Duh.  I don’t like saying “Duh.”  There’s something dumb-sounding about it.  The only thing worse is saying “Duuuuh,” or “Duuuuuuhh.”

Yet, when I read Dr. Bernanke’s Op-Ed in the Wall Street Journal today, my initial response was “Duh, of course, in order to exit all ya gots to do is do the opposite of what ya did to enter.  It will be cheap and simple.”

Why should the Fed think that doing the opposite will be easy?  Take the Fed’s forelorn policy tool, the Fed funds rate.  When has it been easy to raise the rate?  Only very bold central bankers would act before it was clearly needed.

Wait, Give Dr. Bernanke a chance.  What did he say?

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

What is his first method?  Suck cash out of the system temporarily, and hold fixed-income assets while waiting.

The second method is to let the Treasury suck cash out of the system temporarily, perhaps compromising Fed independence somewhat.

Third?  Make a good offer to the banks so that they lend to the Fed and not to customers, slightly longer-term.

Finally, the Fed could suck in cash by selling the Treasury, Agency, and Mortgage bonds they have acquired, perhaps raising longer-term interest rates in the process.

It all sounds easy.  But tightening the Fed funds rate is not easy, particularly toward the end of the cycle.  What of these new policy tools?  Will they face similar difficulties?

Yes, and maybe more.  The Fed lacks experience with these tools.  As I have said before, policy accommodation is like a drug: easy to receive and hard to withdraw.

As the withdrawal occurs, there will be pain, and more so as the withdrawal continues.  Can you imagine what happens to the bond markets when they realize the Fed is selling?  It will be ugly.  Welcome to the asymmetry of the markets, Dr. Bernanke.

One thing that was neglected were all of the specialized lending programs.  How do they get unwound?  I’m not sure, but I believe the same pain thresholds apply, only that special interests will complain privately.


Making the markets happy is a fool’s bargain, Dr. Bernanke.  Doing that leads into a liquidity trap, as your acquaintance Dr. Greenspan left you with.  The markets need to be jolted every now and then to know that you aren’t their slave.  Without that, the markets grow complacent, realizing that the Fed exists for their aid and comfort.

In the short-run, Dr. Bernanke, it is always easier to please that fickle mistress, the markets.  Dr. Greenspan learned that all too well.  The markets will eat until they are obese — even beyond that, until they are regurgitating breakfast.  In a macroeconomic sense the markets are not efficient — they will take whatever the government gives, and beg for more, until it kills them, like a drug overdose.

In that sense, the long term is not the sum of short terms.  Rather the seemingly optimal short terms can lead away from what would be optimal long term.


With that, I end this piece.  On the off-chance that you are reading this, Dr. Bernanke, Ben, I would simply say that removing policy accommodation is easier said than done.  There are always tensions, regardless of the method, and political and economic pain to boot.  Embrace the pain, and let elected officials deal with the consequences.  You’re a brave man, but it is their responsibility — let Congress deal with the crisis.

Seven Miscellaneous Notes

1) I am proud of my two middle children, Peter and Jonathan (#4 and 5 out of my 8 ) who have started an “odd jobs” business in this environment, doing yard work, pet sitting, etc.  As other neighbors in our area have seen their good work, all of a sudden, they are gaining a lot of new business.  They are both workers, and hard work pays off.

2)  I appreciate this article in Barron’s where the thoughts of Doug Kass are featured.  I have very high respect for Mr. Kass, because he marries two qualities: he has a keen sense of market timing, and yet a sense of relative value also.  I agree with him the intermediate-term returns should be blah, because it is more difficult to lever up at present.

3)  The states are in more trouble than the US Government, because they have to run balanced budgets, and can’t print money.  California can send out IOUs, which aren’t a currency (yet).  Philadelphia can stiff vendors for now, but what of the future?  California may come to some sort of short -term agreement that postpones real troubles until next year.  Same for Philadelphia.  And, true for many municipalities that are finding cash to be short, because capital gains, sales, and real estate taxes are flagging.

Unlike Gregor (bright man that he is), I do not think that the US Government will bail out California.  Why?

  • Every state will ask for a bailout.
  • States have no bankruptcy code, so those pressing them for money have few options.  (That said, say goodbye to the municipal bond market.)
  • The US Government has enough problems as it is — if you want help, take a number and get in line.

As it is California is a basket case, with dysfunctional politics from the referendum process.  Let California get its own house in order, and reform its government, including the initiiative process.  If it still has problems once it is in as good a shape as other states, fine, let it petition the Federal Government.  It won’t get there anytime soon.

4) Regarding the Fed, I’m not the only one suggesting that there be more regulation.  You can listen to Allan Meltzer, or William Greider.   I give Dr. Meltzer more weight here, but one thing is clear — the Fed is an undemocratic institution with few avenues for accountability.

5)  Will we have robust growth soon?  Former Federal Reserve Governor Laurence Meyer, thinks we won’t see full employment until 2015.  Truth is, with aging demographics, we may not see full employment for a longer time, as baby boomers that can’t afford to retire continue to work.

6)  Aside from regulatory sloppiness, why does Goldman Sachs get a free pass on their VAR calculation (and also here)?  What is VAR for, except to constrain risk?  No one should get exemptions.

7)  My view is that derivative and cash positions should be treated the same in a regulatory sense.  But derivatives were unregulated compared to cash positions.  Investment decisions with the same economic result should be equally regulated.  Much as I am not crazy about government regualtion, with regulated institutions, derivatives should be decomposed into their cash equivalents, and regulated the same way.

Industry Ranks

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

Now, as a bonus to Aleph Blog readers, I’ll share with you my second industry rotation model, which I put out weekly to clients.  This model looks at the S&P 1500 Supercomposite, and using price momentum, among other factors, encourages the purchase of equities that have done well over the past  year.  Comparing it to the first model, this report always works in the red zone, because price momentum tends to persist in the short run.  This is a short term model.

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

Anyway, consider this, and if you have more good ideas on industries, share them with the group.  I can always learn more.

China, the Wild Card — Seven Notes

1) Is China really growing or not?  Wait, is that a stupid question, or what?  Of course China is growing, and pulling the global economy out of the ditch as well.  Read this report from Time.  Uh, maybe not.  What if it is all a lending bubble?

What seems to be happening is that the powers that be in China are encouraging banks to lend aggressively.  Firms in China aren’t finding a lot of opportunities in export markets, so they build up inventories “that they know they will need eventually.”  Financial counterparties and individuals speculate on financial assets like real estate and stocks as they find cheap financing available.  (Example)

That’s my view of China at present.  I think those that are arguing for a resurgence in China at present are missing the similarities to the late 1980s with Japan where large amounts of productive capacity were built up with no markets large enough to sell the incremental production to.

I could be wrong, but this is leading me to lighten up on cyclicals.  Maybe some utilities…

2) With all of the noise of those looking for a replacement for the US Dollar as the world’s global reserve currency, I have two questions:

  • Are the surplus nations looking to reduce their surpluses, and thus suck in fewer foreign assets?
  • Is there a new deficit nation that is politically stable, militarily strong, etc., that is capable of running current account deficits for some time?  Surplus nations need a safe place to invest.

3) In the meantime, the US tries to assure trading partners that their purchasing power is safe.  We remember the laughable assertion of Tim Geithner trying to assure the Chinese that they did not have to worry about devaluation of the dollar.  Well, now he is saying the same things to the Saudis.  At least with the Saudis, we are doing their bidding in the Middle East, by bottling up Iran,  so perhaps he does not have to worry so much there.

4) Back to point 2.  Are the current account surplus nations willing to consume from the rest of the world and flip around to deficit conditions, letting their currencies appreciate, and killing their politically powerful export industries?  That’s what it will take to replace the US Dollar.  I don’t care who is arguing against the US as a reserve currency.  The reserve currency must by nature offer high quality securities on net to the surplus nations to invest in.  It must run current account deficits on average.

That’s why China can’t be the world’s reserve currency.  China isn’t willing to stop export promotion, or encourage domestic consumption.  India and Russia may kvetch as much as they like, but both are in the same boat as China, but to a lesser degree.

Oddly, the best policy for most of the complainers would be to allow/encourage imports, and stop export promotion.  Freed from these distortions, the global economy would start to normalize.  Cross-border capital flows would decline because exports would not need to be balanced out.

5) The US has no interest in selling Yuan-denominated debt yet.  China eagerly buys Treasuries today.

6)  Does the one child policy fuel excess savings in China?  Maybe, but I doubt it is a big factor.  Dowries are unlikely to eclipse the actions of the central bank and government.

7) A final note from Andy Xie — there is a lot of momentum in China, but little underlying change in the fundamentals.


My summary is this:  To the degree that the recent upturn is driven by expectations that China pull the global economy out of the ditch, the move is mistaken.  As my friend Cody Willard asked me three years ago, what happens if Chinese growth proves to be a sham?  Can you trust their statistics?

My answer was that I wasn’t certain, but that things would get more clear if that were the case — and I think things are clearer now.  My policy implication is to move assets out of export-driven sectors, and those driven by China demand.  Utilities, here I come. ;)

Central Bank Independence is Overrated

Central Banks, should they exist, should be able to do what is right for monetary policy, which includes regulation of credit.  In a fiat money world, where credit exists as electronic entries, credit is money.

But wait, what if central bank independence is compromised from within?  What if voluntarily becomes the lap dog of the President, Treasury, or Congress?

It takes a bold man to stand up to the powers that be, and the Fed has had its share of them.  Marriner Eccles opposed Truman.  William McChesney Martin, Jr. stood up to Presidents and Congress for his long term as Chairman.  Paul Volcker blew cigar smoke at representatives and Senators as he restored sound money to the US amid screams of pain in the economy.

Central bank independence doesn’t mean squat unless the central bank uses it!

In the name of independence, for fear that the President or Congress would restrict the central bank, many Fed Chairmen have given in to the powers that be:

  • Ben Bernanke, rescued entities that he should not have rescued, and established lending programs that use the national credit to benefit a minority of participants.  These actions should have been taken by Congress, if done at all, so that the voters could decide whether it was right to do it or not.  Bernanke validates the idea that the government keeps the Fed around to do what it cannot do constitutionally.
  • Alan Greenspan threw liquidity at every little and big problem, and was slow to withdraw liquidity, pushing the US slowly but surely into a liquidity trap, which Ben Bernanke was saddled with.
  • G. William Miller and Arthur F. Burns, who facilitated the inflation of the ’70s, at the behest of Nixon and Carter.
  • Daniel R. Crissinger and Roy A. Young, who facilitated the loose monetary policy of the ’20s.

Central bank independence means risking your own tenure for the good of the institution.  Marriner Eccles and Paul Volcker did not get reappointed because they offended the President.    Central bank independence does not mean compromising in order to protect against micromanagement.  Independence means being a man, and telling the President and congressmen that you will do what is right to preserve sound money, regardless of the consequences.

The Fed as Systemic Risk Regulator

I have suggested in the past that the Fed should regulate systemic risk as an aspect of its mandate only because they are the biggest creator of systemic risk through loose monetary policy.  I am not suggesting this on the basis of competence — that is ridiculous.  But on the basis of modifying the behavior of the Fed to make it more resistant to loosening rates early because of systemic risk concerns — that makes sense, because it will increase the emphasis on a sound currency.

Now, many economists are pleading with Congress to be gentle on the Fed because an independent Fed is critical to sound economic policy.  That would be true if the Fed were willing to take politically unpopular actions that were in the best interests of the economy.  Sadly, that is not true of the present Fed.  They do what the politicians want, and give the politicians cover, because the politicians can point at the Fed as the actor, via the rubric of “Central Bank independence.”

I say that the Fed needs more accountability and transparency to Congress, and ultimately to the American.  The quasi-public, quasi-private nature of the Fed needs to be changed to public or private.  Section 13.3 of the Federal Reserve Act, which allowed for the most egregious bailout actions, should be repealed. If bailouts need to be done, let Congress do them, and let them take the heat for their actions.

Not only should the Fed be audited as any large public or private organization, but if they are a public organization they should respond to the FOIA requests from major news organizations (Bloomberg, Fox Business, etc.) without hiding behind technicalities of protecting business secrets.  The insurance industry regularly reveals detailed data on their operating companies, with little seeming harm.  The banks can afford to do the same.

Power without accountability should be foreign to our republican form of government.  Control of our currency rightfully belongs to Congress, and Congress should tighten controls on the Fed so that its degree of independence is limited to the ordinary matters pertaining to a central bank — preserving the soundness of the currency.  Its competence there has been limited; but hey, at least focus on the basics would restore confidence in an institution that no longer has the confidence of the American people.

“Central Bank independence” is a nice phrase, but to the economists who petitioned Congress to preserve the status quo, I would simply ask this: How and from what should the central bank be independent?  To whom and in what ways should it be accountable?

Morning Financials

I put out a short report each morning on financial stocks, giving a quick summary of the big movers, market tone, and what sub-industries are moving.  I am publishing a copy of it today here as a bonus for Aleph Blog readers.  Enjoy.  Comments welcome.

The information herein and the data underlying it has been obtained from sources that we believe are reliable, but no assurance can be given that this information , the
underlying data or the computations based thereon are accurate or complete or that the returns or yields described can be obtained. Neither the information nor any opinion
expressed constitutes a solicitation by us for the purchase or sale of any security. All prices are indications only.
David Merkel, CFA, FSA 16 July 2009
Morning Financials Update – Big Movers
Top 20 Financial Stock Movers
Company [ticker]
Price Move
MGIC Investment Corp [MTG]
Adj. Loss/Shr $2.86 vs $1.04 Loss Est. Injecting $1 billion into in inactive subsidiary, allowing it to write new business. Wisconsin DOI goes along with it. Fitch Downgrades on Announced Restructuring Plan
Pacific Capital Bancorp NA [PCBC]
No news materially driving the stock price
CVB Financial Corp [CVBF]
Beats estimates. Adjusted EPS 19c vs 10c Estimate
East West Bancorp Inc [EWBC]
Misses estimates. -1.83A v -0.42E. Aggressive credit management being employed — if true, problems may be smaller in the future.
Umpqua Holdings Corp [UMPQ]
Beats estimates. Adjusted EPS 15c vs 9c Loss/Shr Loss Estimate
Commerce Bancshares Inc/Kansas [CBSH]
Beats estimates. Adjusted EPS 49c vs 38c Estimate
MB Financial Inc [MBFI]
Beats estimates. Adjusted EPS 16c vs 26c Loss/Shr Loss Estimate
Charles Schwab Corp/The [SCHW]
Beats estimates 0.20A v 0.18E. Client assets down, which may push future earnings down.
Developers Diversified Realty [DDR]
No news materially driving the stock price
Host Hotels & Resorts Inc [HST]
Rated New `Underperform’ At Wedbush. Perhaps some sympathy from Marriott’s bad profit report.
Federal National Mortgage Asso [FNM]
Allison Says Housing Program Showing Signs of Success. Uh, really?
No news materially driving the stock price
Cousins Properties Inc [CUZ]
Slashes 3Q dividend by 40 percent.
Stewart Information Services C [STC]
No news materially driving the stock price
Federal Home Loan Mortgage Cor [FRE]
Allison Says Housing Program Showing Signs of Success. I don’t see that at all.
First Commonwealth Financial C [FCF]
No news materially driving the stock price
CapitalSource Inc [CSE]
No news materially driving the stock price
American International Group I [AIG]
Prudential Said to Resume Talks Over AIG Japan Units. AIG Said to Ask Buyout Funds to Ally With Taiwan Firms on Taiwanese Life Unit.
Boston Private Financial Holdi [BPFH]
No news materially driving the stock price
CIT Group Inc [CIT]
US unlikely to aid CIT, which faces a likely bankruptcy. Can an independent commercial finance company survive tough times without a deposit franchise? I don’t think so.
The information herein and the data underlying it has been obtained from sources that we believe are reliable, but no assurance can be given that this information , the
underlying data or the computations based thereon are accurate or complete or that the returns or yields described can be obtained. Neither the information nor any opinion
expressed constitutes a solicitation by us for the purchase or sale of any security. All prices are indications only.
 If CIT can’t get help, that means all entities seeking help should expect less help at the margin, or at least more sturm und drang.
 Banks and thrifts are leading and Commercial finance and GSEs are trailing.
 Speculative names doing badly today.
 Survivors in investment banking are picking up more business and profits.
 Rising unemployment is the biggest hidden risk to the financial economy at present. As jobs are lost, people default on more debts.
 Commercial and high-end residential real estate still under pressure.
 The short-term performance model for financial stocks recommends only Reinsurers here. They face lower risk on the asset side of the balance sheet.
 Whether insurers or banks, avoid equity-sensitive names here – aim at companies that don’t have a high degree of sensitivity to stock market performance.
 The market in the short run is driven off of government policy, which is uncertain.
 Better to play it safe at this point. We have just experienced a very sharp bear market rally. Remember, sharp moves tend to reverse, slow moves tend to persist.
Group Price Movements for this Morning
Commercial Serv-Finance
REITS-Regional Malls
Commer Banks-Western US
Property/Casualty Ins
Finance-Credit Card
Commer Banks Non-US
Finance-Auto Loans
Diversified Banking Inst
S&L/Thrifts-Central US
S&L/Thrifts-Eastern US
Commer Banks-Eastern US
Financial Guarantee Ins
Multi-line Insurance
Finance-Consumer Loans
REITS-Shopping Centers
Fiduciary Banks
REITS-Health Care
Real Estate Oper/Develop
Life/Health Insurance
REITS-Office Property
Commer Banks-Central US
Grand Total
Finance-Invest Bnkr/Brkr
Insurance Brokers
Retail-Pawn Shops
Commer Banks-Southern US
Real Estate Mgmnt/Servic
Invest Mgmnt/Advis Serv
Finance-Mtge Loan/Banker
REITS-Single Tenant
Super-Regional Banks-US
I look at these companies for big news events that have occurred since the last close. Often there isn’t any, but big changes here can be an indication that someone knows something, or there is trading noise. After that, it is up to the analyst to dig. Often, the dog that does not bark is the clue, as stocks move up or down on no news, as well as unexplained large spikes in volume, CDS spreads, and implied volatility of options.
Disclosure: long ALL NWLI SAFT RGA AIZ PRE

The Equity Premium is No Longer a Puzzle

For a number of years, I have mused over the equity premium puzzle, and have generally written that the premium return that equities earn over stocks is less than most asset allocators assume. In January 2006, wrote an article on this topic at RealMoney: Kiss the Equity Premium Goodbye.  A few quotes:

This article won’t win me a lot of friends in the money management industry. Here’s the skinny: Stocks are unlikely to return much more than bonds over the next 10 to 20 years.Most investment consultants tell people to invest in equities because, in the long run, stocks beat bonds and cash. I agree, but how big is this advantage? Many studies suggest that the equity premium is somewhere in the vicinity of 6%; i.e., stocks beat cash by 6 percentage points a year. Against bonds, the advantage is said to be 4% or so.

However, there are persuasive arguments that the value of the equity premium will be much lower going forward. In the book Triumph of the Optimists, Elroy Dimson, Paul Marsh and Mike Staunton argue that the future equity premium in the U.S. is likely to be closer to 4% over cash for two main reasons:

  • Corporate cash flows have grown faster in the last 50 years than in the prior 50, and investors have bid up stocks as a result. However, the authors believe that such high rates of growth will not continue. If corporate cash flow growth reverts to the rate of the first half of the 20th century, future returns based on current equity values will be poor indeed.
  • Perceived risk in stock investing has diminished. Investors have bid prices up in anticipation that the equity premium is higher than it should be, and on the belief that it is not risky to try to capture it.

The researchers Peter Bernstein and Robert Arnott draw similar conclusions, but they get there in different ways. They point out that over the years, the size of the future equity premium has varied with the level of belief in its existence. When market players deny its existence, equity valuations are low, past equity performance has probably been poor, and the future equity premium is large — think of 1931, 1937, 1974, 1982, November 1987 and 2002. When everyone believes in the inevitability of stocks, à la “Dow 36,000″ (we’ll get there by 2025 or so), equity valuations are high, past equity performance has probably been great, and the future equity premium is small — think 1929, 1972, August 1987 and February 2000.

I believe stocks have been bid up because of the benefit needs for the retirement of the baby boomers. Though the savings rate is low, investment vehicles such as pension plans have made large commitments to equities, partially because plan sponsors can justify lower contributions to benefit plans by assuming a high rate of return, which stems from assuming that the equity premium will persist.

and this:

This doesn’t directly generalize to the market as a whole, because all stocks are owned by someone at the end of each day. Isn’t there always a buyer for every seller, and vice versa? Yes, but they aren’t always public-market buyers and sellers. Cash comes into the market via IPOs (both primary and secondary), rights offerings and any other way that new shares get created for the payment of cash. Cash comes out of the market through dividends, buybacks and any other way that companies disburse cash to shareholders, whether directly or in exchange for shares.

Companies tend to sell stock when it is advantageous; IPOs happen more frequently when valuations are high, and buybacks happen more frequently when valuations are low. This suggests a project for future study: Calculate the dollar-weighted return for the public equity market as a whole, and compare it with the time-weighted return figures.

It’s a difficult but not impossible project, but I don’t have the time or resources to do it. If it hasn’t been done already, it might make a rare practical Ph.D. thesis for someone. Returns for the market as a whole would equal the change in market value, plus the cash cost of shares taken out of the market (buybacks, LBOs, etc.) and dividends, less the cash added to the market through IPOs and other forms of share issuance for cash (i.e., employee stock option exercise, rights offerings, etc.). I don’t have firm numbers, but my guess is that dollar-weighted returns are less than the time-weighted returns by 1 percentage point, give or take 50 basis points.

Though the composition of an index fund changes by period to reflect additional equity issuance/buyback by companies in the index, it misses the effect on returns from having to allocate more capital when valuations are high, and having to receive capital back when valuations are low. In a whipsaw period like that which we have had from 1998 to the present, it makes a lot of difference, because many investments during the bubble era put fresh capital into the market at a time of high valuations, with buybacks predominating as valuations troughed.

In short, though the academic studies rely on time-weighted rates of return for their conclusions regarding the equity premium, which represents buy-and-hold investors, dollar-weighted returns, which is what most investors actually receive on their investments, are lower. The difference occurs because corporations issue stock when valuations are high, and retire it when valuations are low.

Okay, here’s the punchline — with not just a hat tip, but a full bow to Eric Falkenstein at Falkenblog, Ilia D. Dichev has done the research that I wanted to see done.  The difference between time-weighted and dollar-weighted returns is around 1.3% for NYSE stocks (1926-2002), around 5.3% for NASDAQ stocks (1973-2002), and 1.5% for developed market stocks generally  (1973-2004).

Doing a very rough average, and considering that the NASDAQ was in a boom period for most of the study period, I am comfortable with a reduction in the US equity risk premium over bonds down to 1-2% on average, and over cash to 3-4% on average.

At that level, being in stocks works for long term investing, but it would almost never pay to be 100% in stocks.  The old 60/40 stocks/bonds allocation begins to look really intelligent over the long haul, but maybe not today because high quality bond yields are so low.

So, where does this leave me on the equity premium puzzle?  It is no longer a puzzle.  One can gain moderately over the very long haul in stocks versus bonds, but with significant volatility.  Don’t risk what you can’t afford to lose in the stock market, and other risky investment vehicles.

PS — this makes the old dictum on the cost of equity valid again — the cost of equity capital for a firm should be 2-3% above their longest bond yield.  Bye, bye, CAPM.

Goldman’s Gain, America’s Risk?

Today I was featured at the New York Times “Room for Debate” blog, along with five others more notable than me.

The question was “about Goldman’s compensation pool, which will be  $11.36 billion (set aside) for the first half of 2009 (working out to about $386,429, on average, for each of the roughly 29,400 employees and temps).

The average reader may be perplexed about huge bonuses making such a comeback.We’re asking various economists, whether it’s reasonable to be critical of this kind of payday at Goldman when the rest of the economy is still floundering? Or is this a sign that the financial industry is stabilizing and the federal government’s aid is doing what we want it to do?”

Word limit was 300.  I had more to say, because if you’ve read me for any length of time, you know that I am no fan of government intervention.  I was against the bailout from the start, preferring Resolution Trust-style solutions.

My view is that Goldman would have survived on its own without the bailout, though it would have scraped by.  That said, absent the bailout, Goldman might have ended up being a near-monopoly.  Bank of America would be gone, as would Citi, and Wachovia. Wells Fargo, JP Morgan and Morgan Stanley would be question marks.  The amount of increased pricing power to the remaining investment banks would be even larger than it is today.

Most of the government programs Goldman Sachs benefited from were available to many institutions of their size and class.  The government took the risk that some of the money would be used by healthy firms to make more money, in order to prevent panic regarding firms that needed the money to survive.  Other money, like the TARP, was forced on Goldman.

Does this mean I don’t think that Wall Street (and thus Goldman) has too much influence on government policy?  No, I believe that the US Treasury has been captured by those that regulate them.  This includes Pimco and Blackrock, who finance the government, and the investment banks, who try to profit from government policy.  There are too many appointees in high positions at the Treasury and Fed coming from firms that seek to influence the US government.

I don’t fault Goldman for its actions; they are a profit-seeking firm, and a very good one.  I fault our government for intervening where they should not have done it.

Let the bonuses be paid, why should the employees of Goldman be held responsible for the errors of the US Government?  That is water under the bridge.  Let us move on and try to make future government policy better (less interventionist).

PS — does that mean we shouldn’t investigate Goldman Sachs to see if they aren’t front running the market with their high frequency trading?  No, that’s worth looking into, but such an investigation would need some deeply smart people to be able to understand what is going on.

Book Review: The Myth of the Rational Market

There are few books that I read that leave me feeling as if I have taken a trip down memory lane.  The Myth of the Rational Market was that for me.

In my junior year at Johns Hopkins, I wrote my senior thesis on predicting splits in the stock market.  I had to do it in my junior year because I had applied to do a combined BA/MA in political economy in my senior year.

My thesis, springing from what I had learned in Dr. Carl Christ’s class on financial economics (which in itself was an anomaly in the political economy department), forced me to analyze the then-fresh literature on event studies on efficient markets, including the famous paper by Fama, Fisher, Jensen, and Roll on how it was impossible to make money off of stock market splits.

That paper was important, because prior research was not agreed on the topic, and it was an example of something not all that significant that could be a signal of greater things — that managements would only split the stock when they had confidence.

Young David, having been raised in a home where his self-trained mother had regularly beaten the market, found the efficient markets hypothesis less than compelling.  Like his mother, he felt that superior analysis of fundamentals should outperform.

But here was a situation where it was obvious that stocks that split outperformed before they split.  My thesis asked, “Could splits be predicted?”

Going through the literature, I came up with some variables that could be useful — some were valuation-based, some were technical (price, volume), and some were anomalies (insider trading).  I ended up finding that stock splits could be predicted more often than not, but more importantly, that the variables that correlated with stock splits were more generally correlated with outperformance (in the 7%/yr region).  Those variables included valuation, momentum, and insider trading — which for a paper written in 1982 was notable.  I concluded that the Efficient Markets Hypothesis was flawed, also notable for its time.

Wait — this is a book review.  As I read Justin Fox’s work, I admired its ambition.  This attempts to cover financial markets efficiency, with some efforts toward economic efficiency generally.  It covers a lot of ground — all of the major players in the efficiency of financial markets debate are featured, and written about in simple language — there are no equations to wade through as I once did.  This book is comprehensive, and touches on many of the more obscure critics of the Efficient Markets Hypothesis.  Bright men who are tangential to the Financial Economics profession get their play — Kahneman, Tversky, Minsky, Mandelbrot, and more

Many of these men that questioned market efficiency went down the same trail that I did; they were led by the data, which conflicted with neoclassical economic theory.  Many of them came to my view that the market is pretty efficient, but not perfectly so.  Efforts at finding inefficiency promote market efficiency.  Efficient markets make people lazy, which leads to inefficiencies that can be profited from.

I liked this book a great deal.  It gets a bit thin at the end when it tries to incorporate the current crisis into its framework.  More broadly, it is at its weakest where it merely touches on a significant contribution, but does not dig deeper.  That said, a book of 500 pages would be far less readable than one of 300+.

Who would benefit from this book:

  • Those who are too certain about their positions on market efficiency.
  • Those that assume that the market is always or rarely right.
  • Those that select asset managers, because there is a lot of volatility around investment returns.  What is luck? What is skill?  We know less here than we imagine.
  • Academics in economics that are not familiar with the finance literature, because this would give an outline of the questions involved.


When I do book reviews, I actually read the books.  In the few cases where I scan a book, I reveal that in the review.  I also offer the easy ability to buy books through Amazon.com, and if you want to buy this book click here:  The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Full disclosure: if you buy anything through Amazon after entering through my site, I get a small commission, but your costs do not go up.

Some Practical Thoughts on Asset Allocation

When I think about asset allocation, I typically begin with my model that chooses between BBB corporate bonds and common stocks.  The model still favors corporate bonds.  After that, I look at the bond market, and ask myself where I think risks have more than adequate compensation.  I look at the following factors:

  • Duration (Average Maturity is similar, sort of) — do we get fair compensation for lending long?
  • Convexity — does the bond benefit or get hurt by interest rate volatility?
  • Credit — are we getting decent compensation for credit risk?
  • Structure — Structured notes always trade cheap to rating, but how cheap?
  • Collateral/Sectors — Are there any collateral classes or sectors that are trading cheap to their fundamentals?
  • Illiquidity — are illiquid issues trading stupidly cheap?
  • Taxes — How are munis trading relative to tax rates and creditworthiness?
  • Inflation — is the CPI expected to accelerate?
  • Foreign currency — if nothing looks good on the above (or few things look good), perhaps it is time to buy non-dollar denominated notes.  My view is buy foreign currencies when nothing else looks good, because foreigners will do the same.

At present, I am not crazy about corporate credit relative to other bonds.  I would move up in quality.

We are getting decent compensation for duration risks, so I would buy some amount of long Treasuries.  I would also hold some cash, running a barbell.

On convexity, I would be market weight in conforming mortgages.  If I had an edge in analyzing non-conforming mortgages, I would buy highly rated tranches of seasoned deals (2005 and before).

I would do a lot of analysis, and buy seasoned CMBS (2005 and before) — there are real risks, but the seniors should not get killed.

Munis offer promise for taxable accounts — the difficulty is doing the credit analysis on long bonds.

On inflation — I am not a fan of TIPS right now.  I would rather buy foreign bonds.  The actions of foreign nations lend themselves to dollar depreciation.

So, where would I go with a portfolio that has an intermediate horizon, say, 5-10 years out?

  • 30% global equities — half US, half foreign (emphasize value, but not financials)
  • 15% long Treasuries
  • 15% residential mortgages — seniors, conforming
  • 10% CMBS seniors
  • 15% cash
  • 15% foreign bonds

Yeah, I know this seems conservative, but I am not a believer in the current rally in stocks or corporate debt.  This is a time to preserve capital, not hunt for yield.

To Control Bubbles, the Fed Must First Control Itself

I’ve written before about the Fed’s de facto triple mandate:

  1. Low goods-price inflation.
  2. Low labor unemployment.
  3. Protect the financial system in a crisis.

Number 3 is the implicit obligation of the Fed, for several reasons:

  • The Fed carries out monetary policy (in ordinary times) through the banks.
  • Banks in the Federal Reserve System have close ties to the regional Federal Reserve Banks.
  • Bankers and those sympathetic to bankers comprise a large portion of the leadership and staff of the Federal Reserve.
  • Regulating banks gives jobs to many at the Fed.

Stepping back, let me tell you a story.  In the mid-90s, I became worried about inflation going out of control again, given the degree of monetary growth that I saw.  I’m not sure where I got the idea, but eventually it struck me that in the ’70s, when inflation was running hot, we had a lot of spenders and few savers.  In the ’90s, more savers and fewer spenders.  (You have to add in agents of the baby boomers, including the defined benefit plans, and the growth in 401(k)s, and products like them.)  Goods weren’t inflating from excess money, assets were being inflated as the baby boomers were socking away funds for retirement.

(Note to stock investors: be wary when market P/Es rise dramatically — there are limits to what is reasonable in P/Es for any level of corporate bond yields.  This applies to price-to-book and -sales ratios as well.)

As one more example of how monetary policy affects the asset markets, consider how the Fed temporarily flooded the banks with liquidity to avert problems regarding Y2K, and the stock markets reacted to the excess liquidity with a two month lag.  The Fed helped put in the top of the tech bubble.  I don’t know how the money leaked out of the banks to the stock market, but excess reserves under good conditions will produce loans.

Thus, I came to the conclusion that the Fed ought to look at asset inflation as well as goods inflation somewhere in the late ’90s.  But doesn’t the implicit third mandate cover that?  Alas, no, the third mandate is reactive, not proactive.  It kicks in after a crisis hits — Greenspan then floods the market with liquidity, and only steps back when things are running hot again.

A proactive policy would limit the degree of easing that the FOMC could do — once the spread of ten-year Treasuries over two-year Treasuries exceeds 1%, all easing would stop.  The banks can easily make money with a yield curve that steep… not much money, but enough to keep them alive (the financial sector would shrink under these rules).  There would be a second rule that when he spread of ten-year Treasuries over two-year Treasuries is less than 0%, all tightening would stop.  During times of extreme inflation or unemployment, these rules could be waived by Congress for a year at a time.  But that lays the policy back at the door of Congress, which represents the people and the states, where the decision belongs.

A policy like this eliminates the risk that the Fed can steepen the yield curve dramatically, leading to bubble creation — the excess credit has to go somewhere.  Another limit on the Fed could be a limit on total leverage in the economy — above a certain limit, such as 2x GDP, the Fed raises the Fed funds rate, regardless of the unemployment situation, until indebtedness falls.

Bubbles are financing phenomena.  Controlling bubbles can be done by controlling credit, and that is what the Fed tries to do — control credit, which is money in our era.  (Until we go back to something better, and get the government out of the money business — some sort of commodity standard.)

The present Fed holding action inflates assets not goods.  By offering financing to asset markets that are in disarray, it supports asset prices.  For now, none of that balance sheet expansion leaks out to the general public, and thus, little goods inflation.  But also, little true stimulus.

In short, the Fed should limit its powers to reliquefy the economy, because sloppy efforts in the past 25 years produced the popped bubbles that we are now dealing with.  Better to leave policy tight longer, and not loosen so much in troubles.  Don’t worry, we might have to wait longer for recovery, but the recoveries will be sounder when they come.

Parting Shots