Monday, December 28, 2009

Investing Over Business Cycles - Alpha

In this issue:
1. What is a Business Cycle?
2. Business Cycle Investing
3. Soros’ Theory of Booms and Busts
4. Cycles within Cycles
5. Glacial Cycles and the Fall of Rome

“History doesn't repeat itself, but it does rhyme,” wrote Mark Twain. His words apply to investing, where profits and returns come from cycles. Hence the most basic axiom of investing, “buy low and sell high,” can and should be put in context. Two things determine “high” and “low.” One is intrinsic value: an investor must be able to discount cash flows with some certainty, and compare this to prices. The other is cycles: an investor must know where in the business cycle we currently are because intrinsic values depend on earnings, which are a product of the economic environment. Below we lay out the case for business cycle investing and end with some comments on other cycles and where in the business cycle we are now (our subjective odds of a W, V, and L).

Please see the attached pdf file for this newsletter, here:

Investing Over Business Cycles - RISK OVER REWARD NEWSLETTER PDF

Fannie and Freddie Get a Blank Taxpayer Check - Alpha

A queer holiday update from Hussman here.

It was about a sneaky Christmas eve decision the US Treasury made regarding the largest buyer of mortgages (after the Fed) - and as the WSJ notes, the timing wasn't a coincidence.

Basically, the Fed and Treasury have kept the US property markets alive (residential, commercial, etc.). The Fed bought $1,040bn in agency and MBS in 2009 (more than a trillion dollars!), and $300bn in US Treasuries (monetized debt, where the Fed printed money). See here to compare Dec. 23, 2009 to Dec. 24, 2008 (the change):

The US Treasury bought $220bn through Fannie and Freddie. Both are more insolvent today than they were a year ago (the value of their assets have decreased even further, while their liabilities, held by bond funds and foreign central banks, have stayed constant without any defaults or haircuts).

For one example of how all property investors are dependent on Fannie/Freddie, here's what the largest apartment REIT company (EQR) in the US says about their dependence:
"The continued credit crisis has negatively impacted the availability and pricing of debt capital. During this time, the multifamily residential sector has benefited from the continued liquidity provided by Fannie Mae and Freddie Mac. A vast majority of the properties we sold in 2008 and 2009 were financed for the purchaser by one of these agencies. Furthermore, Fannie Mae and Freddie Mac provided us with approximately $1.6 billion of secured mortgage financing in 2008 and $500.0 million thus far in 2009 at attractive rates when compared to other sources of credit. Should these agencies discontinue providing liquidity to our sector, have their mandates changed or reduced or be disbanded or reorganized by the government, it would significantly reduce our access to debt capital and/or increase borrowing costs and would significantly reduce our sales of assets."

Remember, that the collapse of Fannie and Freddie is what caused the economic "equilibrium shift" from a mild recession to a depression (their death spooked investors, which then pushed the riskiest banks and insurance companies, like Lehman and AIG, to fail).

Here's what I find interesting from the Treasury release:
1) Does the following mean that the US Treasury will no longer support the MBS property market bubble through Fannie and Freddie buying MBS?
"Program Wind Downs
The program that Treasury established under HERA to support the mortgage market by purchasing Government-Sponsored Enterprise (GSE) -guaranteed mortgage-backed securities (MBS) will end on December 31, 2009. By the conclusion of its MBS purchase program, Treasury anticipates that it will have purchased approximately $220 billion of securities across a range of maturities.
The short-term credit facility that Treasury established under HERA for Fannie Mae, Freddie Mac, and the Federal Home Loan Banks will terminate on December 31, 2009. This credit facility was designed to provide a backstop source of liquidity and has not been used. "

2) Does the release mean the US Treasury will try to shrink Fannie and Freddie's asset base, meaning that real estate investors won't be able to get mortgages through them anymore (in some long-run scenario)? Or that it won't for three more years, which is the out that allows the Fannie/Freddie mortgage support (i.e. shell/monetization game) to continue? How "committed to principle" is the Treasury? Remember, that the $110bn that Treasury has given so far gets multiplied many times over, since it's an equity base that Fannie/Freddie lend off of. If a cap is $200bn and the multiplier is 10x, this is opening the door toward a further $2 trillion expansion of Fannie/Freddie's lending, where the $200 bn in front is loss-equity capital that taxpayers take (to bail out stupid homebuyers and debt issuers). This is a massive bailout... yet again.
"Amendments to Terms of Preferred Stock Purchase Agreements
At the time the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship in September 2008, Treasury established Preferred Stock Purchase Agreements (PSPAs) to ensure that each firm maintained a positive net worth. Treasury is now amending the PSPAs to allow the cap on Treasury's funding commitment under these agreements to increase as necessary to accommodate any cumulative reduction in net worth over the next three years. At the conclusion of the three year period, the remaining commitment will then be fully available to be drawn per the terms of the agreements.
Neither firm is near the $200 billion per institution limit established under the PSPAs. Total funding provided under these agreements through the third quarter has been $51 billion to Freddie Mac and $60 billion to Fannie Mae. The amendments to these agreements announced today should leave no uncertainty about the Treasury's commitment to support these firms as they continue to play a vital role in the housing market during this current crisis.
The PSPAs also cap the size of the retained mortgage portfolios and require that the portfolios are reduced over time. Treasury is also amending the PSPAs to provide Fannie Mae and Freddie Mac with some additional flexibility to meet the requirement to reduce their portfolios. The portfolio reduction requirement for 2010 and after will be applied to the maximum allowable size of the portfolios – or $900 billion per institution – rather than the actual size of the portfolio at the end of 2009.
Treasury remains committed to the principle of reducing the retained portfolios. To meet this goal, Treasury does not expect Fannie Mae and Freddie Mac to be active buyers to increase the size of their retained mortgage portfolios, but neither is it expected that active selling will be necessary to meet the required targets. FHFA will continue to monitor and oversee the retained portfolio activities in a manner consistent with the FHFA's responsibility as conservator and the requirements of the PSPAs."

I'm waiting for Hussman's views on how to interpret this cryptic release. It just looked like the US govt. is writing its largest loss-driven blank check (after AIG) and no one is paying attention (of course, the Citigroup bailout/guarantees and the Fed's low-quality asset purchases will come home too).

UPDATE: Here are the interesting explanations from Hussman, Tim Duy's Fedwatch, and Paul Krugman at Princeton blogging for the NY Times.

Thursday, December 17, 2009

All that glitters... is GOLD - Alpha

Hypothesis: Gold will rise in dollar-terms as its major competitor currencies, the USD and EUR, are devalued when their governments inflate away the burden of debts but printing more fiat currency.
The boom-bust cycle is early in the boom phase for gold.

Analysis: The US government and Euro bloc countries will be forced to run deficits for the next 3-5 years, both to backstop banking losses (which are roughly 40-60% taken in the US and Euro, according to the IMF, not to mention the unsustainable social program spending that is expected soon. Medicare spending starts inching up in 2012, due to the first retiring boomers, and this will double all total outstanding US debt in 15 years (2012-2027). Until 2015, deficits will be about 12% in the US, and 4-12% in the Euro area (Germany is at 5% expected, Greece at 12% and above). See EU projections.

The only way the governments can meet their deficit spending is by:
i) Raising taxes and cutting spending. Some of this will happen on the margin, but spending is sticky and voters by their behavior prefer inflation to tax raises. Greece is the bellwether country for the PIIGS and European stability (testing the "no bailout" clause in the EMU pact).

ii) Borrowing money from the private sector, by crowding out through high interest rates or forced "gunpoint" borrowing. Note that in the US bank reserves have been held in USTs for the last 12 months - a shadow crowding out where private borrowers can't get money.

iii) By creating money through monetization/printing. The US did $300bn of this in October 2009, as the Fed admitted, and bought over $1,000bn in MBS and ABS.
When inflation worries reached their peak in the 1970s, gold reached an all-time, inflation-adjusted dollar high of about $2,200/oz.

Gold shouldn't be treated as an asset like land, stocks, or bonds. Rather, it’s money. Money has 3 uses: a medium of exchange, a measure of value, and a store of value. Gold will never be as good a medium of exchange as USD and EUR currency and checks (I ignore the Yen and pound because they haven't been major reserve currencies in the last 50 years, and also the yuan as it isn't fully convertible). The transactions costs are too high (it's easy to pay with dollar and euro bills or use your Visa/Mastercard to pay in them). Gold probably won't be as good a measure of value, if inflation is relatively low (under 10% annually), as people can still compare goods and services using USD and EUR "markings." Yet as an arbitrary store of value, gold will do quite well, because it's supply is fixed and slightly declining, while the supply of dollars and euros is exploding.

A decent overview of the many writings on gold is here: "Is Gold a Reasonable Investment"

The World Gold Council puts out an interesting quarterly report on gold, available here: (but beware proponent bias).

Supply Analysis:
The amount of actual resources in the world, loosely measured by "wealth stock" and GDP, stays fixed and grows at a stable rate of 2-5% (world GDP growth, a wide band give my lack of economic forecasting ability). The total amount of the world gold stock has actually come down from Q1 2000 (33.4K tons) to Q1 2009 (29.7K tons). See the attached spreadsheet from the World Gold Council. As a "currency", the supply of gold has decreased. I assume it stays flat in the future, but if it keeps decreasing, all the merrier.

Compare this to the monetary base of the USD and EUR. The Fed's adjusted monetary base has grown from $875bn to $1900 bn (2.2x), and the M1 measure in the Eurozone has grown from Eur. 3.8trn to Eur. 4.5trn (1.2x). Gold, meanwhile, averaged between $600 to $700 an ounce from early 2006 to mid 2007. My key assumption is that gold's "fair price" is its average price before the monetary expansion of $650. Gold's price peaked at in December 2009 at ~$1200. Assuming gold tracks the USD monetary base expansion in 2008 and 2009, it's fair price should be, by a back of the envelope calculation: 2.2*650 = $1430 per ounce. Compared to the euro: 1.2*650 = $780 per ounce. That's a wide range. But just look at the direction. Deficits in both the US and Euro area are unsustainable. My simplistic logic is that if the supply of gold is fixed, its price rise must match the increase in the world's fiat currency system of the USD and EUR. If the US monetary base goes up another 50% from current levels, then I believe gold should be "worth" 1430*1.5 = $2145/oz. Simply put, gold is a horrible asset to hold in normal times, when inflation is low and governments are stable. It's a great (speculative, not investment) asset at macroeconomic turning points, like early in the Great Depression and in the 1970s as the US went off the gold standard and inflated away debts.

US: The entire residential and commercial real estate markets (and hence banking system) is being kept alive by two things, thanks to Bernanke. One, zero interest rates for the big banks, who then subsizide housing and governments while penalizing businesses. Two, massive MBS and CMBS purchases by the Fed, to the tune of $1.3trn (not a typo, that's trillion), which must on face end in March, but will realistically continue and likely be monetized in one way or another. Ever wonder why Bernanke looks so haggard? It's not just the Fed losing its independence - my guess is that he knows he'll have to monetize.

But gold as a percentage of the US monetary base is VERY VERY low (bad paper money is crowding out the good, glitterin' metallic kind - Gresham's law at work):

Euro Area: The Greece situation, where the govt. initially forecasted a 3% deficit and then said, "Hey, we were lying!" and then came up with 12%, shows that the Mediterranean PIGS are untrustworthy. Either the richer countries take on more deficits to bail out the PIGS, or they suffer political blowout and monetary collapse together - an unappealing choice. As much as the direct pressure on Bernanke is high, the pressures on the ECB are only getting hotter. Do you really think the ECB can stop accepting shoddy Greek banks' assets as collateral, triggering a run, or will they have to monetize losses away? My main point is, historical evidence shows gold supply is shrinking, but I conservatively estimate it stays flat. Strong historical evidence suggests government debt goes up by 80% and monetization occurs after the end of such a crisis, esp. when the 2 largest economies in the world are involved (the US and the Euro-area).

Demand Analysis:
Note that in 2008, jewelry demand fell by 245 tons, but bar/coin, retail, and ETF demand went up by 498 tons.

China, the world's biggest reserve holder, needs a safer place to put its safe money. Among hard assets, that's either land, natural resources (metals, oil, etc.) or gold. Consider the Chinese discussion:
"Li Lianzhong, who heads the economic department of the party’s policy research office, said that China should use more of its $1.95 trillion in foreign-exchange reserves to buy energy and natural-resource assets. At a foreign exchange and gold forum, Li said buying land in the United States was a better option for China than buying US Treasury securities. “Should we buy gold or US Treasuries?” Li asked. “The US is printing dollars on a massive scale, and in view of that trend, according to the laws of economics, there is no doubt that the dollar will fall. So gold should be a better choice.” (Jakarta Globe,

Guess what, the Chinese bought almost no US Treasuries in October 2009. Where will China's excess reserve buying go, besides Australian and African mines? Buying American land is politically radioactive, so the most fungible and safe currency-like asset is… gold. It's difficult to say how much of China's excess buying will be offset by fewer Indian jewelry purchases (but the Indian central bank, the RBI, has increased its gold purchases lately). Again, consider China's reserve growth from 600 tons to 1054 tons from 2008 to 2009. Do not expect China to blare in the markets about their current buying.

Finally, consider the smart money, the hedgies. Legendary names such as Paul Tudor Jones of Tudor Investment and David Einhorn, founder of Greenlight Capital have also been enthusiastic. Mr Jones, whose company manages more than $11bn in bonds, equities and commodities, told investors recently that it was time to buy the metal. “I have never been a gold bug,” he wrote, but added: “It is just an asset that, like everything else in life, has its time and place. And now is that time.” John Paulson, another well-known hedge fund manager, has adopted a similar view, telling investors he was concerned about the dollar. “So I looked for another currency in which to denominate my assets. I feel that gold is the best currency.”,s01=1.html

Disconfirming Evidence and Arguments:
-Gold has risen from ~$300 in 2001 when central banks were selling to $1200 today when central banks are buying, a four-fold increase. Anytime any asset rises that much, you have to worry about a bubble.

-Gold yields nothing - it's not a productive asset. Hence it's tough to ever assign a fair value to it, through a DCF analysis, like stocks, bonds, and property. This is the best critique of gold. But then again, dollars and euros sitting in a bank don't yield anything either and it's tough to value them (despite the indecipherable moves of Fx market). Gold technically has a negative yield due to storage costs, unlike cash which banks will graciously hold for you today without charge.

-Historically gold has been highly correlated with oil prices, at about 0.70. If oil falls due to weak global growth or a second collapse, so will gold.

-Gold's day-to-day jewelry demand use, in India, seems to top out at $700 to $800/oz (buying dips significantly above those levels, as people substitute silver and other precious metals). I need to talk to more Indians in the jewelry business to see whether they are re-anchoring expectations to a new price, or substituting other metals and avoiding gold. Since jewelry demand is by far the highest portion of the annual gold demand (about 2/3), higher prices could put a natural dampener on this.

-It's unclear what gold's industrial value substitute $-level is, but here are the uses:

-The best critiques of gold come from the inimitable Professors Buiter and Roubini (but they see it as an asset, not as a currency):

Monday, December 14, 2009

Buffett Avoids the Lehman Brothers Bullet - Alpha

In a WSJ article this weekend (Scott Patterson, "In Year of Investing Dangerously, Buffett Looked 'Into the Abyss'", WSJ, DECEMBER 14, 2009), Warren Buffett claims he had a mediocre year in 2008, where his best deals were bad deals he avoided. He says: "I made plenty of mistakes," he says. "I didn't maximize the opportunities offered by the chaos. But in the end, it worked out OK."

As one example of a well-missed deal, Buffett avoided investing in Lehman Brothers Holdings before it went bust. Attached as a pdf, the WSJ published Buffett's scribbles on Lehman's 10-K, where Buffett noted pages where he found problematic items. The 10-K is here (and if you go to the "Print Preview" mode in Firefox, the page numbers approximately correspond to Buffett's notes):

Also, for the concerns that the short seller David Einhorn, of Greenlight Capital, had with Lehman Brothers, here see Einhorn's speech at the Ira Sohn conference in May 2008:

Below are some comments on what I believe Buffett found troubling, given his notes/scribbles:

1) LIQUIDITY POOL FUNDING INADEQUATE: Lehman's Liquidity pool (to cover expected cash outflows for the next 12 months, in a stressed environment), is only sized for a ratings downgrade of one notch (compare to Enron and Dynergy, who suffered multiple notch downgrades in the early 2000s, as wholesale funding ran out and the fell into a vicious circle of downgrades and fleet-footed funding).

2) LEHMAN's BOGUS LEVERAGE RATIO: Lehman has a bogus "net leverage ratio", where it reduces debt and increases equity to make leverage look lower. The actual leverage ratio is horrible. For example, the net leverage ratio only increased from 14.5x to 16.1x from 2006 to 2007 (11%), but the real leverage ratio increased from a shocking 26.2x to 30.7x (17%). Only Fannie and Freddie, of major financial entities, have higher leverage ratios (and note they went bust a few weeks before Lehman). Here is their definition and the table:

Lehman's "go-for-bust" definition of a leverage ratio:
"Our net leverage ratio is calculated as net assets divided by tangible equity capital. We calculate net assets by excluding from total assets: (i)cash and securities segregated and on deposit for regulatory and other purposes; (ii) collateralized lending agreements; and (iii) identifiable intangible assets and goodwill. We believe net leverage based on net assets to be a more useful measure of leverage, because it excludes certain low-risk, non-inventory assets and utilizes tangible equity capital as a measure of our equity base. We calculate tangible equity capital by including stockholders’ equity and junior subordinated notes and excluding identifiable intangible assets and goodwill. We believe tangible equity capital to be a more meaningful measure of our equity base for purposes of calculating net leverage because it includes instruments we consider to be equity-like due to their subordinated nature, long-term maturity and interest deferral features and we do not view the amount of equity used to support identifiable intangible assets and goodwill as available to support our remaining net assets. These measures may not be comparable to other, similarly titled calculations by other companies as a result of different calculation methodologies."

3) LEHMAN's CONDUIT: A conduit is a structure where a bank borrows short-term to lend long-term to poor credit-risks using highly illiquid assets as collateral. A very bad idea - some major banks in Germany were ruined by their conduits, and Citigroup had to tap dance like an elephant to overcome its conduit and VIE exposure. Overall, Lehman's $2.4bn conduit isn't that large (but it's basically an off-balance sheet liability).

4) LEHMAN's ACCOUNTING FOR PENSION LIABILITIES: Under SFAS 158, it seems Lehman underreserved for what it's pension liability would be. For 2007, that would have lowered earnings by $210mn. A drop in the bucket given other concerns.

5) LEHMAN's MBS AND ABS EXPOSURES: Lehman (almost proudly) states:
"We originated approximately $47 billion and $60 billion of residential mortgage loans in 2007 and 2006, respectively, and approximately $60 billion and $34 billion of commercial mortgage loans in 2007 and 2006, respectively."
The question is, how much of this did Lehman sell to suckers in other countries, and how much did they keep on their balance sheet? Ouch! The inventory from the past few years, which they kept, is quite high (and the subprime stuff is worth pennies on the dollar):

6) LEHMAN's DERIVATIVES BOOK: This is basically a black box, as over-the-counter derivatives are valued by Lehman itself. Lehman's total derivatives contract book is a stunning $738bn. Buffett writes elsewhere: "Like Hell, both [reinsurance and derivative contracts] are easy to enter and almost impossible to exit." Hence Lehman can sell an OTC derivative to a counterparty and book a $50mn profit, while the other side can also book a $50mn profit (traders on both sides get year end bonuses on these gains). But one side is wrong, and you only find out years and years later with massive losses, as Buffett laments about his General Re acquisition here (see the "Derivatives" section on page 13): (this is also pasted in the most recent post on this blog). Buffett's final comment: "When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running." (If that's true, Mr. Buffett, why buy convertible debt in GE and Goldman Sachs?)

7) LEHMAN's ASSET LIABILITY MISMATCH PER ITS FAIR VALUE TABLE: All financial firms need to list the liquidity level of their assets, per the accounting rule SFAS 157 on Fair Value. Assets at Level 1 are very liquid and easy to value, wheras Level 3 are illquid and hard to value. Lehman has many Level II and Level III assets (~$219bn are Level 2 and 3 out of $291bn total ), but the liabilities behind these assets are Level 1 ($109bn out of $149bn total). Hence, wholesale funders can ask for their money back but Lehman can't sell assets to pay them (this is how Lehman actually went bust). To be fair to Lehman, all the big broker-dear/money center banks had this problem (all banks do, to some extent). It's just that Lehman was swimming much more naked than the rest (and didn't have a former CEO as the US Treasury Secretary to bail them out).

8) LEHMAN's SECURITIZATION MODEL: Lehman is heavily in the business of buying small assets (mortgages, credit card loans, auto loans, etc.) and securitizing them (making bonds out of pools of loans). It then sells these securities to foreign buyers. Two points to this. First, Lehman has $798bn in client securities, and it pledges $725bn of them as collateral for Lehman's own financings. This was made painfully clear to hedge funds who used Lehman as a prime broker and found out what the word "rehypothecate" meant when they couldn't get their money and securities back in 2008. Second, Lehman's machine is a monster and it's heavily exposed to residential mortgages (what turned out to be the worst stuff to securitize, unlike auto loans which pay off in 5 years). Lehman issued $294bn of securitizations in 2006 and 2007, of which $246bn was for residential real estate.

9) LEHMAN's QSPE AND VIE EXPOSURES, PLUS LENDING COMMITMENTS: QSPE's and VIEs are off-balance-sheet vehicles to make (often dumb) investments. Lehman engaged in writing credit default swaps and investing in real estate deals. For Lehman's real estate prowess, read about some of its deals here:
Lehman also has a mindboggling $122bn of lending commitments it has to make in 2008, many of them to private equity firms for bonds and loans in dumb buyout deals (it has to break out the deal lawyers and try to get out of these).

10) LEHMAN's EMPLOYEE COMPENSATION: Like most Wall Street firms, it's outrageously high in terms of total levels and composition (far too short term, heavy on cash and light on restricted stock). For example, Lehman has stock compensation amortization at ~$1bn to 1.3bn on average, but pays out a whopping $8.7bn to 9.5bn in total compensation. That's because the employees are smart and don't want to own equity (who would, for such a doomed ship)? They prefer hard cash paid monthly, with that big annual bonus.

Warren Buffett on Derivatives in 2002

From the 2002 Berkshire Hathaway Chairman's Letter (p.13):

Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.

Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts.

Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives
transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables. Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the
creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.

When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn’t want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and are now terminating it.
But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either
industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.

Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them.

Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

Of course, both internal and outside auditors review the numbers, but that’s no easy job. For example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384 14 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a
portfolio like that, expert auditors could easily and honestly have widely varying opinions.

The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually
tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a
company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more
downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a
liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through
Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred 15
people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for
weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a
future date it will receive any gain or pay any loss that the bank realizes.
Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and
analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles
caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view,
however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Sunday, December 13, 2009

The Yield Curve - Vega

In this issue:
1) Basic Theories of the Yield Curve
2) Basics In Action
3) What has the Yield Curve Told Us in the Past?
4) Is the Yield Curve "Smart"?
5) Chinese Demand

Dear Friends, Colleagues, and Investors:

The yield curve is the collection of interest rates offered by Treasury securities at various maturities (see graph below for current yield curve). The yield curve has historically provided a great deal of information about the future of the economy. The New York Federal Reserve regards it as a valuable forecasting tool in predicting recessions about a year ahead of time; it's been consistently more accurate at predicting recessions than professional economists over the last 30 years. Today the yield curve appears to be pricing in moderate growth and little inflation, while the equity and commodity markets appear to be pricing in robust growth and significant inflation. In this newsletter I'll explore the Treasury yield curve and explain what it's telling us today.

Please click on the link below to read the newsletter with all its graphics:

1) Basic Theories of the Yield Curve

The yield curve refers to the relationship between the interest rate on debt versus the maturity of the debt. For a bond, the higher the price, the lower the yield. There are a few different ways to think about the yield curve, each of which contributes to our understanding.

Pure Expectations Hypothesis: This simplistic view is that investors price each individual Treasury entirely based on their expectations for future short-term interest rates. So if the yield curve is sloping upward (i.e. if 10 year treasuries yield more than 2 year treasuries), investors must believe that short-term interest rates will be higher in 2 years.

Liquidity Preference Theory: This adjusts the "Pure Expectations Hypothesis" to take into account the fact that investors generally don't like to be locked into a long-term contract. Most investors will demand more yield to commit their money for a longer period of time. The Liquidity Preference Theory explains why the yield curve is usually upward sloping.

Preferred Habitat Theory: This more subtle theory acknowledges that investors sometimes want to hold debt for a specific amount of time. For example, a company may want to earn interest for 6 months until they must invest in a new factory. Alternatively, an insurance company may want to lock in a higher yield for 30 years to match the longer term liability of the life insurance contracts they provide. The Preferred Habitat Theory can explain any shaped yield curve.

2) Basics in Action
The yield curve is generally upward sloping. If investors expect inflation and short-term interest rates to remain steady, the yield curve will slope upward because investors value liquidity (as explained by the Liquidity Preference Theory). If investors expect interest rates to fall, the yield curve may be flat or even downward sloping (inverted). Investors will accept a lower return to lock in a yield for a longer period. For example, if short-term rates are currently 4% and the market expects rates to fall to 1%, you might accept a 2% rate of return over 10 years (as explained by the Pure Expectations Hypothesis). Throughout much of the 19th century the US experienced deflation so the yield curve was often inverted.

Beyond the shape of the yield curve, its absolute level gives us information about inflation expectations and risk aversion. If investors expect inflation of 5%, they’re likely to demand at least 6% return to loan their money to the government. If investors view the world as volatile and scary, they’re likely to accept a lower return in exchange for the safety of Treasury securities.

The effect of "Preferred Habitats" is more subtle. This point is debatable, but I believe that as China has become a large but reluctant buyer of treasuries over the last decade, their preference for shorter-term debt has reduced short-term rates relative to long-term rates.

3) What has the Yield Curve Told Us in the Past?

An inverted yield curve usually precedes a worsening economic situation. For example, in August of 1981, the yield curve was inverted, meaning that short-term interest rates were higher than long-term interest rates. The next year saw a severe recession and stock market correction. In April of 1992, the yield curve was steep with long-term bonds yielding 5% more than short-term bonds; the bond market was correctly anticipating robust growth and the stock market performed well over the next couple years. The graph below shows that the yield curve has become inverted about a year before every recession since 1950. You may also notice that there have been a few "false alarms" where the yield curve became inverted but no recession followed.

In the 1920s, the yield curve inverted in both 1923 and 1927, so its success rate as a recession predictor was only 50/50. From 1934-1950, the yield curve never inverted; it failed to predict 3 recessions (see graph below).

4) Is the Yield Curve "Smart"?
Why is the yield curve a useful tool in prediction recessions and equity returns?

One hypothesis is that bond investors are simply “smarter” than equity investors. Mom & Pop gamble on stocks in their retirement accounts, while bond trading is generally reserved for financial professionals. Perhaps bond investors can somewhat accurately predict recessions and their opinions are reflected in the bond market earlier than in the equity market.

Another possible explanation is that the shape of the yield curve directly impacts economic growth. For example, with a very steep yield curve, banks can easily produce great profits. They effectively “borrow” short-term via deposits and lend longer term via loans or buying treasuries. If the yield curve is steep they may be able to pay depositors 0.25% and then buy treasuries yielding 5% for easy profits. If the yield curve is inverted, it becomes extremely difficult for banks to make money.

A final and often ignored factor is that the shape of the yield curve is a reflection of recent actions of the Federal Reserve. Long-term interest rates tend to be anchored as investors correctly believe that interest rates revert to a common mean over many years. So, if the Federal Reserve reduces short-term interest rates, this is likely to produce a steeper yield curve; this effect is strengthened by the fact that lower short-term interest rates may increase long-term inflation expectations, which helps prevent the yield curve from falling in parallel. A steeper yield curve correlates to higher economic growth, but that may be a "confounding variable." Perhaps the growth is coming purely from the lower short-term interest rates, and the steeper yield curve is a byproduct. Similarly, a flat yield curve frequently occurs after the Federal Reserve raises short-term rates which has the effect of depressing growth. In other words, it may be the change in short-term interest rates that matters; the change in the yield curve is a byproduct of long-term interest rates moving less than short-term interest rates.

Each of the three explanations above is probably somewhat true and contributes to our empirical observation that the shape of the yield curve does a good job of predicting recessions.

5) Chinese Demand

A unique dynamic exists today that we must consider when extrapolating from the past. Our unprecedented trade imbalance with China makes them captive Treasury buyers. When Americans import more than we export, foreigners are left holding US dollars. Our greatest trade imbalance is with the Chinese who have been extremely risk averse with their dollar holdings. The Chinese government has maintained the trade imbalance by pegging their currency to ours to support their export sector. By pegging their currency, they’ve accumulated about $4 trillion US dollars. Some of that money is kept in simple currency, but they’ve used about $800 billion to buy treasuries. Maybe they’re thinking that a 2% yield, while small, is still better than nothing. Maybe they’re thinking that by lending us the money they are supporting the value of the total $4 trillion of US dollars they hold. Regardless, the Chinese policy decision to maintain the trade imbalance has the side effect of making them big Treasury buyers almost regardless of yield. They are rightfully concerned about the sustainability of our deficit though, so most of their Treasury holdings are short and medium-term. Under the "Preferred Habitat" lens, this means that the biggest marginal buyer of our treasuries does not want to hold our long-term debt. The result is that the price of our long-term debt drops relative to our short-term debt which means that the long-term yield rises; the yield curve steepens.

Economists who reject the "Preferred Habitat Theory" argue that the current yield curve means the market is predicting modest economic growth. While the yield curve throws doubt on the equity and commodity markets, it still appears more sanguine than many analysts. However, if the "Preferred Habitat Theory" is the dominant dynamic, the yield curve may not be a meaningful predictor today at all; without the large trade imbalance, perhaps the yield curve would be flatter today.

Your "Upward Sloping" Trader,

Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty, macroeconomics, security valuation, and how to think about markets and invest profitably -

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Sunday, November 22, 2009

Note to Stock Pickers: Study Bonds and Bond Markets - Alpha

In this issue:
1) The Achilles Heel of Stock Pickers
2) Bond Basics are Related to Stock Basics
3) Bond Market Indicators
4) Tea-Leaf Reading in Bond Markets
5) Get Rich or Die Tryin’

Dear Friends, Colleagues, and Investors:

Having learned to invest in the bull markets of the 1990s and 2000s, I often saw the world of capital markets as an equity investor buying stocks. Now I realize it’s important to step back and see the bigger picture, both to be a better stock picker and an all-around better total return investor (who can hold bonds, cash, ETFs, REITs, and other securities as needed). My hypothesis is that stock pickers would be much better at what they do if they study bonds and bond markets.

Please see the attached pdf file for this newsletter, here:


Thursday, November 12, 2009

In Support of the Tobin Tax - Ari Paul

Dear Friends, Colleagues, and Investors,

A "Tobin Tax" was originally designed to be a tax on foreign currency transactions with the goal of reducing short-term speculation. The economist James Tobin suggested that a tax of about 0.25% be levied on all foreign currency transactions; the income earned from the tax would be incidental; the greater effect would be to dampen speculative money flows that wreck havoc on economies. There is now widespread talk of applying a Tobin tax to all financial transactions.

The most obvious effect of the Tobin Tax would be to shrink the financial sector. As a professional trader at a large market-making firm, a Tobin tax would likely be devastating to my career, so my writing this week may surprise you. In this newsletter I'll lay out a vigorous case for why the Tobin tax should be implemented. The objections to the Tobin tax are more obvious than its benefits so I'll present the case in a question and answer format.

1) Will a Tobin Tax Increase Unemployment?

If the financial sector shrinks, won't a lot more financial professionals will be out of work?

By definition, investors as a whole will perform exactly as well as the market (minus transaction costs). If everyone expends a lot of time and energy to beat the market, as a group, they are wasting valuable resources. Now, a little bit of competition is healthy as investors research companies and help push asset prices where they should be. However, many of the smartest engineers and business minds now devote themselves purely to outwitting one another in completely useless ways. There are some twenty hedge funds filled with programmers and engineers trying to figure out how to send orders to stock exchanges a millisecond faster than one another. The fastest will make billions of dollars in profits. Yet reducing latency from 200 milliseconds to 190 milliseconds provides absolutely no value to society, or even to the market as a whole. These hedge funds soak up large amounts of the intellectual capital of the country. For the last few years about 30% of Harvard's MBA graduates have been heading to Wall Street jobs. These are the business leaders who could be entrepreneurs inventing new services or managers finding ways to increase labor productivity. Instead, they're "playing poker" (e.g. pursuing technical analysis, algorithmic trading, and low latency trading) with astrophysicists and electrical engineers who have also been enticed by the higher pay of Wall Street. It's impossible to estimate the cost to society of having these otherwise productive people spend their time siphoning money off the general public.

Depending on the scale of the Tobin Tax, it could well put 30% of all financial professionals out of business. That's a good thing. We want our electrical engineers working on cheaper energy, not trying to send stock orders a millisecond faster than engineers at another hedge fund.

2) Will a Tobin Tax Make the Market Less Efficient?

The "efficient market hypothesis" suggests that the more speculators are involved in a market, the more "efficient" the market will be. These speculators might push the value of stocks and other assets to "fair" value which helps the capital markets run smoothly. For example, by pushing the stock price of a good company higher, speculators let that company raise capital to expand. By lowering the stock price of an insolvent company, speculators signal to the company's creditors and suppliers that the company is in trouble. This is great in theory, except it doesn't actually happen.

When transaction costs are very high, only a handful of market participants can earn significant profits. The less skillful investors/traders go out of business quickly, because not only do they need to beat their competitors, they also need to overcome the higher costs of business. So with high transaction costs, the main market movers are the very best investors/traders. As the transaction costs are lowered, less and less skilled gamblers are enticed to play, and these gamblers do what you'd expect - they push prices in stupid ways. It's these less skilled gamblers that produced the tech bubble in the late nineties and the real estate bubble we're still dealing with. Lower transaction costs act similarly to easy credit - they encourage gambling. Gambling makes the market less efficient as the gamblers are more likely to act as a herd and send prices far from fair. So a Tobin Tax might make the markets more efficient. While this isn't clear, I judge it unlikely that a Tobin tax will make the markets any less efficient.

3) Will a Tobin Tax Drive Up Transaction Costs?

The more speculators are involved in a market, the more liquidity the market will have. The idea is that the speculators reduce the bid/ask spreads and therefore reduce the transaction costs to all involved. For example, today you can buy Microsoft stock for $28.51 and sell it at $28.50. This suggests that the fair value is $28.505, so the theoretical cost to execute the transaction is just half a penny. If there weren't so many speculators constantly willing to bet on Microsoft's stock, you might have to pay $28.61 to buy the stock and you'd only be able to sell it at $28.40. The fair value is still $28.505 but now you're paying more than a dime to execute the trade. Wouldn't the Tobin tax drive up transaction costs and therefore be a burden on all of society?

A Tobin tax would certainly raise transaction costs, but this isn't necessarily a bad thing. For example, we deliberately make cigarettes more expensive with a tax to discourage people from smoking. In this analogy, the effect of speculation on society is similar to that of smoking. It's true that anyone buying or selling Microsoft stock would effectively pay more to do so, but for investors, the cost is negligible. Warren Buffett deliberately kept the bid/ask spread of Berkshire Hathaway wide to discourage speculation. Most people lose money trading stocks. In fact, more than 70% of professional mutual fund managers underperform the indexes they try to track. In other words, the more you play the stock market game, the more you're likely to lose. Yet, many retail investors believe they can consistently beat the stock market and are convinced to gamble and try. They're lured by "low commissions" on stock trades and they're lured by small bid/ask spreads. The low transaction costs make it seem inexpensive to gamble. The low costs make it seem like they have a great chance of wining. With higher transaction costs, many of these hopeless gamblers would be dissuaded from gambling in the first place. Not only does stock market gambling cost the general public great amounts of money, it produces a deadweight loss to society. Where does the lost money go? It goes to professional traders who only exist because the public keeps losing money. If the public stopped gambling on stocks, the traders (who are generally bright and well educated) would find gainful employment producing something of value to society. The higher transaction costs from a Tobin Tax would keep more money in the public's pockets.

4) Isn't a Tobin Tax a "tax", and aren't taxes bad?

Whatever money the Tobin tax raises will be coming out of the already weak financial sector, businesses, and even an individual's 401K. Isn't this bad?

The most obvious "benefit" of the tax - the generation of revenue, is the least important benefit. Taxes aren't inherently a good thing or a bad thing; they redistribute income and depending on how intelligently the government spends the money, that could be productive or destructive. It's also important how the tax is collected. For example, income taxes have been proven to reduce the amount of time people spend working, obviously a destructive side effect. The Tobin Tax is about as productively collected a tax as I can imagine. If managed properly, it would have little impact on the kind of financial transactions that benefit society, but would eliminate a great bulk of the kind of transactions that are harmful. For example, if a company is a great investment, that 0.25% tax wouldn't dissuade any intelligent long-term investor from buying their stock. However, it would completely end stock day trading. The effect on an individual's 401K would be negligible; the vast majority of the tax would initially come from financial speculators, many of whom would quickly leave the industry. The remaining burden of the tax would fall on legitimate hedgers and the remaining profitable speculators.

5) Can We Trust That the Tax Will be Intelligently Applied?

Isn't it likely that big financial firms would find ways to outsmart the regulators and gain legal loopholes or simply escape enforcement? The big firms have ignored other rules like the "uptick rule" for shortselling, or the ban on naked shortselling.

This is a very real and serious criticism. If you believe the federal government is not competent enough to impose meaningful financial regulation, you are justified in opposing a Tobin tax as it could be abused to merely solidify the oligopoly of the major financial players. To implement a uniform Tobin tax, we will probably need the kind of populist anger and political consensus that existed in the great depression and gave rise to the Glass-Steagall Act.

In Summary: A Tobin tax would reallocate smart hardworking people from the "poker game" of trading and wealth management, to more productive enterprises. If applied intelligently, it would reduce speculation, dissuade the public from wasting time and money gambling in the stock market, and have few negative effects. It seems unlikely to gain enough political support to pass, and even if it was passed by all the major financial centers, there would be a real risk that it would not be uniformly applied.

Your Masochistic Trader,
Copyright 2009 Risk Over Reward. All Rights Reserved

Friday, November 6, 2009

The Movable Bullseye - Alpha

In this issue:
1) What is the purpose of investing?
2) Beating Inflation
3) Beating Bonds
4) Beating a Risk Index
5) How to beat the chess grandmaster Bobby Fisher

Dear Friends, Colleagues, and Investors:

We have noticed that many investors, both sophisticated and small, don’t seem to understand the purpose of their investing. “Making money” is too simple an answer, as you can make money and still be worse off. The question is simply, “Why invest?” The answer to this question is philosophical and affects your pocket book in a deep way.

1) What is the purpose of investing?

The purpose of investing is not “making money.” That is the correct answer for investment advisors, as most make money off their clients’ ignorance and carelessness through layers of fat fees. A rational investor should do three things:

i) Preserve the after-inflation value of capital. This means an investor’s capital should buy the same amount, or more, of goods and services after a few years. An example:
-An investor has $100, which can buy 10 bread loaves and 2 massages.
-The $100 is invested and grows to $140 in 5 years.
-In year 5, the $140 can buy 10 bread loaves and 2 massages.
-The investor is on even ground – no losses and no gains. Despite “making money” she is no better off.
Any strategy that loses to inflation but beats its benchmarks, however numerous and glorious the benchmarks are, is bunk. Few equity mutual funds (less than 20%) have beaten their index benchmark in the last 5 and 10 years. Almost none have beaten inflation, which has averaged a little above 3% (no major US equity benchmark has beaten inflation in the last 5 years).

ii) Match or beat the “risk-free” opportunity cost of capital. Any investor can buy a risk-free asset and sleep safely. An opportunity cost is something that an investor forgoes. For example, if you get coffee at Starbucks, your opportunity cost is coffee from home, from Peets Coffee, or from the corner mom-and-pop vendor. More specifically to investing, if you invest in bond A, your opportunity cost is what bond B, C, or D could have given you. Generally, a diversified bond index like the Barclays Capital US Aggregate Bond Index (the “Barclays Agg,” formerly called the Lehman Aggregate) is probably the best marker for a risk-free investment, though on closer analysis this is a tough call. At the very least, investing in the securities market should get you a return better than your bank savings account or CD.

iii) Match or beat the “risk-taking” opportunity cost of capital: An investor that wants to take more risk can buy risk assets. She should measure her progress against three benchmarks: inflation, the risk-free bond benchmark, and a “risk index” that is appropriate to the type of risk she is taking. The most common “balanced” US risk index is a 60/40 blend of the S&P 500 and the Barclays Agg, but the appropriate risk index should be specific to an investor’s goals.

2) Beating Inflation

Beating inflation is a common sense benchmark. It is what sophisticated managers mean, explicitly or implicitly, when they promise “absolute returns.” Any investment strategy offering absolute returns, yet not beating inflation, is stale sugar water.

The more nuanced question here is, “What is inflation – which index should one use?” This is relevant for two reasons. First, investors have a global opportunity set: they can pick the currency of their portfolio and many measures of inflation. Second, official government measures of inflation aren’t that trustworthy.

The conventional wisdom is that investors should use their home country currency and the most commonly used home inflation indicator. For Americans, this would be the US dollar (USD) and the Consumer Price Index for Urban Consumers (CPI-U). Yet as the dollar weakens, smart investors are looking more to a basket of currencies or gold as alternate measures of their portfolio’s worth. Take gold as an example. Suppose your portfolio is worth $100K today (about 100 ounces of gold). Suppose it grows to $150K in 5 years, but that only buys 80 ounces of gold. You are poorer. For simplicity, it’s easy to just use your home currency as the base measure. Yet if your home currency isn’t the Chinese yuan (CNY), which seems undervalued, but rather the USD, you may want to think twice about the base unit.

Suppose you stay with the dollar. Is the CPI-U a good measure of inflation? Perhaps not. For decades, the US government defined CPI-U using a fixed basket of goods. In the 1990s, government officials changed this to include substitution effects and hedonic improvements. Basically, they reasoned that: if beef prices went up, people would substitute cheaper chicken, and so chicken should be weighted more in the basket hence higher beef may lead to lower inflation; if a computer selling for $1000 had much better performance stats, it should be weighted cheaper, hence lowering inflation, though you still paid $1000 your computer. Both these Clinton era changes brought CPI-U inflation way down in the US and UK, while consumers still felt ripped off. For more information on these games with inflation indexes, read what John Williams of ShadowStats writes and David Altig of the Atlanta Fed counters. Governments playing games with currencies and inflation is centuries old; rich countries like Argentina still play the game today. As Williams suggests, the best measure of inflation is intuitively an equal-weighted basket of goods and services, as the CPI-U was previously calculated (what Williams calls his I-7 or his SGS Alternate I-8 inflation measure). But you can’t get the I-8 from the Federal Reserve or the BLS, you need to go to

Finally, investment managers who earn performance-based fees (carry) make off like rogues and bandits when inflation is higher than expected. Few investment funds have a hurdle rate, and often the hurdle is low (4 to 6%). In a world of high inflation, esp. when inflation is above the hurdle rate, all assets go up in price and your investment manager takes a disproportionate cut of your principal while adding no value.

Beating inflation is a no-brainer. So how come so few institutional investors write it in their contracts with managers? Why don’t more managers compare their return to inflation? The dirty secret is that many managers would do quite poorly and so they don’t want to measure their value-add (or value-subtract) by this bulls eye.

3) Beating Bonds

Beating bonds should be the next goal of any investment plan. Today, it’s easy to invest your money in a low-cost, diversified bond index and sleep safely. Bonds give you safety of principal and some idea of an expected return: the SEC yield, yield-to-maturity, and yield-to-worst approximate what you will earn. In the US in the 20th century, short term bonds (1-3 year maturities), beat inflation in almost every 10-year period (if the bonds were held to maturity). Hence investing in bonds is one step above beating inflation; it’s better than getting a smidgen of a nominal return from a savings account or bank CD. Of course an investor can make bad individual bond bets and lose money quickly: she can buy 30-year Treasuries when rates are low (4%) and sell them just as rates peak at a higher lever (12%); or she can buy high yield bonds when spreads and defaults rates are low, right before a business cycle turns negative. Also bond math and bond investing can be quite complicated. Experts can use Taylor series, linear programming, or option pricing models to price bonds. Yet a diversified index of bonds, like Vanguard’s Total Bond Market Index Fund, is a safe and simple place to be most of the time (not before sudden shifts from deflation/low inflation to high inflation, though).

Again there are some nuances. Investors can argue about:
-the best reference bond index should be US-based or Global-cum-US (to take currency exposures into account)?
-what to do before high inflation hits (buying low duration or linker bonds)?
-whether the index include just government bonds or a diversified pool of bonds (government, corporate, agencies, loans, etc.)?
The answers to these questions depend on the sophistication of the investor.

Beating bonds is a goal that most equity or other risk-asset investors do not acknowledge. Today, many absolute return hedge fund managers or long-only equity managers will point to their returns relative to an equities index (the S&P 500, Wilshire 5000, Dow Jones Industrials, etc.). Yet if they underperformed a bond reference index, like the Barclays US Aggregate Bond Index, these equity managers have destroyed your wealth. If you’re not getting a premium from stocks over the safer counterparts of bonds, your managers are fleecing you. And 3, 5, and 7 year returns are the best timeframe to measure this. In any single year, bonds can beat stocks. If bonds beat stocks for more than 3-years, you have a bad manager.

4) Beating a Risk Index
From the discussion above, investing is easy. You save money. You stick your saved money in a diversified bond index, from a trusted provider (Vanguard, Fidelity, Pimco), to “own” the bond market. If the experience of the US bond markets from 1900 to 2009 offers any future guidance, a diversified bond investor can expect a steady return about 2-3% points above inflation.

Yet bond returns may not be enough for investors who want to take more risk and earn higher returns (but keep in mind you can take more risk, bad risk, and earn lower returns!). In about 60% of all ten-year periods from 1900-2009, stocks and other risk assets beat bonds. When evaluating managers of risk-assets, investors should find an appropriate risk-index to measure performance. Find and set a bulls-eye and don’t let the manager change it if she underperforms. Some thoughts on the bulls eye of manager measurement:

i) All managers should be compared to inflation and a bond index. Investing in stocks, real estate, hedge funds, and private equity is sexy but silly if these asset classes and managers underperform inflation or bonds for any 3-year period or longer. Inflation and bonds are absolute benchmarks for all risk assets to beat; don’t let managers play mental jujitsu with you and try to convince you otherwise. Beyond inflation and a bond index, managers should only be compared to a single risk index.

ii) Don’t let managers pick multiple indexes that are economically very different. Managers will then cherry pick the best index in his communications and claim victory. I’ve seen dozens of “top” managers do this. The S&P 500 is quite different than the Wilshire 5000 or the MSCI All-Country World Index. Many absolute return hedge fund managers use the S&P 500, the MSCI ACWI, and the US Barclays Bond Aggregate together. However, these are three very different indexes with low or negative correlations. Hence one index will always do poorly as the others do well. The crafty but unscrupulous manager will compare his returns to the worst index. The heroic and honest manager, if she chooses all three, will compare her returns to the best performing index for any period. Yet beating all three in nearly all periods is impossible and shouldn’t be the standard – it’s like asking for a spouse with movie star looks, Einstein’s brains, Oprah’s empathy, and eternal unconditional love and devotion to you. Hence honest managers should only be compared to a single risk index.

iii) A risk index should be as broad as a manager’s legal/strict mandate, and not narrow like what the manager voluntarily chooses to invest in any period. A manager who has the mandate to invest in global stocks but chooses to limit herself to US stocks has made a country/geographical bet. Don’t let her choose the S&P 500 as her index (note to Warren Buffett – pick a broader index!). If a manager has a mandate to invest in 3 countries, her benchmark should be the best-performing broad equity index from those three countries in that time period, or a static, blended benchmark of three indexes.

iv) Simplicity and openness: Avoid using too many benchmarks (more than 3) or complicated blended benchmarks, as people have a hard time following them (due to bounded rationality). Also, non-proprietary benchmarks (like those from Cambridge Associates or other niche firms) usually don’t release verifiable data and hence shouldn’t be trusted or used. For example, a private equity firm is better off comparing its returns to a broad public equity index plus an illiquidity premium (say the Wilshire 5000 plus 400 basis points), rather than comparing itself to the opaque Cambridge Associates Private Equity Index.

The basic point is that every investing strategy taking risk should have a benchmark set beforehand. At a minimum, a manager must beat inflation and bonds, carefully defined, over a three and five year period. Beyond that, it takes some creative thinking to come up with a benchmark.

For example, a pure global macro fund can theoretically invest in any security, country, or asset class. Hence even a traditional 60/40 benchmark of the S&P 500 and US Barclays Aggregate is too limiting for a macro manager. It’s like playing basketball without have to bounce a ball, respect the court boundaries, or follow any rules. Any idiot macro manager should be able to beat a single country’s equity index (but strangely, few do!). Since the vast majority of global wealth is spread between stocks, bonds, and real assets, perhaps a macro manager should be measured against a benchmark blend of the MSCI ACWI, the Barclays Global Aggregate Bond Index, and the S&P/Citigroup World REIT Index. For simplicity, all three indexes are global, liquid, transparent, and widely known – a 33% split avoids the problem of annually re-measuring the balance of global wealth. Of course the REIT index isn’t a great measure of global real assets, but using three other niche benchmarks to measure real assets would make the blend unbearably difficult to understand.

5) How to beat the chess grandmaster Bobby Fisher
Bobby Fisher was one of the great chess grandmasters. At 13, he won the “Game of the Century.” He was the youngest US grandmaster, dominated world chess championships in the 1960s, and wrote a wonderful beginner’s book on playing chess, called “Bobby Fisher Teaches Chess.” So how do you beat Bobby Fisher? Here’s the secret:

To beat Bobby Fisher, don’t play him in chess. Pick something else: basketball, Hollywood trivia, ballroom dancing, stage acting, arm wrestling, or paintball.

That is really the secret that most money managers use. They tell you they’re going to “make money” for you. That’s easy, like thumb wrestling with Bobby Fisher. The real difficulty is to consistently beat inflation, a bond index, and a risk index. Very few managers can do that.

Of course, evaluating investment managers is more complicated:
-Managers can make dodgy asymmetric bets where the tail risk is a bulldozer (selling out-of-the-money options), or can buy securities that go from being very liquid to frozen (CDS).
-Managers can also play performance games where they post great returns with small amounts of capital (make $30 million on $100 million), and then raise lots of money to destroy much more (raise $10 billion only to lose $4 billion). They prove themselves dangerous to society. Unfortunately, many famous hedge fund and mutual fund managers fall into this category.
-Managers can make money by doing unethical things. If you’re not a sociopath, social and ethical goals matter. You may not want a strategy with high returns that devastates the urban poor or some other part of society (what were subprime investors thinking?).
But these are advanced bulls eye topics.

Investing to make money isn’t enough. You have to beat inflation, a diversified bond index, and a well-chosen risk index. If you can’t beat the indexes, just buy the indexes (at low cost) and sleep soundly.

Your bemused investor who has seen far too many bogus manager pitches,
Copyright 2009 Risk Over Reward. All Rights Reserved

You have permission to publish this article electronically or in print as long as the following is included:
Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty, macroeconomics, security valuation, and how to think about markets and invest profitably

Wednesday, November 4, 2009

Party Like It's 2007 - Ari Paul

If you’ve misplaced your calendar, you could be forgiven for thinking it’s the fall of 2007. Big banks are again paying out record bonuses to speculating traders. I’m again receiving letters from banks begging me to borrow money for 0% in special promotional offers. We’re again offering 0% down mortgage loans to people with poor credit (and like last time, it’s being encouraged by congress). There is again widespread talk of how the US dollar must eventually collapse and endless optimism about commodities.

What’s going on? Are investors/citizens/congress really that shortsighted? Ah, the remarkable power of liquidity. When the fed (and central banks around the world) throw enough money at people, those people are given tremendous incentives to gamble. Now, the gamblers don’t see themselves as gamblers. Rather, they rationalize that this or that asset market is cheap. They find convincing analysis by smart economists to justify stockpiling commodities or buying corporate bonds on margin. Similarly, when congress writes a blank check to a construction company, they’ll always find a highway that needs fixing.

The harder thing to explain is the near complete lack of response by the president and congress to the rising populist anger. For better or worse, responding to public sentiment is usually what politicians do best. So why is the modus operandi of the financial sector almost completely unchanged? After every major banking collapse in history (and there have been many), there was a period of conservatism when banks went back to the basic business of taking deposits and making loans. I think the answer is that Congress has just moved slowly, but the regulation is coming, and it will be very heavy. The financial firms donate a lot of money, but every person still only gets one vote. The main street narrative is clear – the financial sector was at least partly responsible for getting us into this mess and they haven’t taken their fair share of the pain. Over the next year, we’ll see that narrative translated into heavy handed legislation.

Aside from the additional regulation, I think we’re in for a repeat of many of the other changes that followed 2007. Just as the speculative bubble in 2007 was largely caused by excess credit, the recent rallies in “risky assets” have the same source. There’s no limit to how much money the fed can print, but I believe the tide is turning politically and we’ll start seeing credit tighten over the next 6 months. For example, today the front page of the WSJ featured an article about how economists and government officials worldwide believe bubbles are forming ( As I wrote 3 months ago, I expect the catalyst for a broad sell off to be the withdrawal of liquidity by central banks. It looks like the credit tightening is growing nearer.

An interesting social trend that's gaining steam is a push towards isolationism. In the last couple months, both liberal and conservative pundits have started calling for us to pull out of both Iraq and Afghanistan (e.g. Fareed Zakaria, Thomas Friedman, George Will). Another trend just starting is "age warfare." People under 40 are asking, "hasn't my generation's future been mortgaged enough to support the overspending of our parents and grandparents? Why are we taking on yet more debt to mail seniors checks?" We're only beginning to see the economic and social fallout from last year's crisis.

Thursday, October 29, 2009

Is China in a Bubble? - Ari Paul

In this issue:
1) Industry and Commodities
2) Real Estate
3) Credit
4) Equities
5) Are We The Mongolians?

Dear Friends, Colleagues, and Investors,
There's been a lot of talk lately about various Chinese asset markets being bubbles. Let's take a look.

1) Industry and Commodities
China's industrial sector is growing quickly, and many are arguing, unsustainably. Iron ore imports are up 65% year over year. Imports of most commodities and manufacturing of basic goods are far higher that one would expect given China's GDP growth. This appears to be a bubble driven by stockpiling by the government as well as by speculators. Peasants have stockpiled an estimated 50,000 tons of copper in a bet on rising commodity prices. If the world economy has a robust V-shaped recovery, global demand may catch up to China's stockpiling, but that's a big "if". While there's no obvious limit to how much more stockpiling the Chinese government and people can do, commodity imports and manufacturing are indeed in a bubble. It would probably take 3 years for world demand to catch up to the artificial Chinese demand for commodities.

2) Real Estate
China’s property values appear dramatically inflated. With a price to income ratio of over 12 in the major cities compared to a 5 to 1 ratio that the World Bank considers affordable, the Chinese people can't afford the new construction. Over the past year, completed real estate is up about 25% while sales are down about 22%. That’s a huge disparity that developers are starting to remedy – new construction is down about 1% year over year. These numbers are from the official Chinese statistics, but it's hard to know what we can trust. While China’s real estate market does appear to be in a bubble, it's no longer a growing one as you can see from the graph of real estate prices below. The economist Andy Xie makes the point that, "China's urban living space is 28 square meters per person, quite high by international standards. China's urbanization is about 50% and could rise to China's urban population may rise by another 300 million people. If we assume that all can afford property, Chinese cities may need an additional 8.4 billion square meters of space. China's works-in-progress covers more than 2 billion square meters...The construction industry has production capacity of about 1.5 billion square meters per annum. Absolute oversupply - not enough people for all the buildings - could happen quite soon." The Chinese government has started reducing the flow of easy credit which has put a lid on prices. The question is will real estate remain stable until demand can catch up, or will prices collapse violently?

3) Credit
Loans in the first 9 months of 2009 totalled 8.7 trillion Yuan vs 3.5 trillion Yuan in 2008. M2 (measure of the broad money supply) was up 29.3% over the previous year. Despite this massive money growth, the official statistics show that China is facing deflation because of tremendous overcapacity. I’ve seen estimates suggesting that China really faces inflation of around 10%; it’s not easy weeding through the competing data. Banks were basically ordered by the government to increase loans over the last year and there's is lots of anecdotal evidence that banks were throwing money at businesses with no investment prospects and even businesses that didn't want the loans. The situation is widely acknowledged - chairman of China Merchants Bank, Qin Xiao, says China must urgently tighten monetary policy to avoid inflating bubbles. China has recently moved to tighten credit, but we will likely see non-performing loans rise sharply over the next few years. Below is a graph of Chinese M2 (broad money supply).

4) Equities
Chinese equities are still almost 50% off their highs with GDP more than 15% higher. Simple metrics like P/E and P/B suggest that Chinese stocks aren’t cheap, but nor are they in a bubble. While many if not most Chinese companies commit accounting fraud, they are still growing quickly. No bubble here.

5) Are We The Mongolians?
The longstanding myth of the Chinese Wall was that it was built in the 3rd century BC. Most of whatever existed at that point was destroyed before the 12th century; the great wall we think of today was built by the Ming Dynasty in the 14th-17th century. The Great Wall was a great failure as the Manchu warriors entered China in 1644 and conquered Peking, establishing the Ch’ing dynasty, which reigned for three centuries. Today, China has established many economic controls to protect and preserve the pseudo-capitalist economic climate of mainland China. These new walls are likely to prove similarly ineffectual over the next few decades as western powers again impregnate China with their culture. Hopefully the modern invaders will be more beneficial to China than the Mongols were.

The large current account surplus and the influx of foreign direct investment led to a bubble in real estate over the past decade. More recently, the explosion in bank lending and fiscal stimulus have produced a commodity and manufacturing bubble. However, the tremendous attention that these bubbles are receiving suggests that they are not particularly severe. In severe bubbles, the final spike occurs dramatically and with almost no one mentioning that it's bubble. Rather, regulators, analysts, and speculators all bend over backwards to justify the rally fundamentally. With a surfeit of bubble watchers today, we're less likely to get the classic conclusion to bubbles - the violent bursting.

For this issue I drew upon insights from Michael Pettis (, Victor Shih (, and John Mauldin ( Much thanks to them.

Your "Marco Polo" Trader,


Copyright 2009 Risk Over Reward. All Rights Reserved

You have permission to publish this article electronically or in print as long as the following is included:
Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty, macroeconomics, security valuation, and how to think about markets and invest profitably