Photo Credit: Tulane Public Relations || James Carville wants to be “reincarnated” as the bond market, to scare everyone — boo!
I was reading this article at Reuters, and musing at how ludicrous it is?for the Fed to think that it can control the reaction of the bond market to tightening Fed policy, should it ever happen. ?The Fed has never been able to control the bond market, except on the short end, and only with the highest quality paper.
The long end is controlled by the economy as a whole, and its rate of growth, while lower quality bonds and loans also respond more to where the credit cycle is. ?The Fed has never been able to tame the credit cycle — the boom and the bust. ?If anything, they make the booms and busts worse.
Now they think that their new policy tools will enable them to control the bond market. ?The new tools are nothing astounding, and still mostly affect short and high quality debts.
One thing is certain — when the Fed starts tightening, some levered parties will blow up. ?Even the mention of the taper caused shock waves in the emerging bond markets. ?And when something big blows up, the Fed will stop tightening. ?It always happens, and they always do.
So please give up the idea that the Fed?can do what it wants. ?It looks like it can in the short-run, but in the long run markets do what they want, and the Fed has to respond, rather than lead.
Different sectors of the stock market, and their prospects.
This was the first half of the interview. ?If they run the second half, I will post it. ?Note my modest confusion on the tech bubble as I forget the second thing and try to recall it, while vamping for time. ?I don’t often glitch under pressure, but this was a bad time to have a foggy memory (on something that I wrote myself). ?Sigh. 🙁
Full disclosure: positions in sectors mentioned, but no positions in any specific securities mentioned
Before I write this evening, I have updated the blog’s theme so that it is more readable on mobile devices. ?I’ve tried to preserve most of the best of the former design. ?Let me know what you think. ?Also, I have tried to get commenting to work using Jetpack. ?For those that want to comment, if you can’t, drop me an email, and I will try to work it out. ?I prefer more interaction than less, even if I can’t always get around to responding.
Guarantees that they’ll get their money back first if the company goes public or sells.
They can also negotiate to receive?additional?free?shares if a subsequent round’s valuation is less favorable
Warrants to allow the purchase of shares at a cheap price if valuations fall.
Here’s my take. ?When companies try to offer protection on credit or market capitalization, the process usually works for a while and then fails. ?It works for a while, because companies look best immediately after they receive a dollop of cash, whether via debt or equity. ?Things may not look so good after the cash is used, and expectations give way to reality.
In the late ’90s and early 2000s a number of companies tried doing similar machinations because they had a hard time borrowing at reasonable rates, or, they wanted to avoid clear public disclosure of their debt terms. ?In the bear market of 2000-2002, most of these schemes blew up, some catastrophically, like Enron, and some doing minor damage, like Dominion Power with their fiber ventures subsidiary.
When you hear about a guarantee, think about how large it is relative to the total size of the company, and what would happen if the guarantee were ever tapped by everyone who could. ?If the guarantee is fueled by some type of dilution (issuing stock now or contingently in the future), maybe the total shares to issue would be so large that the price per share would collapse further.
There’s no magic here — there is no good way in the long run to guarantee a certain market cap or creditworthiness. ?That said, I agree with the article, this sort of behavior comes near the end of a cycle, as does the behavior in this article:?Why Bankers Are Leaving Finance for No-Salary Tech Jobs.
We saw this behavior in the late ’90s — people jumping to work at startups. ?As I?often say, the lure of free money brings out the worst in people. ?In this case, finance imitates baseball: those that swing for the long ball get a disproportionate amount of strikeouts. ?This also tends to happen later in a speculative cycle.
So be wary with private equity focused on tech, and any collateral damage that may come from deflation of speculative valuations in technology and other hot sectors.
There was a lot of hoopla yesterday over the FOMC removing the word “patient” from its statement. ?But when you read the sentence that replaced the sentence containing the word patient, you shouldn’t think that much has changed:
Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.
There are two contingencies here, which are both subject to considerable latitude in interpretation:
Seeing further improvement in the labor market
Being?reasonably confident that inflation will move back to its 2 percent objective over the medium term
I have long argued that the FOMC doesn’t have a strong theory for what they are doing, and have designed their language in speaking to the markets to maximize their flexibility. ?It has not been the obfuscation of the overly confident Greenspan era, but the endless blather that comes from trying to be “transparent” and drown the market in communications, because they never quite understand us properly.
Now, for the first time in a while, the FOMC statement shrank, and for that, I thank the FOMC. ?It should shrink further, and it would be better if the FOMC said nothing, and went back to pre-Greenspan practices, and let the actions of the Open Markets Desk at the New York Fed do the talking. ?Deeds, not words.
Now, data isn’t the same as deeds, and they aren’t always as clear as words, but the FOMC gave us a release of the forecasts of its members yesterday. ?The graphs in this piece reflect the central tendency of their estimates, giving proper weight to the dominant views, as well as less weight to the views from the?outliers.
Start with the graph at the top of this article. ?The average of all of the views suggests tightening in September. ?Now, with 15 favoring a move in 2015, a move will likely happen this year. ?If you look back through their data releases, a preponderance of opinion has pointed to 2015 since September of 2012, with never fewer than 12 members pointing to a move in 2015 since then.
But what of the shift in opinions regarding the level of the Fed Funds rate over time? ?What happened to that with the removal of the “patient” language?
My but they got more dovish…
Look at the reduction in the expected end of year Fed Funds rate — down 0.35% in 2015 (to 0.77%), 0.51% in 2016, 0.32% in 2017, and 0.12% in the long run. ?That last number is significant, because of the change in composition of those giving opinions, and it indicates a more generally dovish group.
But the downward moves in values indicate fewer tightening moves for 2015 — at present the estimate would be 2-3 quarter-percent moves. (And five more eaches in 2016 and 2017, for those who dream that savers might get some compensation, and that the government’s budget works at higher levels of interest rates)
A big reason for the shift is the move in views on PCE inflation:
Still behind the deflationary curve…
That’s a 0.59% move down in PCE inflation estimates for 2015. Odds are, it will be lower than that. The FOMC as forecasters always chase trends, and rarely get ahead of them. They also believe in the power of monetary policy to produce inflation, and more perversely, growth. As it is, their actions have produced little of either.
It does explain why their estimates for 2016 and beyond are so high. Would any of the members dare to break from the lockstep, and concede that monetary policy does not have significant power to affect the economy for good?
Here is the real GDP graph:
Down, down, down…
Note the continued move down in estimates for all future periods. Interesting to see the pessimistic shift.
Finally, the unemployment rate graph:
Discouraged workers of the world unite, you have nothing to lose but…
There are many jobs to be had, if people will search for them, and if they think the wages are worth taking, versus alternatives of leisure, working in unreported labor markets, etc…
Conclusion
Looking at the data, the FOMC certainly isn’t hawkish at present. That is consistent with the change in language in the statement, which left timing for any future hikes in the Fed Funds rate vague, and subject to interpretation. This explains the fall in the US Dollar, and the rise in the prices of stocks, long bonds, and commodities. The markets viewed it all as continued monetary lenience, and given the composition of voting members on the FOMC, that should come as no surprise at all.
Until something breaks, expect the FOMC to continue to err on the side of monetary lenience… it’s the only thing they know.
Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace.
Information received since the Federal Open Market Committee met in January suggests that economic growth has moderated somewhat.
Shades GDP down.
Labor market conditions have improved further, with strong job gains and a lower unemployment rate.? On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish.
Labor market conditions have improved further, with strong job gains and a lower unemployment rate. A range of labor market indicators suggests that underutilization of labor resources continues to diminish.
No change.
Household spending is rising moderately; recent declines in energy prices have boosted household purchasing power.? Business fixed investment is advancing, while the recovery in the housing sector remains slow.
Household spending is rising moderately; declines in energy prices have boosted household purchasing power. Business fixed investment is advancing, while the recovery in the housing sector remains slow and export growth has weakened.
Shades down their view of exports.
Inflation has declined further below the Committee?s longer-run objective, largely reflecting declines in energy prices.? Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.
Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.
No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.
No change. They are no longer certain that inflation will rise to the levels that they want.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced.? Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.? The Committee continues to monitor inflation developments closely.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate. The Committee continues to monitor inflation developments closely.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate.? In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.? This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
No change.
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.? However, if incoming information indicates faster progress toward the Committee?s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated.? Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.
Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.
Removes the concept of patience.? Looks for further labor market improvement, and an increase in inflation expectations ? this is less than meets the eye, because it all still remains contingent.? It is in the eye of the beholder.
No rules, just guesswork from academics and bureaucrats with bad theories on economics.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.? This policy, by keeping the Committee?s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
No change.? Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.
Deleted.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Deleted.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.? The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
?Balanced? means they don?t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.
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.
Comments
I will still argue that this was a nothing-burger. The patience language was eliminated, but what were left in its place were contingent conditions that are subject to a wide degree of interpretation.
Pretty much a nothing-burger. Few significant changes.? The FOMC has a weaker view of GDP and exports.
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.
Forward inflation expectations have continued to fall.
Equities rise 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 FOMC actually chops out ?dead wood? from its statement. Brief communication is clear communication.? If a sentence doesn?t change often, remove it.
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 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.
As I mentioned yesterday, there wasn’t anything that amazing and new in the annual letter of Berkshire Hathaway. ?Lots of people found things to comment on, and there is always something true to be reminded of by Buffett, but there was little that was new. ?Tonight, I want to focus on a few new things, most of which was buried in the insurance section of the annual report.
Before I get to that, I do want to point out that Buffett historically has favored businesses that don’t require a lot of capital investment. ?That way the earnings are free to be reinvested as he see fit. ?He also appreciates having moats, because of the added pricing power it avails his businesses. ?Most of his older moats depend on?intellectual property, few competitors, established brand, etc. ?Burlington Northern definitely has little direct competition, but it does face national regulation, and dissatisfaction of clients if services can’t be provided in a timely and safe manner.
Thus the newer challenge of BRK: having to fund significant capital projects that don’t add a new subsidiary, may increase capacity a little, but are really just the price you have to pay to stay in the game. ?From page 4 of the Annual Letter (page 6 of the Annual Report PDF):
Our bad news from 2014 comes from our group of five as well and is unrelated to earnings. During the?year, BNSF disappointed many of its customers. These shippers depend on us, and service failures can?badly hurt their businesses.
BNSF is, by far, Berkshire?s most important non-insurance subsidiary and, to improve its performance, we?will spend $6 billion on plant and equipment in 2015. That sum is nearly 50% more than any other railroad?has spent in a single year and is a truly extraordinary amount, whether compared to revenues, earnings or?depreciation charges.
There’s more said about it on pages 94-95 of the annual report, but it is reflective of BRK becoming a more asset-heavy company that requires significant maintenance capital investment. ?Not that Buffett is short of cash by any means, but less will be available for the “elephant gun.”
Insurance Notes
Now for more arcane stuff. ?There are lots of people who write about Buffett and BRK, but I think I am one of the few that goes after the insurance issues. ?I asked Alice Schroeder (no slouch on insurance) once if she thought there was a book to be written on Buffett the insurance CEO. ?Her comment to me was “Maybe one good long-form article, but not a book.” ?She’s probably right, though I think I have at least 10,000 words on the topic so far.
Here are two articles of mine for background on some of the issues involved here:
Here’s the main upshot: reserving is probably getting less conservative at BRK. ?Incurred losses recorded during the year from?prior accident years is rising. ?Over the last three years it would be -$2.1B, -$1.8B, and now for 2014 -$1.4B. ?(See page 69 of the annual report.) ?Over the last three years, the amount of reserves from prior years deemed to be in excess of what was needed has fallen, even as gross reserves have risen. ?In 2012, the amount of prior year reserves released as a proportion of gross reserves was greater than 3%. ?In 2014, it was less than 2%.
In addition to that, in general, the reserves that were released were mostly shorter-tailed reserves, while longer-tailed reserves like asbestos were strengthened. ?In general, when longer-tailed lines of business are strengthened in one year, there is a tendency for them to be strengthened in future years. ?It is very difficult to get ahead of the curve. ?Buffett and BRK could surprise me here, but delays in informing about shifts in claim exposure are a part of longer-tailed lines of insurance, and difficult to estimate. ?As I have said before, reserving for these lines of business is a “dark art.”
From page 91 of the annual report:
In 2014, we increased estimated ultimate liabilities for contracts written in prior years by?approximately $825 million, substantially all of which was recorded in the fourth quarter. In the fourth quarter of 2014, we?increased ultimate liability estimates on remaining asbestos claims and re-estimated the timing of future payments of such?liabilities as a result of actuarial analysis. The increase in ultimate liabilities, net of related deferred charge adjustments,?produced incremental pre-tax underwriting losses in the fourth quarter of approximately $500 million.
This was the only significant area of reserve strengthening for BRK. ?Other lines released prior year reserves, though many released less than last year.
There were a few comments on insurance profitability. ?In addition to asbestos, workers’ compensation lost money. ?Property-catastrophe made a lot of money because there were no significant catastrophes in 2014, but rates are presently inadequate there, and BRK is likely to write less of it in 2015.
My concern for BRK is that they are slowly running out of profitable places to write insurance, which reduces BRK’s profitability, and reduces the float that can be used to finance other businesses.
Maybe BRK can find other squishy liabilities to use to create float cheaply. ?They certainly have a lot of deferred tax liabilities (page 71). ?Maybe Buffett could find a clever way to fund pensions or structured settlements inexpensively. ?Time to have Ajit Jain put on his thinking cap, and think outside the box.
Or maybe not. ?Buffett is not quite to the end of his “low cost of informal borrowing” gambit yet, but?he is getting close. ?Maybe it is time to borrow at the holding company while long-term rates are low. ?Oh wait, he already does that for the finance subsidiary.
Final Notes
From an earnings growth standpoint, there was nothing that amazing about the earnings in 2014. ?A few new subsidiaries like NV Energy added earnings, but existing subsidiaries’ earnings were flattish. ?Comprehensive income was considerably lower because of the lesser degree of unrealized appreciation on portfolio holdings.
On net, it was a subpar year for Berkshire Hathaway. ?The annual letter provided a lot of flash and dazzle, but 2014 was not a lot to write home about, and limits to the BRK business model with respect to float are becoming more visible.
Full disclosure: long BRK/B for myself and clients, for now
Photo Credit: Chuck Coker || Another Dynamic Duo and their secret Batcave
This piece has kind of a long personal introduction to illustrate my point. ?If you don’t want to be bored with my personal history, just skip down to the next division marker after this one.
There will always be a soft spot in my heart for people who toil in lower level areas of insurance companies, doing their work faithfully in the unsexy areas of the business. ?I’ve been there, and I worked with many competent people who will forever be obscure.
One day at Provident Mutual’s Pension Division [PMPD], my friend Roy came to me and said, “You know what the big secret is of the Pension Division?” ?I shook my head to say?no. ?He said, ” The big secret is — there isno secret,” and then he smiled and nodded his head. ?I nodded my head too.
The thing was, we were ultra-profitable,?growing fast, and our financials and strategies were simple. ?Other areas of the company were less profitable, growing more slowly, and had accrual items that were rather complex and subject to differing interpretations. ?But since the 30 of us?(out of a company of 800) were located in a corner of the building, away from everyone else, we felt misunderstood.
So one day, I was invited by an industry group of actuaries leading pension lines of business to give a presentation to the group. ?I decided to present on the business model of the PMPD, and give away most?of our secrets. ?After preparing the presentation, I went home and told my wife that I would be away in Portland, Oregon for two days, when she informed me we had an important schedule conflict.
I was stuck. ?I tried to cancel, but the leader of the group was so angry at me for trying to cancel late, when I hung up the phone, I just put my head on my desk in sorrow.
Then it hit me. ?What if I videotaped my presentation and sent that in my place? ?I called the leader of the group back, and he loooved the idea. ?I was off and running.
One afternoon of taping and $600 later, I had the taped presentation. ?It detailed marketing, sales, product design, risk control, computer systems design, and more. ?If you wanted to duplicate what we did, you would have had a road map.
But the presentation ended with a hook of sorts, where I explained why I was so free with what we were doing. ?We were the smallest player in the sub-industry, though the fastest growing, and with one of the highest profit margins. ?I said, “The reason I can share all of this with you is that if you wanted to copy us, you would have to?change an incredible amount of what you do, and kill off areas where you have invested a lot already. ?I know you can’t do that. ?But maybe you can imitate a few of our ideas and improve your current business model.”
So my colleague took the tape to the meeting, and when he returned, he handed me a baseball cap that had the word “Portland” on it. ?He said, “You did it, Dave. ?You won the best presentation of the conference award. ?Everyone sent their thanks.”
Sadly, that was one of the last things I did in the Pension Division, as corporate management chose me to clean up another division of the company. ?That is another story, but one I got few thanks for.
Today I call that hat “the $600 hat,” and I wear it to my kids baseball and softball games as I keep score.
The secret of Berkshire Hathaway is the same as my story above. ?There is no secret.?Buffett’s methods have been written about by legions; his methods are well known. ?The same applies to Charlie Munger. ?That’s why in my opinion, there were?no significant surprises in their 50th anniversary annual letter. (There were some small surprises in the annual report, but they’re kinda obscure, and I’ll write about those tomorrow.) ?All of the significant building blocks have been written about by too many people to name.
Originally, this evening, I was going to write about the annual report, but then I?bumped across this piece of Jim Cramer’s on Buffett. ?Let me quote the most significant part:
…Cramer couldn’t help but wonder if things in the business world could be different if we approached other CEOs the way that Buffett is approached.
Perhaps, if the good CEOs were allowed to stay on longer like Buffett has or if people treated them as if they were their companies the way that Buffett is treated in relation to Berkshire, things could be different?
“Clearly something’s gone awry in the business world if we can praise this one man for everything he does, and yet every other chief executive feels shackled into being nothing like him,” Cramer said.
Cramer is very close to the following insight: the reason why more companies don’t imitate Berkshire Hathaway is that they would have to destroy too much of their existing corporations to make it worth their while. ?As such, the “secrets” of Berkshire Hathaway can be hidden in plain view of all, because the only way to create something like it would be to start from scratch. ?Yes, you can imitate pieces of it, but it’s not the same thing.
Creating a?very profitable diversified?industrial conglomerate financed by insurance liabilities is a very unique strategy, and one that few would have the capability of replicating. ?It required intelligent investing, conservative underwriting, shrewd analysis of management teams so that they would act independently and ethically, and more.
Indeed, an amazing plan in hindsight. ?Kudos to Buffett and Munger for their?clever business sense. ?It will be difficult for anyone to pursue the same strategy as well as they did.
But in my next piece, I will explain why one element of the strategy may be weakening. ?Until then.
Full disclosure: long BRK/B for myself and clients
This piece is an experiment. ?A few readers have asked me to do explanations of simple things in the markets, and this piece is an attempt to do so. ?Comments are appreciated. ?This comes from a letter from a friend of mine:
I hope I don?t bother you with my questions.? I thought I understood bid/ask but now I?m not sure.
For example FCAU has a spread of 2 cents.? That I understand – 15.48 (bid) ? that?s the offer to buy and 15.50 (ask) ? that?s the offer to sell.
Here?s where I?m confused.? How is it possible that those numbers could more than $1 apart? EGAS 9.95 and 11.13.? I don?t understand.? Is the volume just so low? ?And last price is 10.10 which is neither the ask nor bid price.? Can you please explain?
You have the basic idea of the bid and ask right. ?There is almost always a spread between the bid and the ask. ?There can be occasional exceptions where a special order is placed, such as an “all or none” order, where the other side of the trade would not want to transact the full amount, even though the bid and ask price are the same. ?The prices might match, but the conditions/quantities don’t match.
You ask why bid/ask spreads can be wide. ?I assume that when you say wide, you mean in percentage terms. ?Here the main?reason:?many of the shares are held by investors with a long time horizon, who have little inclination to trade. ?Here is a secondary reason: the value of the investment is more uncertain than many alternative investments. ?I believe these reasons sum up why bid/ask spreads are wide or narrow. ?Let me describe each one.
1) Few shares or bonds are available to trade
Many stocks have a group of dominant investors that own the stock for the longish haul. ?The fewer the shares/bonds that are available to trade, the more uncertainty exists in where the assets should trade, because of the illiquidity.
Because few shares are available to trade, price moves can be violent, because it only takes a small order to move the price. ?Woe betide the person who foolishly places a large market order, looking to buy or sell at the best price possible. ?I did that once on a microcap stock (the stock of a very small company), and ended up doubling the price of the stock as my order was fully filled, only to see the price fall right back to where it was. ?Painful lesson!
As a result, those that make markets, or ?buy and sell stocks tend to be more cautious in setting prices to buy and sell illiquid securities because of the difficulty of trading, and the problem of moving the market away from you with a large order.
I’ve had that problem as well, both with small cap stocks, and institutionally trading illiquid bonds. ?You can’t go in boldly, demanding more liquidity than the market typically offers. ?If you are buying, you will scare the sellers, and the ask will rise. ?If you are selling, you will scare the buyers, and the bid?will fall. ?There is a logical reason for this: why would someone come into a market like a madman trying to fit 10 pounds into a 5-pound bag? ?Perhaps they know something that everyone else does not. ?And thus the market runs away, whether they really do know something or not.
In some ways, my rookie errors with small cap stocks helped me become a very good illiquid bond trader. ?For most bonds, there is no bid or ask. ?Some bonds trade once a week, month, or year… indicative levels are given, maybe, but you navigate in a fog, and so you begin sounding out the likely market to get some concept of where a trade might be done. ?Then negotiation starts… and you can read about more this in my “Education of a Corporate Bond Manager” series… I know most here want to read about stocks, so…
2) Uncertainty of the value of an asset
Imagine a stock that may go into default, or it may not. ?Or, think of a promoted penny stock, because most of them are in danger of default or a dilutive stock offering. ?Someone looking to buy or sell has little to guide them from a fundamental standpoint — it is only a betting game, with volatile prices in the short run. ?Market makers, if any, and buyers and sellers will be cautious, because they have little idea of what may be coming around the corner, whether it is a big news event, or a crazy trader driving the stock price a lot higher or lower.
For ordinary stocks, large enough, with legitimate earnings and somewhat predictable prospects, the size of the bid-ask spread reflects the short-run volatility of price. ?In general, lower volatility stocks have low bid-ask spreads. ?Even with market makers, they set their bid-ask spreads to a level that facilitates trade, but not so tight that if the stock gets moving, they start taking significant losses. ?And, as I experienced as a bond trader, if news hits in the middle of a trade, the trade is dead. ?You will have to negotiate afresh when the news is digested.
As for the “Last Price”
The last price reflects the last trade, and in this era where so much trading occurs off of the exchanges, the bid and ask that you may see may not reflect the true state of the market. ?Even if it does reflect the true state of the market, there are some order types that are flexible with respect to price (discretionary orders) or quantity (reserve orders). ?Trades should not occur outside of the bid-ask spread, but many trades happen without a market order hitting the posted bid or lifting the posted ask.
And though this is supposed to be simple, the simple truth is that much trading is far more complex today than when I started in this business. ?I disguise my trades to avoid alarming buyers or sellers, and most institutional investors do the same, breaking big trades into many small ones, and hiding the true size of what they are doing.
Thus, I encourage all to be careful in trading. ?Until you know how much capacity for trading a given asset has, start small, and adjust.
All for now, until the next time when I do more “simple stuff” at Aleph Blog.
I was reading an occasional blast email from my friend Tom Brakke, when he mentioned a free publication from Redington, a UK asset management firm that employs actuaries, among others. I was very impressed with what I read in the 32-page publication, and highly recommend it to those who select investment managers or create asset allocations, subject to some caveats that I will list later in this article.
In the UK, actuaries are trained to a higher degree to deal with investments than they are in the US. The Society of Actuaries could learn a lot from the Institute of Actuaries in that regard. As a former Fellow in the Society of Actuaries, I was in the vanguard of those trying to apply actuarial principles to risk management, both when I managed risks for insurance companies, worked for non-insurance organizations, and manage money for upper middle class individuals and small institutions. Redington’s thoughts are very much like mine in most ways. As I see it, the best things about their investment reasoning are:
Risk management must be both quantitative and qualitative.
Risk is measured relative to client needs and thus the risk of an investment is different for clients with different needs. ?Universal measures of risk like Sharpe ratios, beta and standard deviation of asset returns are generally inferior measures of risk. ?(DM: But they allow the academics to publish! ?That’s why they exist! ?Please fire consultants that use them.)
Risk control methods must be?implemented by clients, and not countermanded if they want the risk control to work.
Shorting requires greater certainty than going long (DM: or going levered long).
Margin of safety is paramount in investing.
Risk control is more important when things are going well.
It is better to think of alternatives in terms of the specific risks that they pose, and likely future compensation, rather than look at track records.
Illiquidity should be taken on with caution, and with more than enough compensation for the loss of flexibility in future asset allocation decisions and cash flow needs.
Don’t?merely avoid risk, but take risks where?there is more than fair compensation for the risks undertaken.
And more… read the 32-page publication from Redington if you are interested. ?You will have to register for emails if you do so, but they seem to be a classy firm that would honor a future unsubscribe request. ?Me? ?I’m looking forward to the next missive.
Now, here are a few places where I differ with them:
Caveats
Aside from pacifying clients with lower volatility, selling puts and setting stop-losses will probably lower returns for investors with long liabilities to fund, who can bear the added volatility. ?Better to try to educate the client that they are likely leaving money on the table. ?(An aside: selling short-duration at-the-money puts makes money on average, and the opposite for buying them. ?Investors with long funding needs could dedicate 1% of their assets to that when the payment to do so is high — it’s another way of profiting from offering insurance in of for a crisis.)
Risk parity strategies are overrated (my arguments against it here:?one, two).
I think that reducing allocations to risky assets when volatility gets high is the wrong way to do it. ?Once volatility is high, most of the time the disaster has already happened. ?If risky asset valuations show that the market is offering you significant deals, take the deals, even if volatility is high. ?If volatility is high and valuations indicate that your opportunities are average to poor at best, yeah, get out if you can. ?But focus on valuations relative to the risk of significant loss.
In general, many of their asset class articles give you a good taste of the issues at hand, but I would have preferred more depth at the cost of a longer publication.
But aside from those caveats, the publication is highly recommended. ?Enjoy!
At Abnormal Returns, over the weekend, Tadas Viskanta featured a free article from Credit Suisse called the?Credit Suisse Global Investment Returns Yearbook 2015. ?It featured articles on whether the returns on industries as a whole mean-revert or have momentum, whether there is a valuation effect on industry returns, “social responsibility” in investing, and the existence of equity discount rate for the market as a whole.
There are no surprises in the articles — it is all “dog bites man.” ?They find that:
Industry returns exhibit momentum
There is a valuation component in industry returns
Socially responsible investing doesn’t necessarily produce or miss excess returns
There is an overall equity discount rate, which is levered about 20-25 times, i.e., a 1% increase in the rate lowers valuations by 20-25%.
The first two are well-known for individual stocks, so it isn’t surprising that it happens at the industry level. ?The third one has been written about ad nauseam, with many conflicting opinions, so that there is little effect is no big surprise. ?The last one resembles research I saw in the mid-90s, where the effect of changes in real interest rates has about that impact on stocks. ?Again, nothing new — which is as it should be.
But now some more on industry returns. ?They found that industry return momentum was significant. ?Industries that did well one year were likely to do well in the next year. ?The second finding was that industries with cheap valuations also tended to do well, but it was a smaller effect.
So, using one-year price returns as my momentum variable and book-to-market as a valuation variable (both suggested in the article), I divided industries for companies trading in the US into quintiles (also suggested in the article) for momentum and valuation. ?(Each quintile has roughly 20% of the total market cap.) ?Here is the result:
Low valuations are at the right, high at the left. ?Low momentum at the top, high momentum at the bottom. ?Ideally by this method, you would look for industries in the southeast corner.
To me, Agriculture, Information Technology, Security, Waste, Some Retail, and Some Transportation look interesting. ?One in the far southeast that is not so interesting for me is P&C Insurance. ?Yes, it has done well, and compared to other industries, it is cheap. ?But industry surplus has grown significantly, leading to more competition, and sagging premium rates. ?Probably not a great time to make new commitments there.
Anyway, the above table should print out nicely on two sheets of letter-sized paper. ?Not that it would be a substitute for your own due diligence, but perhaps it could start a few ideas going. ?All for now.
