability, but of willingness to do so. ?The same is true in saving any marriage. ?Ask, “Is this the way I wanted things to end up? ?Didn’t I have better goals than this?” ?and then get to: “Am I willing to give up my bad habits, my purely personal interests, my pride, for the good of my spouse? ?Am I willing to work in the best interests of the both of us, even if I don’t get everything I want?”

Tough stuff. ?It’s a wonder that any marriages hang together. ?But change is possible, and it usually begins with a shared commitment to agree on goals, execute those goals faithfully, leaving behind laziness, overspending and over-committing (taking on too much debt). ?Dave Ramsey and many others are good counselors in this area.

If you have never budgeted before, it will be time to do so. ?Again, there are many good guides on the Internet, and at bookstores. ?Find one that fits your personality and go with it. ?(I have never kept a budget in my life, so I would have a hard time advising there. ?I don’t spend much on myself, and neither does my wife.)

Telling you that you can raise your credit score is superfluous. ?That’s a symptom, not the disease. ?If you manage household finances well, and keep your word on paying debts on time, that will take care of itself. ?The harder thing is changing the bad habits of spending incautiously.

Now, in the short run, for couples where the two parties are different with willingness to manage money well, there is another solution if both parties are willing to do it. ?The one that is less disciplined with money should cede management of finances to the one that is more disciplined. ?The one that is more?disciplined then gives the one that is less disciplined a regular allowance (mutually agreed upon). ?To husbands I would add that if the wife is the one who is better the money, cede that to her, and don’t let your pride get in the way. ?Be grateful that you have a bright and responsible wife, and take delight in it. ?Far better to have an orderly and well-run household than to have a household that is failing.

This is up to?both parties to the marriage to make it work. ?It is easy to be selfish, and hard to accept the fact that we are flawed in the way that we handle relationships. ?Once humility comes (something that I need too), and communication improves, then real progress can be made in repairing household finances, and hopefully bigger things as well — life isn’t all about money. ?But when money is badly handled, it is an engine of relationship destruction.

Thus, if you have money problems in marriage, choose wisely, be humble and unselfish, and do what is best for the one that you pledged to love till death do you part.

Book Review: The Art of Execution

Posted on 1 October 2015 by David Merkel

Some books are better in concept than they are in execution. ?Ironically, that is true of “The Art of Execution.”

The core idea of the book is that most great investors get more stocks wrong than they get right, but they make money because they let their winners run, and either cut their losses short or reinvest in their losers at much lower prices than their initial purchase?price. ?From that, the author gets the idea that the buy and sell disciplines of the investors are the main key to their success.

I know this is a book review, and book reviews are not supposed to be about me. ?I include the next two paragraphs to explain why I think the author is wrong, at least in the eyes of most investment managers that I know.

From my practical experience as an investment manager, I can tell you that your strategy for buying and selling?is a part of the investment process, but it is not the main one. ?Like the author, I also have hired managers to run a billion-plus dollars of money for a series of multiple manager funds. ?I did it for the pension division of mutual life insurer that no longer exists back in the 1990s. ?It was an interesting time in my career, and I never got the opportunity again. ?In the process, I interviewed a large number of the top long-only money managers in the US. ?Idea generation was the core concept for almost all of the managers. ?Many talked about their buy disciplines at length, but not as a concept separate from the hardest part of being a manager — finding the right assets to buy.

Sell disciplines received far less emphasis, and for most managers, were kind of an afterthought. ?If you have good ideas, selling assets is an easy thing — if your ideas aren’t good, it’s hard. ?But then you wouldn’t be getting a lot of assets to manage, so it wouldn’t matter much.

Much of the analysis of the author stems from the way he had managers run money for him — he asked them to invest on in their ten best ideas. ?That’s a concentrated portfolio indeed, and makes sense if you?are almost certain in your analysis of the stocks that you invest in. ?As such, the book spends a lot of time on how the managers traded single ideas as separate from the management of the portfolio as a whole. ?As such, a number of examples that he brought out as bad management by one set of managers sound really?bad, until you realize one thing: they were all part of a broader portfolio. ?As managers, they might not have made significant adjustments to a losing position because they were occupied with other more consequential positions that were doing better. ?After all, losses on a stock are capped at 100%, while gains are theoretically infinite. ?As a stock falls in price, if you don’t add to the position, the risk to the portfolio as a whole gets less and less.

Thus, as you read through the book, you get a collection of anecdotes to illustrate good and bad position and money management. ?Any one of these might sound bright or dumb, but they don’t mean a lot if the rest of the portfolio is doing something different.

This is a short book. ?The pages are small, and white space is liberally interspersed. ?If this had been a regular-sized book, with white space reduced, it might have taken up 80-90 pages. ?There’s not a lot here, and given the anecdotal nature of what was written, it is?not much more than the author’s opinions. ?(There are three pages citing an academic paper, but they exist as an afterthought in a chapter on one class of investors. It has the unsurprising result that positions that managers weight heavily do better than those with lower weights.) ? As such, I don’t recommend the book, and I can’t think of a subset of people that could benefit from it, aside from managers that want to be employed by this guy, in order to butter him up.

Quibbles

The end of the book mentions liquidity as a positive factor in asset selection, but most research on the topic gives a premium return to illiquid stocks. ?Also, if the manager has concentrated positions in the stocks that he owns, his positions will prove to be less liquid than less concentrated positions in stocks with similar tradable float.

Summary / Who Would Benefit from this Book

Don’t buy this book. ?To reinforce this point, I am not leaving a link to the book at Amazon, which I ordinarily do.

Full disclosure:?I?received a?copy from a PR flack.

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

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

How Much is that Asset in the Window? (II)

Posted on 27 September 2015 by David Merkel

Q: So what is an asset worth?

A: I thought we talked about that.

Q: Yes, but we never really got through it. ?Suppose on a nonvolatile day I want to sell $100 in shares of?an open end mutual fund. ?Now suppose I want to sell 5%?of the total shares of the same fund. ?What are my mutual fund shares worth?

A: This problem isn’t any different than that for an individual stock. ?Liquidity carries a price. ?If you want to buy or sell a lot at any given time, and you are the one demanding the trade be done, you will have to pay up for that privilege. ?People who are less motivated than you will have to receive compensation for taking the other side of the trade.

Q: But on a mutual fund, why should the price move on a big trade? ?Shouldn’t everything be tradable at the closing NAV?

A: Can you sell the whole world at the close? ?To whom? ?Where will you get all of the cash?

Q: Huh?

A: Only a tiny fraction of all the assets in the world trade on any given day. ?There isn’t a lot of reason for most assets to trade — in the long run, we make money when we hold , not when we trade. ?Trading itself is a small net economic loss, with money paid to brokers.

This is why there are primary markets, secondary markets, and within secondary markets, block trades. ?Any big trade in stocks or bonds requires special handling — either a trader has to break it up into a bunch of little trades, or he has to hand it off to a specialist who finds someone willing to take the other side as a whole for a price concession, or the block trader takes the trade himself for a concession and tries to cover the position through small trades.

The thing is, there is not one price for an asset at any given point, but many prices — and they change depending upon how many want to buy or sell, and how quickly. ?More buyers? ?Crawl up the supply curve. ?More sellers? ?Slide down the demand curve. ?There is no one price — and when we do name one price, it is a shortcut — a convenience.

Q: I find that confusing.

A: Look, economics has almost always moved in the direction of greater subjectivity over time. ?An asset does not necessarily have the same value to you as it does to someone else. ?Consider my house as an example.

Q: I’ve been to your house — it’s a bit of a hovel. ?You couldn’t pay me to live there.

A: And I love it. ?I have a lot of happy memories there.

Q: Aren’t we off track? ?There’s a lot of difference between a unique house, and a share of a mutual fund.

A: That is only true because we sell identical tiny slices of a mutual fund. ?If you wanted to sell all of the assets of the mutual fund as a whole, it is the same problem.

Liquidity in markets is always limited. ?Always. ?A small stream of trades helps validate prices for a given asset and related assets, but is inadequate to answer the question of what happens to the price when you want to do a big trade in a short period of time. ?After all, supply and demand curves are theoretical constructs — it’s not as if you can look them up in the daily newspaper.

Q: What’s a newspaper? 😉

A: Humph. ?Are we done yet?

Q: I guess for now. ?Are you going to write anything regarding the SEC’s proposal on open end mutual funds and ETFs regarding liquidity?

A: Probably. ?I had a knee-jerk response to it, but as I read more about it, I became convicted that I had to study it more before I birthed bits and bytes into the cold abyss of the internet. ?Remember, last time I wrote, I sent it to the SEC, and even talked with their legal staff. ?Off the cuff most of the difficulties could probably be solved by loads that get paid to the mutual funds any time shares are created or liquidated, but that’s just a bias. ?I like simple solutions because perfect regulations are a terror — perfection is impossible, so write something simple that covers 90% of it, and ignore the rest.

But all for now — my main question to myself is whether I have enough time to do it justice. ?There’s their white paper on liquidity and mutual funds. ?The proposed rule is a monster at 415 pages, and I may have better things to do. ? If I do anything with it, you’ll see it here first.

Q: Until then.

Book Review: DIY Financial Advisor

Posted on 26 September 2015 by David Merkel

I am generally not a fan of formulaic books on investing, and this is particularly true of books that take unusual approaches to investing. This book is an exception because it does nothing unusual, and follows what all good quantitative investors know have worked in the past. ?The past is not a guarantee of the future, but?if the theories derived from past data make sense from what we know about human nature, that’s about as good as we can get.

The book begins with a critique of the abilities of financial advisors — their fees, asset allocation, and security selection. ?It then shows how models of financial markets outperform most financial advisors.

Then, to live up to its title , the book gives simple versions of models that can be applied by individuals that would have outperformed the markets in the past. ?You can beat the markets, lower risk, and “Do It Yourself [DIY].” ?It provides models for asset allocation, stock selection, and risk control, simple enough that a motivated person with math skills equal to the first half of Algebra 1 could apply them in a moderate amount of time per month. ?It also provides a simpler version of the full model that omits the security selection for stocks.

The book closes by offering three reasons why people won’t follow the book and do it themselves: fear of failure, inertia, and not wanting to give up an advisor who is a friend. ?It also offers three risks for the DIY investor — overconfidence, the desire to be a hero (seems to overlap with overconfidence), and that the theories may be insufficient for future market behavior.

This is where I have the greatest disagreement with the book. ?I interact with a lot of people. ?Most of them have no interest in learning the slightest bit about investing. ?Some have some inclination to learn about investing, but even the simple models of the book would make their heads spin, or they just wouldn’t want to take the time to do it. ?Some of it is similar to seeing a Youtube video on draining and refilling your automatic transmission fluid. ?You might watch it, and say “I think I get it,” but the costs of making a mistake are sufficiently severe that you might not want to do it without an expert by your side. ?Most will take it to the repair garage and pay up.

I put a knife to my own throat as I write this, as I am an investment advisor, but there is more specialized knowledge in the hands of an auto mechanic than in an investment advisor, and the risk of loss is lower to manage your own money than to fix your own brakes. ?That said, enough people after reading the book will say to themselves, “This is just one author, and I barely understand the performance tables in the book — if right, am I capable of doing this? ?Or, could it be wrong? ?I can’t verify it myself.”

The book isn’t wrong. ?If you are willing to put in the time to follow the instructions of the authors, I think you will do better than most. ?My sense is that the grand majority?people are not willing to do that. ?They don’t have the time or inclination.

Quibbles

The book could have been clearer on the ROBUST method for risk control. ?It took me a bit of effort to figure out that the two submodels share half of the weight, so that when submodels A & B flash green — 100% weight, one green and one red — 50% weight, both red — 0% weight.

Also, the book is enhanced by the security selection model for stocks, but how many people would have the assets to assemble and maintain a portfolio with sufficient diversification? ?The book might have been cleaner and simpler to leave that out. ?The last models of the book don’t use it anyway.

Summary / Who Would Benefit from this Book

I liked this book, and I recommend it for those who are willing to put in the time to implement its ideas. ?This is not a book for beginners, and you have to be comfortable with the small amount of math and the tables of financial statistics, unless you are willing to trust them blindly. ?(Or trust me when I say that they are likely accurate.)

But with the caveats listed above, it is a good book for people who are motivated to do better with their investments. ?If you want to buy it, you can buy it here:?DIY Financial Advisor.

Full disclosure:?I?received a?copy from one of the authors, a guy for whom I have respect.

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

Don’t Worry About Public Bond Market Illiquidity

Posted on 23 September 2015 by David Merkel

Photo Credit: Mike Beauregard || Frozen solid, right?

The talk regarding an illiquid public corporate bond market goes on, and if you’ve read me over the past year on this topic, you know that I don’t think it is a serious issue. ?One of the reasons why it is not a big issue is that the public bond market is designed to be low liquidity.

It starts with how bonds are originally issued. ?New bonds and new stocks are issued in similar ways, but with a few differences:

IPOs of stocks have a higher retail component. ?Bonds, aside from muni bonds, are typically almost entirely institutional
IPOs are typically priced cheap, but with bonds the cheapness is smaller and more frequent.
Bond IPOs usually happen with companies that have issued other bonds before
Bond IPOs happen more frequently, except in a bear market
Bond IPOs typically happen more rapidly, minutes to a few days, except in a bear market

IPOs on Wall Street get allocated if they are oversubscribed. ?When they are oversubscribed, the deal is typically good, and everyone wants more, so they put in huge orders. ?The dealer desks on Wall Street solves this problem by allocating proportionate?to the size that they have come to understand the managers in question typically buy and sell at,?with some adjustment for account profitability.

Those that flip cheap bonds for a quick profit typically get penalized, and their allocations get reduced. ?Those that buy bonds in the open market when the deal breaks and becomes “free to trade” can become eligible for larger allocations. ?The dealer desks work in this way because they want the buyers to be long-term holders, and not seekers of easy profits from flipping. ?That doesn’t mean you can never trade a bond you have bought — just not in the first month, subject to a few exceptions like a small allocation, your credit analyst rejected it, etc. ?(Oh, and if one of those exceptions exists, the primary dealers want to do the secondary trade. ?If the exceptions don’t exist, they don’t want to know about it.)

If flippers ever get big, despite the efforts of the dealer desks, they will price a deal very tight, and let the flippers take a big loss, with no one wanting to buy the excess bonds unless they are much, much cheaper.

The main effect of this is that once a deal is allocated, it is typically “well-placed,” with few secondary trades after the IPO. ?This is even more pronounced with mortgage bonds, which aside from the AAA tranches, have very small tranche sizes, making them very illiquid.

In this environment, where yields have fallen over the past few years, it is difficult for financial companies that have bought bonds to replace the income if they sell the bond. ?Thus, few bonds will be sold unless they are in the hands of?buyers that don’t have a formal balance sheet, or, when credit quality is deteriorating badly.

Add in one more factor, and you can see why the market is so illiquid — the buy side of the market is more concentrated than in prior years, with big buyers like PIMCO, Blackrock, Metlife, Prudential, etc. being a larger portion of the market. ?Concentrated markets with few holders tend to be less liquid.

All Good/Bad Things Must Come to an End

Some of these factors can be reversed, and others can be mitigated.

There’s no reason why the buy side has to stay concentrated. ?Big institutions eventually break up because diseconomies of scale kick in. ?Management teams typically do worse as companies get more complex.
Eventually interest rates will rise. ?Once bonds are in a nearly neutral to negative capital gains positions, parties with balance sheets will trade bonds again.
Even mutual funds that own a lot of yieldy bonds can have a strategy for dealing with the illiquidity. ?Yieldy bonds have excess yield relative to bonds of similar duration and credit quality, and are often less liquid because there is something odd about them that makes some portion of the market skeptical, which reduces liquidity. ?A mutual fund holding a lot of less liquid bonds, can deal with illiquidity by selling opportunistically, selling more liquid bonds in the short-run, while discreetly inquiring on a few less liquid issues to see where real bids might be. ?Remember, the amount of underperformance is likely to be limited, if any, so a run on a mutual fund is not likely, but in the unlikely case of a run, this can mitigate the effects. ?Personally, I would not be concerned, so long as you keep your pricing marks conservative if cash outflows become a rule in the short-run.

In closing, don’t worry about illiquidity in the bond markets. ?If there is a need for liquidity, the problem will solve itself as sellers lose a little bit in order to gain cash to make payments. ?It’s that simple.

Two Bits of Advice for the Fed

Posted on 19 September 201520 September 2015 by David Merkel

Here are two ideas for the Fed, not that they care much about what I think:

1) Stop holding regular press conferences and holding regular meetings. ?Only meet when a supermajority of your members are calling for a change in policy. ?Don’t announce that you are holding a meeting — perhaps do it via private video conference.

Part of the reason for this is that it is useless to listen to commentary about why you did nothing. ?You may as well have not held a meeting. ?Another reason is that governors could act more independently if a meeting can’t be called unless a supermajority of voting members calls for it.

Yet another reason is that the frequent and long communication has not eliminated the Kremlinology that exists to interpret the Fed. ?When changes to the FOMC statement are small, they get over-interpreted — remember the “taper” comment? ?Far better to say nothing than to repeat yourself with small meaningless variations.

Along with that, you could eliminate issuing statements altogether, and go back to the way things were done pre-Greenspan. ?Need it be mentioned that monetary was executed better under Volcker and Martin? ?We don’t need words, we need to feel the actions of the Fed. ?That brings me to:

2) Stop trying to support risky asset markets. ?It is not your job to give equity or corporate bond investors what they want. ?If you do that, too much liquidity gets injected into the system, creating the financial bubbles of 2000 and 2007-9.

Instead, give the risk markets some negative surprises. ?Don’t follow Fed funds futures; make them follow you. ?Show them that you are the boss, not the slave. ?Let recessions do their good work of clearing out bad debts, and then the economy can grow on a better basis. ?Be like Martin, and take away the punchbowl when the party gets exciting.

Do these things and guess what? ?Monetary policy will have more punch. ?When you make a decision, it will actually do something.

Realize that policy uncertainty is not poison for risk markets. It forces businessmen to avoid marginal ideas — things that only survive when the weather is fair. ?The accumulated underbrush of bad debts doesn’t keep building up until the eventual fire is impossible to control.

If were going to have fiat money, do it in such a way that bubbles do not develop, which means not caring about the effects of policy on risky asset markets. ?This might not be popular, but it would be good for the economy in the long run.

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As a final note let me end with one chart from the recent data from FOMC participants:

I?suspect the FOMC will tighten in December, but remember that the FOMC doesn’t have a roadmap for the environment they are in, and they are acting like slaves to the risky asset markets. ?Another burp in the markets, and lessening policy accommodation will be further delayed.

Redacted Version of the September 2015 FOMC Statement

Posted on 17 September 2015 by David Merkel

Comments

This FOMC statement was another great big nothing. Only notable change was the influence of risky asset markets and foreign markets on the decision-making process on the FOMC.
Don?t expect tightening in October. People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever.? This is the sort of statement they issue when things are ?steady as you go.?? There is no hint of imminent policy change.
Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
Equities flat and long bonds rise. Commodity prices rise and the dollar falls.
The FOMC says that any future change to policy is contingent on almost everything.
Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.? We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

Okay, Go Ahead, Sweat the Fed

Posted on 17 September 2015 by David Merkel

Photo Credit: Nate Steiner || There is always enough time to panic. ;) — Photo Credit: Nate Steiner || There is always enough time to panic. 😉

Today, I happened to stumble across an old article of mine: Easy In, Hard Out (Updated). ?It’s kind of long, but goes into the changes that have happened at the Fed since the crisis, and points out why tightening policy might be tough. ?Nothing has changed in the 2.4 years since I wrote it, so I am going to reprint the end of the article. ?Let me know what you think.

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In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.? Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.? Staying short maintains flexibility.

Yes, the Fed does not mark its securities or gold to market.? Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.? Rare exceptions ? home soil wars that fail, or political repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.? (Hey, the central bank has been eliminated twice before.? It could happen again.)

The only real effect is on how much?seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.? This isn?t trivial; when people hear the central bank is ?broke,? they will do weird things.? To avoid that, the Fed?s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.? Can you imagine what the replacement cost of the NY Fed building is?? The temple in DC?

Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.

Back to the main point.? What effect will this abnormal monetary policy have in the future?

Scenarios

1) Growth strengthens and inflation remains low.? In this unusual combo, it will be easy?for the Fed to collapse its balance sheet, and raise rates.? This is the dream scenario; and I don?t think it is likely.? Look at the global economy; there is a lot of slack capacity.

2) Growth strengthens and inflation rises.? The Fed will likely raise the interest on reserves rate, but not sell bonds.? If they do sell bonds, the market will back up, and their losses will be horrible.? If don?t take the losses,?seigniorage could be considerably reduced, or even vanish, as the Fed funds rate rises, but because of the long duration asset portfolio, asset income rises slowly.? This is where the asset-liability mismatch bites.

If the Fed doesn?t raise the interest on reserves rate, I suspect banks would be willing to lend more, leaving fewer excess reserves at the Fed, which could stimulate more inflation. Now, there are some aspects of inflation that remain a mystery ? because sometimes inflationary conditions affect assets, rather than goods, I think depending on demographics.

3) Growth weakens and inflation remains low.? This would be the main scenario for QE4, QE5, etc.? We don?t care much about the Fed?s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.

4) Growth weakens and inflation rises, i.e. stagflation.? There?s no good set of policy options here. The Fed could engage in further financial repression, keeping short rates low, and let inflation reduce the nominal value of debts.? If it doesn?t run wild, it could play a role in reducing the indebtedness of the whole economy, though again, it will favor debtors over savers.? (As I?ve said before, in a situation like this, or like the Eurozone, all creditors want to be paid back at par on the bad loans that they have made, and it can?t be done.? The pains of bad debt have to go somewhere, where it goes is the argument.)

I?ve kept this deliberately simple, partially because with all of the flows going back and forth, and trying to think of the whole system, rather than effects on just one part, I know that I have glossed over a lot.? I accept that, and I could be dead wrong, as I sometimes am.? Comment as you like, with grace and dignity, and let us grow together in our knowledge.? I?ve been spending some time reading documents at the Fed, trying to understand their mechanisms, but I could always learn more.

Summary

During older times, the end of a Fed loosening cycle would end with the Fed funds rate rising.? In this cycle, it will end with interest of reserves rising, and/or, the sale of bonds, which I find less likely (they will probably be held to maturity, absent some crisis that we can?t imagine, or non-inflationary growth).? But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the ?policy accommodation.?? That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.

Far better to be like McChesney Martin or Volcker, and be tough, letting recessions do their necessary work of eliminating bad debt.? Under Greenspan, and Bernanke to a lesser extent (though he persists in pushing the canard that the Fed was not too loose 2003-2004, ask John Taylor for more), there were many missed opportunities to stop the buildup of bad debts, but the promise of the ?Great Moderation? beguiled so many.

Removing policy accommodation is always tougher than imagined, and carries new risks, particularly when new tools have been used.? Bernanke can go to his carefully chosen venues and speak to his carefully chosen audiences, and try to exonerate the Fed from well-deserved blame for their looseness in the late 80s, 90s, and 2000s.? Please, Mr. Bernanke, take some blame there on behalf of the Fed ? the credit boom could never have happened without the Fed.? Painting the Fed as blameless is wrong; the ?Greenspan put? landed us in an overleveraged bust.

I?m not primarily blaming the Fed for its current conduct; we are still in the aftermath of a lending bust ? too much bad mortgage debt, with a government whose budget is out of balance.? (In the bust, there are no good solutions.)? I am blaming the Fed for loose policies 1984-2007, monetary policy should have been a lot tighter on average.? But now we live with the results of prior bad policy, and may the current Fed not compound it.

Postscript

The main difference between this time and the last time I wrote on this is QE3.? What has been the practical impact since then?? The Fed owns more MBS and long maturity Treasuries, financed by more reserve balances at the Fed.

Banks use this cheap funding to finance other assets.? But if they want to make money, the banks have to take credit risk (something the Fed is trying to stimulate), and/or interest rate rate risk (borrow short, lend long, negative convexity, etc).? The longer low rates go on through interest on reserves, the greater the tendency to build up imbalances in the banking system through credit and interest rate risks. 1992-1993 where Fed funds rates were held at 3%, was followed by the residential mortgage backed security market melting down in 1994, not to mention Mexico.? Sub-2% Fed funds rates from 2002 through mid-2004 led to massive overinvestment in residential housing, leading to the present crisis.

Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates.? Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough.? Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008.? And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound.? At present, my suspicion is that we still have more trouble to come in banking sector.? Here?s why:

We?ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% ? this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight.? This is why I believe that any removal of policy accommodation will prove very difficult.? The greater the amount of policy accommodation, the greater the difficulties of removal.? Watch the fireworks, if/when they try to remove it.? And while you have the opportunity now, take some risk off the table.