All for now.  I’m tired.

People often accept naive views of how the market works, perhaps considering how their own life seems to work, and not considering  the other side of the trade.  As an example, aside from laziness, why do market observers report a day where the market goes down on no significant news as “profit taking,” or grab at some lame smaller story which couldn’t explain the decline?  For every seller, there is a buyer.  No money went into or out of the market unless there was a new IPO, rights offering, company sale for cash, buyback, cash dividend, etc.  People don’t run away from or run to the market; only the terms of the tradew change at the margin.

The same applies to current account deficits.  They have to get funded from somewhere, and on unfavorable terms to the lender if the borrower happens to be the world’s reserve currency.

Thus, when I consider arguments over whether America is to blame for its profligate ways, or whether those that funded the deficits are to blame, I simply say that the books have to balance.  Neither is to blame; both are to blame.

It is not as if China has free capital markets.  Given their neomercantilism (uneconomic export promotion), they had to find places where their exports would be accepted.  The answer was the US.  After that, what do their banks do with excess dollars?  They buy fixed income dollar assets, which they foolishly think will preserve value until they need to liquidate the assets for goods or services of some sort.

That recycling of the current account deficit forced rates lower in the US while the Fed was tightening.  For the Fed to have fought that influence, they should have tightened more rapidly, compared to the plodding 1/4% each FOMC meeting.  How often have mortgage interest rates fallen while the Fed is tightening?  Not often, which is why the Fed was impotent during the last tightening cycle.  It is also why the blows hitting the global economy have fallen more lightly on the US.  To the extent that foreigners buy our bonds denominated in dollars, that transfers a part of the pain to them.  Thanks, but you could have avoided our pain had you opened your markets to our goods and services.

There are many efforts in play to try to replace the dollar.  Most if not all will fail.  At present, the US is politically secure in ways the other large currencies are not, and many invest in the US not to preserve full value, but to preserve most of the value, whatever that may be.

As with many things in life — it takes two to tango.  Blame is infrequently singular.  Both the US and China should own up to their shares of the current problems.  Then, maybe, solutions could be found.

• Past public information can’t be used to obtain better-than-average returns. (weak form of the EMH — cuts against technicians)
• Past and present public information can’t be used to obtain better-than-average returns. (semi-strong form of the EMH — cuts against fundamental analysis)
• Public and private information can’t be used to obtain better-than-average returns. (strong form of the EMH — believed by few)

In practice, the academic community holds to the semi-strong  form, while the investment community holds to the weak form.  One thing is certain: the market is dominated by large institutions, and the market on the whole, less fees, cannot beat the returns of the market on the whole.

Part of the problem with the EMH is that with respect to the market as a whole, of course it is true.  The real question is whether any particular strategy covering a small portion of the assets of the market can consistently beat the returns of the market on the whole.  I believe the answer to that question is yes.

An implicit assumption of the EMH is that research costs are free.  They are not free.  Also, it implicitly assumes that a dominant number of investors understand what information drives the markets.  Both assumptions are not true — even in the most clever firms, there is information that is missed, and research costs are expensive, and not always rewarded.

But the effort to earn above-average returns forces the market closer to the EMH.  When the competition is tough, finding excess returns is hard.  This makes it a limiting concept.  We never get there, but effort to find above-average returns gets us closer to that ideal.  Conversely, when many decide to index, those who do not index have a better chance at earning above normal returns, because there is a large chunk of naive capital in the market seeking average returns with certainty.

I want average people to use index funds for many reasons:

• It lowers their costs.
• It is tax-efficient.
• Most people aren’t very good at picking equity managers.  They go for the manager who is hot, in the style that is hot, rather than one that did better in the past, and is in a cold spell now.  They go for large fund groups that spread their research over large asset bases, diluting whatever skill they might have.   The best managers are the smaller specialists running their own funds, and who eat their own cooking.  They are also inconvenient to use.
• It improves conditions for the remaining active managers.

I also want them to buy-and-hold (dirty words) because they aren’t very good at market timing, and also have enough in safe assets to lower the downside of returns to a level that does not panic them.  Most people are bad at most investment decision-making.  Better to hand it off to those who don’t panic or get greedy, than to be a part of those who buy into tops or sell into bottoms.

On the AMH, quoting from another piece of mine of the topic:

The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it’s not worth the search costs any more.

And so it is for those of us who are active managers.  We have a twofold task:

• Base our strategies in areas that are unlikely to be overfished for long — e.g., low valuation, positive momentum, and earnings quality.
• Dip into areas that are temporarily out of favor, whether those are industries, countries, or odd risk factors.  (Odd risk factors: occasionally certain factors in the markets are poison, and even the slightest taint marks a security off-limits, even though those that are barely affected are fine.  My example would be Enron-like structures 2001-2002.  Few would buy the stocks or bonds of companies that had them, even though those structures were not large enough to impair the company, as they did with Enron.  We bought the bonds of a Dominion subsidiary with abandon, because we knew the covenants the bonds had would not kill Dominion, and we had extra value as a result.  What killed Enron benefited us, indirectly.)

To active managers then, I warn: watch how your main strategy goes in and out of favor.  It happens to all of us.  Add to your main strategy most when it is out of favor, and add to whatever alternative you have when your main strategy is running hot.

To average investors, then, I advise: if you adjust frequently, add to your winners and prune your losers.  If you adjust infrequntly (once a year or less), prune your winners and add to your losers.  In the short run, momentum persists, in the longer-term, it mean reverts.

Know yourself.  If you are prone to panic and fear with investments, better to hand the job off to someone competent who will be dispassionate.  If you have conquered those emotions, you can potentially do better yourself in investing.  But ask yourself what your sustainable competitive advantage is in investing.  If you don’t have one, better to index.

I ran into something similar back in 2006, so I wrote this CC post:

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples.

In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

Hmm… in early 2006, we were considerably in advance of the peak that would come in late 2007, but considerably above where we are now.  In my opinion, given my longer timeframe, a good call.

But maybe correlations might rise during times when everyone is anxious to buy risky assets, not just when the want to throw them away.  Do asset correlations rise near peaks for risky assets?

My model on correlations relies on the major industry sectors of the S&P 500:

• Consumer Discretionary
• Consumer Staples
• Energy
• Financials
• Health Care
• Industrials
• Information Tech
• Materials
• Telecom Services
• Utilities

If lots of money is getting thrown at stocks, won’t the correlations between sectors rise?  And if so, won’t future returns be low or negative?

Here is a graph showing the price return on the S&P 500 over the next 60 days as a function of the average sector correlation over the last 60 days:

Not much of a relationship, huh?  1% R-squared.  And it goes the wrong way — high correlations very weakly favor higher returns.

But what if we do a regression where future S&P 500 returns are regressed on past S&P 500 returns and average sector correlations?

Wow, we get a 2% R-squared! It also shows that momentum persists, and higher average sector correlation has a similar effect to the above model, still positive on future returns.

Here is a heat map where the average 60-day past return is on the horizontal axis, and average sector correlation is on the vertical axis, and the variable displayed is frequency of occurrence.

Looks pretty average, with the two effects being fairly separate, with an odd southwestern quadrant.

Here is a heat map where the average 60-day past return is on the horizontal axis, and average sector correlation is on the vertical axis, and the variable displayed is average future 60-day returns.

Here are my tentative findings:

• Price momentum persists.  60 days of weakness/strength tends to beget 60 more days of weakness/strength.
• Extremely high or low average sector correlations seem to go along with low returns.  Middling average sector correlations seem to go along with higher returns.
• Low average sector correlations and lousy past price performance seems to beget excellent future performance.
• High average sector correlations and lousy past price performance seems to beget lousy future performance.
• When past price momentum is high, average sector correlation doesn’t seem to matter as much.
• If past trends continue, average returns over the the next 60 days are around 2.5% with a very wide error band.  Current average sector correlation is 50%, and past 60 days returns are 9%.

One final graph:

Do you see a pattern here where high average sector correlations come before market peaks?  I don’t.

All that said…

I know the earlier articles dealt with asset class correlations, rather than correlations with stock market sectors.  I would have expected the same result.  Maybe there is aonther way to do this analysis separating out safe sectors from risky sectors.

But what are safe sectors?  Utilities? Consider 2001-2003.  Telephone services? Also 2000-2003.  Financials? 2007-?  Perhaps Consumer Staples is the only truly safe sector… or maybe it should be energy? Consider the early ’90s.

This is one article where I end scratching my head, but publish anyway, because:

1) My readers may help me.

2) It is valuable to know where research dead ends exist.

After all this, I don’t see average sector correlations as a valuable variable in investing.  Maybe that is not true of asset classes.  If anyone has the proper data to send to me on that, I will reproduce an analysis like this, and tell you what I find.

In a true bust, defaults are rampant, as badly capitalized firms fail amid weakening demand.  During booms, some  firms magnify the results by levering up (borrowing more).  This is the behavior that created booms and busts, together with the momentum effects that Brad DeLong’s model demonstrates.

Modeling in default behavior and leverage should complete the model.

I am presently reading a book by Justin Fox, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.  So far, a good book.  He has a recent blog post that impressed me as well: Dumbing Down Regulation.

Should regulation be dumb?  In one sense yes, in others, no.  It really depends on how well the regulators understand the risks involved, and how much they can encourage professionalism among marketers and risk managers.  As those two increase, regulation can be smart.  “Follow these detailed rules to calculate the capital you need to be solvent 99% of the time.”

But when either of those two aren’t true, dumb regulation may be in order:

• Strict leverage limits, reflecting the worst outcome from underwriting poor quality loans.
• Disallowing risky types of lending, regardless of capital level.
• Disallowing liabilities that can run easily.
• Disallowing products that commonly deceive buyers.
• Disallowing certain types of contracts that fuddle accounting.

If everyone were smart, things could be different.  Deceiving people would not take place, and managements would not take undue risks.  Limits could be more loose, and products would be designed for discriminating buyers.

But, face it, we are dumber than we think, myself included.  Consumer choice is a good thing, though it implies that some will be deceived, no matter where one places the line of demarcation.  Along with that, some bank will not fit the rules and go insolvent, though it does not register so on the solvency tests.

My poster child for relatively good dumb regulation is the insurance industry in the US.  The industry is far less free-wheeling than the banking industry, and under most circumstances, the solvency margins are set high enough to have few insolvencies.  There is room for improvement, though:

• Make risk based capital charges countercyclical.  Perhaps tinkering with the Asset Valuation Reserve would do that.
• Have some sort of rigorous testing for capital relief from reinsurance treaties.
• Ban surplus notes in related party transactions.
• Ban all forms of capital stacking, especially where the transactions go both ways.  I.e., subsidiaries can’t own securities of any companies  in their corporate family.  All subsidiaries must be owned by the holding company.
• More rigorous testing for deferred tax assets.
• Assets as risky as equities, including limited partnerships, should be a deduction from capital.
• Securitized bonds that are not “last loss” should have higher RBC charges than comparable rated corporates.
• A standardized summary of cash flow testing results should be revealed.

As for the banks, they need to do that and more:

• Insurance companies list all of their assets.  Banks should as well.
• Intangible assets should be written to zero for regulatory capital purposes.
• Risk-based capital standards need to be tightened to at least the level of insurance companies, if not tighter.
• Some sorts of lending to consumers should be banned.  I am talking about complex agreements, that individuals with IQs less than 120 can’t understand.  Insurance policies have to be Flesch-tested.  Bank lending agreements should be the same.  If some argue that the poor need access to credit, I will say this: the poor need to get off of credit.  Credit is for the upper-middle-class and rich.  Poor people should not go into debt.
• Standardized summaries of terms and fees must be created for consumer lending, with large, friendly letters, and simple language that all can read.

What I am saying is that accounting has to be more conservative, and that regulators have to require larger amounts of capital to support their business, particularly at the banks.  Financial products must be made more simple for consumers to understand.  More transparency is needed everywhere, and if the financial companies complain, tell them that they will all be in the same goldfish bowl, so no one will gain an unfair advantage.

Dumb regulation bars certain lending practices, and raises capital levels higher than is needed over the long run.  So be it.  Smart regulation is far more flexible, and trusting that companies and consumers know what they are doing.  Unfortunately, when financial firms fail, there are often larger repercussions.  It is better to limit regulated financial companies to businesses where the risks are well-understood.  Let the less understood risks be borne by those outside the safety net, and bar those inside the safety net from holding any assets in those companies.

Quick Hits:

• The FOMC is following trends in the financial markets. The stock market is higher, and credit spreads are tighter, but what of tomorrow?
• They view much of the weakness as being an inventory correction that will end soon.
• They trust that slack capacity will keep inflation low, despite rising commodity prices. They are less worried bout deflation. Stagflation is not a word in their vocabulary.
• They are trying to lengthen the view of the market on how long the FOMC is able to maintain a low fed funds rate.
• They are projecting calm to all who will listen, but will inflation and the dollar cooperate?  Will economic weakness not deepen from here?  The jury is out.

As it is, states are cutting their budgets drastically because their tax collection is down dramatically.  California is a leading example here.  Will it refuse to pay, and what of its municipalities?  How many will file for Chapter 9, like Vallejo?  My guess is that many municipalities will file Chapter 9, but that California will avoid nonpayment.

There is one more issue worth pursuing here.  Though states have to run balanced budgets (largely on a cash basis), that says nothing about pensions and other long-dated promises.  I find it fascinating that some states are still trying the gambit of pushing retiree expenses out into the future.  To me, that is a sign of desperation slightly smaller than making significant budget cuts.  It’s just playing for time at a time where delay has few advantages.

That’s one reason among many that I do not see “green shoots” at present.  During a period of debt deflation, many troubles fight prosperity as the financing bubble deflates.  If the states aren’t prospering the nation is not either, regardless of what statistics the national government might dream up.

Often,  a tightening cycle would end with a bang, with some credit starved entity (Residential Housing, Nasdaq, LTCM, Lesser-developed Asia, Mexico, etc.) dying.  The Federal Reserve would then spring into action and say, “We must fight the threat of unemployment.”  Would they?  No, they would invoke protecting the financial system, which protects the banks.  After all, monetary policy does not work when banks are compromised, as they are today.  No wonder there is Credit Easing.

So when I hear the Fed proposed to be the systemic risk regulator, I have two thoughts:

1) You did a bad job with monetary policy and bank supervision, but you are nice guys, because you do for the US Government all of the things the Treasury Department can’t Constitutionally do.  Now let’s see if you can do better with controlling systemic risk, even though we haven’t granted you control over all the levers necessary to do so.

2)  Maybe this will make them better with monetary policy; it makes the triple mandate explicit.

My view is that the Fed is one of the major creators of systemic risk in our economy through the use of monetary policy to stimulate our way out of bad times.  The temptation that Greenspan succumbed to was to throw liquidity at problems too early, which avoided liquidation of marginal debts, and the debt levels built up.

If the  Fed has to minimize systemic risk in the economy, maybe it becomes less willing to loosen policy profligately.  I would hope it would work that way.

That said, given the lack of success for the Fed on its goals, I suspect that if it were given the task of reining in systemic risk, it would fall prey to political pressure, and fail at that as well.

I go back to my earlier proposal — the Fed would have to keep the US economy under a limit of private debts being less than 2x GDP.  But can you imagine the Fed tightening during a boom to avoid systemic risk, or raising margin requirements?  I can’t, so even though ideally the Fed would be the right player to manage systemic risk, in practice, systemic risk is unmanageable, because there are too many interests that benefit from boom times.  That’s why I don’t expect much from the proposals to manage systemic risk, regardless of who gets the power to do so.

1) Derivatives.  What is a derivative?  A derivative is a contract where two parties agree to exchange cash flows according to some indexes or formulas.  There are some suggesting today that all derivatives must be standardized, and/or traded on exchanges.  That might make sense for common derivatives where there are large volumes, but many derivatives are “out in the tail.”  Not common, and standardization of what is not common is a fool’s errand.

To regulate derivatives fully is to say that certain types of contracts between private parties may not exist without the consent of the government.  Thinking about it that way, what becomes of free enterprise?  Granted, there are some contracts that cannot be considered enforcable, like that of a hit man, arson for hire, etc.  Those are matters that any healthy government would oppose.

What makes more sense is to bring the derivatives “on balance sheet.”  Let the effects of the notional value play out, showing owners what is happening, rather than hiding it.

2) Rating agencies — Moody’s, S&P, and Fitch deserve some blame for what happened, but the regulators needed the rating agencies.  They still do.  The rating agencies make imperfect estimates of relative credit quality for a wide munber of instruments, which then feed into the risk-based capital formulas of the regulators.  To rate such a wide number of instruments means that the issuers must pay for the rating, because there is no general interest for most ratings.

Yes, let more rating agencies compete, but they will find that the “issuer pays” model is more compelling than the “”buyer pays” model.  The concentrated interests of issuers in a rating trumps the diffuse interests of buyers.  Bond buyers need to learn to live with this, and employ buy-side analysts that don’t take the opinion of the rating agencies blindly.  What the analysts at the rating agencies write is often more valuable than the rating itself, though it doesn’t change capital charges.

Rating agencies make the most errors with new asset classes.  Better that the regulators do their jobs and prohibit immature  asset classes where the loss experience is ill-understood.

I don’t think that rating agencies are going away any time soon.  I do think that the government and regulators contemplated this, but concluded that the changes to the system would be too drastic. (Contrary opinions: one, two)

3) Yield-seeking — the desire to seek yield is near-universal.  As a bond manager, I found it rare that a manager would do a “reduce yield, improve quality or certainty” trade.  The pattern is even more pronounced with retail accounts.  They underestimate the value of the options that they are selling, and take a modicum of yield in exchage for lower certainty of return.

Can this be banned, as some are proposing with reverse convertibles?  I don’t think so, there are too many variables to nail down, and too many people in search for a yield higher than is reasonable.  Yield-hogging is an institutional sport, not only one for retail fans to grab.  As one of my old bosses used to say, “Yield can be added to any portfolio.”  How?

• Offer protection on CDS
• Lower the quality of your portfolio.
• Buy all of the dirty credits that trade cheap to rating.
• Buy securities from securitizations — they almost always trade cheap to rating.  (Ooh! CDOs!)
• Sell a call option on the securities you hold.
• Buy mortgage securities with a lot of prepayment or extension risk.
• Accept the return in a higher inflation currency, assuming that their central bank will tighten.
• Do a currency carry trade.
• Lever up.
• Extend the length of your portfolio.
• Underwrite catastrophe risk through cat bonds.

Adding yield is easy.  The transparency of that addition of yield is another matter.  Reverse convertibles have been the hot issue recently since this article.  Here is a small sample of the articles that followed: (one, two, three).  Reverse convertibles, and other instruments like them give bond-like performance if things go average-to-well, and stock-like performance if things go badly.  The inducement for this is a high yield on the bond in the average-to-good scenario.

What to do?

I have three bits of advice for readers.  First, don’t buy any financial instruments tht you don’t understand well. This especially applies when the party selling them to you has options that they can exercise against you.  Wall Street excels at products that give with the right hand and take with the left, so beware structured products sold to retail investors.

Second, don’t buy any financial product that someone appears out of the blue and says, “Have I got a deal for you!”  Stop.  Take your time, ask for literature, maybe, but say that you need a month or more to think about it.  Haste is the enemy of good financial decision-making.  Instead, do your own research, and buy what you conclude that you need.  Consult trusted advisors in either case.

Third, don’t be a yield hog.  Yield is rarely free.  There are times to take risk and accept higher yields, but those are typically scary times.  At other times, make sure you understand the portfolio of risks that you accept, and that you are being adequately paid for those risks.  Better to have a ladder of high quality noncallable debt, and take some risk with equities than to take risk in a series of yieldy and illiquid bonds that you don’t understand so well.  At least you will be able to know what risks you have, and that is an aid to asset management.

Final Question

This article began as a discussion of things that are very hard to change in the current environment.  I thought of several here:

• The continuing need for derivatives, and the impossibility of full standardization
• The continuing need for rating agencies
• Human nature makes us yield hogs.
• Wall Street builds traps for investors off of that weakness.

What other things are very hard to change in the current environment?