Risk and Return

Hedge Fund manager Doug Kass has some questions that clients should ask of their advisors. I should point out that everybody has a bad year, I assume we will have a point where we will have to ask these questions in a harsher light of ourselves. However, these questions can separate those who you might stick with, and who was riding the wave up and added little value that wasn’t lost on the way down. Also, they illuminate who is learning from experience, and who is merely justifying poor decisions. Given the  environment, I wouldn’t wait until year end:

Money tends to go where it is best treated, as measured by an asset class, hedge fund or by a traditional investment adviser. As a result, a lot of money will be shifting by year-end, and it is bound to have a disruptive market effect as well as likely to feed continued volatility.

If you delegate investing to an adviser, here are several questions that you may consider asking during a 2008 year-end review of your investment performance:

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Briefly, I think I will answer for those of you who do invest with us, how I would answer the questions. Feel free to question us more closely in person. Note: While this discussion applies broadly to all of our clients, it is specifically addressed to the vast majority of our assets under management, accredited and qualified investors (those with a net worth of 1 million and up) in our model portfolio’s.

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

In our case this discussion really should not be constrained to 2008. We believe we are in the midst of a long term bear market that began with the bursting of the tech bubble in 2000, especially for US financial assets. We participated in the cyclical bull that began in 2003, with significant allocations to international, emerging market, real estate and other high flying assets. Starting in 2006 we began to become more defensive as valuations became more and more unreasonable, allowing our portfolio to move forward based on those areas we felt were most attractive. That allocation allowed us to post strong results through the third quarter of 2007, but the portfolio was dominated more and more by assets not dependent on the general direction of the market. By 2007 we felt returns were likely to turn negative, the economy would struggle and a defensive portfolio was the most prudent path. We had by February of 2007 scrubbed nearly all exposure to financial stocks from our portfolio.

In general our expectations have been met. The markets, especially financial stocks have struggled. Following our strong showing through the first three quarters of 2007 we had a strong burst in the fourth quarter as the markets in the US fell. We weathered the storm in January with a small gain and when all was said and done had a solid first half of the year, with positive returns in each quarter, with solid gains in June to finish off the second quarter.

We began to have concerns short term with our exposure to commodity stocks, especially energy, and hedged that exposure somewhat. We assumed that some of the relationships in our hedged positions might have a short term reverse as well. Unfortunately all of our main performance drivers reversed from the middle of July to the middle of August. It was unusual that all would reverse at the same time, as opposed to being spread out. Unfortunately most, if not all, of our gains during 2008 were lost, though we were still positive since the downturn in the broader equity markets began in October. We feel that most of what we are doing now is still well positioned, with the most likely trouble spot being our unhedged positions, specifically commodity stocks and Asia. Depending on their relative performance we will have a flat to positive end to the year. Our expectation is we will finish the year with returns in the high single digits, which is what we expected at the beginning of the year.

What about surprises? The relative strength of small cap and real estate stocks stick out. We feel they will resume their under performance going forward. Commercial real estate is starting to roll over and we expect that to weigh on REITs. Small cap stocks are still very overvalued, and earnings likely to continue to disappoint. As credit markets and the economy become even more strained access to credit will hit them hard. If they struggle greatly relative to larger, higher quality stocks we could see our expected return numbers increase markedly.

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

We have outperformed broad market indices handily year to date, since the downturn began, and for trailing one, three and five year periods. Heck, we are positive for the year! Accomplishment enough, if unspectacular. Compared to the indices the various areas of our portfolio have performed from okay to fantastic. No major underperforming areas.

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

We felt the US faced a high probability of a recession coupled with a worldwide slowdown. We felt the credit markets were the most vulnerable, due to a severe housing downturn, and inflation would be an concern. Interest rates were a bit uncertain since, with inflation an issue and growth vulnerable, the fed would be pushed in both directions. More importantly, due to the difficulties in the credit markets we felt interest rates would be relatively insensitive to the federal reserves efforts and interest rates would remain stubbornly high, with credit spreads likely to widen dramatically. Thus we felt diversifying credit exposure internationally would be prudent and bonds would not be as positive a counter to equity risk as they were in the last downturn.

That has all come true, but our moves to diversify in fixed income have not proven of much benefit. However, our emphasis on other strategies to reduce risk versus fixed income has added value, demonstrating that an over reliance on traditional fixed income to protect in a downturn would not be optimal. In fact, fixed income has been a drag on performance on both the upside and downside of the market over the last two years for us.

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

Yes, though our change occurred before the downturn. We have made some small tactical changes as the year has progressed, though our fundamental approach we feel is still sound. We are preparing for some significant changes in the near future, especially if the equity markets weaken substantially from here and we position the portfolio for a more positive market environment.

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

This question really doesn’t apply to us since we don’t trade individual securities, though we have hedged positions where one side or the other have struggled. That of course is the expectation for a hedged pair of positions targeting an absolute return. Nevertheless we wish some had been more successful, even if as a pair they outperformed the indices.

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Not only do we, it is a core value at our firm, and that is exactly how we put it. “We eat our own cooking.”

Hat Tip: Barry Ritholtz

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer. For information on our investment process see here.

Technorati Tags absolute returns, advisors, assessing performance, bonds, investment performance, markets, stocks

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And millions of us may benefit.

The dispute arose when more than 30 mutual life insurance companies became publicly traded corporations in the late 1990s and earlier this decade, in a process known as “demutualization.”

Mutual companies are owned by their policyholders, so the companies provided stock and cash to compensate them for the loss of their ownership interests when they went public.

All told, roughly 30 million policyholders received distributions, Ulrich estimates. MetLife Inc. provided over $7 billion of stock to about 11 million policyholders when it went public in 2000, while Prudential distributed $12.5 billion in stock to another 11 million.

The IRS held that the recipients hadn’t paid anything for the shares and owed taxes on the full amount when the shares were sold. Cash distributions also were fully taxable, the IRS said.

That didn’t sound right to Ulrich, 72, an accountant for 49 years. He began researching the issue in 2001, when he received shares from two companies, Prudential and Indianapolis Life.

Ulrich concluded that policyholders had paid for their ownership rights through their premiums so the distributions should have been tax-free.

Funny, a family member gave me some shares he inherited from Met Life’s demutualization just last night to help him with. The man is a hero in my book. The IRS’s position was illogical, but they often make calling them on such matters too burdensome for most to fight. Good for him.

Technorati Tags Charles Ulrich, demutualization, IRS, Life Insurance, MetLife, Taxes

Tags: Charles Ulrich, demutualization, IRS, Life Insurance, MetLife, Taxes

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Back in February of 2007 we began to scrub our portfolio’s of all exposure to financials, which wasn’t very high at that point anyway. Needless to say, instant alpha.

Of course, the follow on question I get repeatedly, especially those who have been investing with Bill Miller and Legg Mason Capital all the way down, is that surely it is time to get back in?

Obviously Bill, and Legg Mason in general, believe that the sell off in financials is overdone, and that long term investors will be rewarded at this point. Of course, they have said that all along to disastrous effect. The question moving forward is whether they are right now, or is it that they still don’t understand the situation?

I am not one to assume I know the future, but what I do believe is that it is important to assess the risk to any investment thesis. So let is start with the general issues:

• Maybe financials are undervalued, but how can anyone have confidence in what the value of many of these institutions is? What are their assets worth?
• The thesis seems to assume that once credit markets ease and the economy improves it will be back to business as usual. However, whole lines of business are not only going to be weak for some time, such as mortgage origination and lending, but in many cases may not exist going forward.
• The money they made in the past was based on ways of doing business, and with amounts of leverage, that they, regulators and investors will not want to see going forward.
• How diluted will any investment one makes today be once the turnaround starts? Repeated capital raising has already decreased existing investors share of the companies dramatically. So even if business gets back to its past levels each share will still be worth a lot less. How much more capital will they need to raise?
• What is the risk of failure of many of these institutions?
• Finally, how much worse will it get in terms of losses, and thus how much capital will need to be raised if they are to survive?

To get a handle on these risks let us take a quick look at a few things.

Remember when the losses would be less than 100 billion, then maybe 200 billion? The 500 billion mark has now been crossed. I still stand by my estimate of at least 1.2 trillion before it is all said and done. Given the strains the financial sector has shown so far, how is it going to weather more than double the hit it has already taken?

Before speculating about that, lets look at this chart:

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As you can see, the massive attempts to raise capitalhas resulted in little more than a loud poof!

All charts via Jake at Econompic Data

Thanks to Barry Ritholtz for the charts.

Most institutions have seen more capital destroyed than they have raised, and essentially all have a much weaker capital base than when they started. So, if we assume that more losses are forthcoming, and the most optimistic estimates are in the 400 billion range, we will see even more raising of capital, further diluting the worth of every share outstanding.

Given the losses and further dilution alone I would suggest the risk factors are extremely high. Except it gets worse. Who is going to give them the capital to survive future losses? At this point the largest sources of capital, private equity firms and soveriegn wealth funds, have already committed vast sums to this sector. How much more are they willing to cough up given the risks? Thus many of these institutions may go under. Of course, normally they would be acquired by a stronger institution,  but that also requires stronger institutions. The breadth of this crisis means that hardly anyone is strong enough to acquire a failing institution, especially with their own losses mounting.

The gist? While the future is unknown, and there may be factors which make the worst case scenario’s less likely than it appears, and we should never underestimate Wall Streets ability to find ways to squeeze money out of us, at this point the risks move any capital devoted to the banks, brokerage houses, Fannie, Freddie and the others is not investment, but speculation. Extremely risky speculation at that. Sometimes speculation pays off, but the odds seem stacked against it at this point.

Technorati Tags banks, Bill Miller, broker dealers, credit crisis, financials, Legg Mason

Tags: banks, Bill Miller, broker dealers, credit crisis, financials, Legg Mason

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Thanks to Barry Ritholtz I found this analysis from Vladimir Klyuev at the IMF,  What Goes Up Must Come Down? House Price Dynamics in the United States.

While I have been of the opinion we have a good ways to go, I think these charts are pretty telling. I don’t see anything here to make me suspect a bottom is anywhere close.

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Price Index, Single Family Existing Homes

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Real Home Prices and Rents

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OFHEO Purchase Only Price Forecasts

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Home Price Simulations

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Technorati Tags economy, Housing Market, IMF

Tags: economy, Housing Market, IMF

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I apologize ahead of time if this post is a bit intemperate.

Buried around a truism, the New York Times has produced a misleading and rather silly piece on the value of “predictions.”

The thrust of the piece is that predicting the markets and the economy, especially in the short term, is fraught with peril. True enough. That is why whenever giving our view of the future it is in terms of the risks one takes relative to the returns one might get. Hence the name of this site.

However, some things can be said, and often with a great deal of confidence. Timing is an issue, the magnitude can cover quite a bit of ground, but things can still be said. The problem for investors is that in a world filled with conflicts of interest and myopia how to tell which views on those tradeoffs to which one should pay attention? It is not that “predictions” (which is a term they use loosely) are to be ignored.

Anyway, that is the stated context for the article. The subtext however is the denigration of “outlandish” predictions, by which they mean those emanating from us negative nellies. Thus, the somewhat cautious claim of Bill Gross of a trillion dollars in losses related to the credit crisis is trivialized:

But despite this decidedly mixed track record, forecasters still enjoy a rapt audience, particularly at a moment when so much in the markets depends on the uncertain course of the housing market and the broader economy.

At investment and commercial banks, losses tied to bad mortgage investments, which now exceed $450 billion, are certain to rise further if home prices continue to decline and more
people default on their mortgages. Last week, Bill Gross, a prominent bond fund manager, offered another forecast for the final bill: $1trillion. Some market watchers say the figure could be even higher.

Obviously we will not know for sure until some time down the road, but it is interesting that Gross, as well as a number of others who have been hooted down for their alarmism, have consistently been proven to be too optimistic. The 450 billion dollar figure which everyone recognizes will go dramatically higher (that is math, not opinion) is already dramatically higher than we have been repeatedly told would be the most the losses would be.

Our firm, as well as a number of others, are not band wagoning here. We “predicted” that we would be fortunate if the losses didn’t reach a trillion or more. No precision, no claim to knowledge we didn’t have, just a little simple math which showed it would be “bigger than a breadbox.”

Despite that obvious track record which shows that some people saw at least the general outline, if not the exact shape of things, we get this kind of piffle:

Ideally, predictions on companies and stocks would be “thoughtful, nontheatrical forecasts that take a look at long-term fundamentals,” said Abby Joseph Cohen, a longtime strategist at Goldman Sachs.

But, Ms. Cohen added, less dramatic forecasts rarely make headlines. “If what is being provided to viewers and readers are these theatrical forecasts, that is what many people will pay attention to because that’s what they have available.”

Abby may be a wonderful person to have over to dinner, and a dear friend to have, but she is also someone who has led more investors over a cliff than any major strategist of the last ten years. Abby has been the outlandish one, as anyone who was unfortunate enough to listen to her in 1999 and 2000. I am sure she views the thoughts of those who have consistently stressed the risk levels and overvaluation of stocks over the last 10-12 years as being outlandish in their claims. However, look at the returns of the market over the last 10+ years (10 year return for the S&P500: 2.55%.) Pitiful.

“We have gone from an abnormally calm period, and we’ve blown right through normal volatility,” Ms. Cohen said. “We are in an exceptionally volatile period.”

Does anyone fact check at the Times? That is an outlandish claim. It is most decidedly not true. For those who wish to get a more accurate description of volatility today versus history, the essential Ed Easterling of Crestmont Research will bring you up to speed (pdf.) Listen to Abby at your peril.

This however tales the cake. First, the truth:

Another source of investment guidance used to come from research analysts, who try to predict quarterly earnings at companies. But there is a great deal of guesswork involved here, too. Analysts correctly predict earnings only a fifth of the time. Nearly two-thirds of quarterly earnings beat estimates, and the rest come in too low, according to data from Thomson Reuters. Many companies, of course, try to defuse overly optimistic forecasts to manage investors’ expectations and deliver “better-than-expected” results.

Then this nonsense:

This year, Wall Street’s crystal balls have performed even worse than in the past. As earnings season for the second quarter winds down, 67 percent of companies reported earnings higher than what analysts had predicted, and 22 percent reported earnings that were worse. Only 10 percent of companies matched analysts’ expectations.

We go from a decent point about how wrong analysts are to this misleading………

Okay, I will attempt not to get steamed. The problem with analysts is they are consistently too bullish, and by huge amounts. Exactly the opposite of what that statement implies. Yes, companies consistently beat the estimates when they are finally reported, but only after analysts slash those estimates almost down to the day the reports are made. This year companies have consistently failed to make estimates that were made just weeks earlier. Compared to what was “predicted” 3, 6 or twelve months ago the earnings have been dramatically lower. There is a problem with analyst predictions, and investors should be warned. However, this just muddies the issue of what those problems are. Conflicts of interest, behavioral biases, being too optimistic about the particular industries they cover (even when not conflicted) etc. It is not that they are too cautious about earnings prospects.

Then, to add insult to injury, we get this:

Poor predictions are nothing new in the financial world: in 1999, a pair of prognosticators — James K. Glassman and Kevin A. Hassett —published a book titled “Dow 36,000”; the blue-chip index closed last week at 11,370.

But investors seeking light in a dark period may just have to stick with no one’s predictions but their own.

That helps investors. We get evidence that some of the silliest predictions of the past were wrong; a false implication that analysts are often wrong, but too bearish; a plea from one of the most disastrously bullish strategists of our era not to listen to outlandish claims from people who have been proven correct; and people who make valid points (such as Taleb) are placed in a context with which I am sure they are uncomfortable; all in the service of a message that no one’s advice is worth taking. Never mind that most of the greatest investors of the past half century warned repeatedly that returns were likely to be unsatisfactory, regardless of this present crisis. Never mind that many, if not most, of those same voices warned repeatedly that the housing market was set for a fall, that a credit crisis was likely imminent, and on and on.

No, we shouldn’t listen to anybody.

Since the Times doesn’t want to tell you this, or examine it, I’ll jot down a few things to keep in mind.

• Analysts are almost always too bullish.
• As one of her sources, Taleb, would likely agree, economic models based on assumptions of equilibrium (essentially all of them) unsurprisingly almost always (until the horse is out of the barn) predict some sort of equilibrium, or at least a tendency to move back towards it. Thus economic activity is often well outside of their predictions. More importantly, “fat tail,” or extreme, events occur at rates far more frequent than their models assume. There are literally dozens of market and economic events which have occurred over the last century, when statistically (according to the assumptions of modern finance and economics) it was unlikely even one would happen.
• The real returns from stocks are much lower than most market commenters and professionals realize.
• You can with a fair degree of confidence predict most asset class returns over 5-10 years of time. I said with a fair degree, not certainty. Unfortunately most attempts to do so use unrealistic assumptions or historic returns. The first problem is obvious, but requires knowledge of what is reasonable. Most people use the latter, historic returns, as their guide. Big mistake.
• Also, somewhat off topic, though important nonetheless, stocks are not cheap yet, but they may still go up.
• I think it is unlikely they will not go lower from here.
• For Clients: If stocks do go up smartly and we don’t do as well as we could have, we have had a pretty darn good 12 months (or five years for that matter.) Trailing a bit now would hardly be a crisis, and as last year proved, we may not trail even then.

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Technorati Tags forecasts, media, New York Times, Risk

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Durable goods cam in better than expected, though it may only be due to a temporary bump:

Miller Tabak’s Peter Boockvar notes that “the Govt stimulus package has a depreciation tax credit that expires by year end — so companies have to now use it or lose it. That could have had an impact on order rates but we need more than one month’s data to see by how much.”

The housing data is still discouraging:

US Quarterly Foreclosures by Quarter

chart courtesy of RealtyTrac

The pain, though still concentrated is spreading across the country:

“Forty-eight of 50 states and 95 out of the nation’s 100 largest metro areas experienced year-over-year increases in foreclosure activity in the second quarter,” said RealtyTrac CEO James J. Saccacio in the press release announcing the Q2 report.

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Technorati Tags Durable goods, housing, Latest data

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You may remember the website we discussed back in January. Dale Franks just discovered their program, because they now are on Television. He asks the obvious question:

So, should the mortgage companies get off scott-free from facing the results of their poor business decisions when it comes to the loans—loans they shouldn’t have made in the first place?

From my comment there:

No, they shouldn’t. I don’t endorse walking away, but when you take out a loan, and offer collateral, it is assumed that one possible recourse is to give back the collateral. Since lenders don’t want that to happen, they are supposed to examine the worth of that collateral pretty carefully, and get some money down. That way it isn’t in the interest of the homeowner to “walk away” even if they don’t mind the damage to their credit.

The lenders didn’t do either, now people are returning the house when it is in their best interest. I don’t count on the benevolence of my bankers, I suggest they shouldn’t have counted on consumers to take it on the chin for their sake either. Nor do I want our government, or the Fed, to keep bailing them out, either directly or indirectly by helping people keep houses they cannot afford. Neither is likely to work anyway.

Technorati Tags banks, credit crisis, Federal Feserve, housing, Housing Market, youwalkaway.com

Tags: banks, credit crisis, Federal Feserve, housing, Housing Market, youwalkaway.com

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Heavier hitters than myself are slowly lining up to put out estimates of the total losses from the credit crisis more in line with my thinking. Welcome aboard!

Using far more “off the cuff” methods than Nouriel Roubini, the IMF, Jeremy Grantham, John Hussman, UBS, John Paulson or Goldman Sachs, I have been expecting the starting point for discussion should be something around 1.2 trillion, with significant risk to the upside on that number. That was across the system.

Now, in addition to that rather prominent band of bears comes Bridgewater, one of my favorite reads, who estimate that financial institutions alone will see losses of 1.6 Trillion. This comes courtesy of Paul Kedrosky who translated the leaked report:

Explosive Study: The banking crisis will be much worse

Westport (USA) - The expected losses from the financial crisis will reach $1600 billion. To-date financial institutions have so far announced only $400 billion. The pessimistic forecast comes from a confidential study by Bridgewater Associates, the second largest hedge fund in the world.

“We are facing an avalanche of bad assets,” says the study. The biggest losses were the U.S. credit banks before. “We have big doubts that the financial institutions will be able to have enough new capital in order to cover the losses,” the authors write.

Bridgewater Associates in financial circles enjoy a first-class reputation, several central banks are among its customers. “Bridgewater are on the pessimistic side,” says George Magnus, Senior Economic Adviser at UBS in London, “but they have absolutely right.”

I don’t know if this hitting the blog world explains the sickening reversal in the market today, but if it doesn’t it probably should.

Off the cuff ? What do I mean?

Simple, sometimes when you start adding up something that is really huge it doesn’t really matter or help to know exactly how much risk there is, or where all the damage will come from, it is bigger than a breadbox, or in this instance, bigger than a piano falling from 10 stories up. At some point it pays to just get out of the way. I remember telling clients who kept asking me when would be a good time to invest in the Nasdaq (especially QQQ’s) during the last bear market that I had no idea, and frankly didn’t see the point in trying to figure it out. I wasn’t even going to look at it until it was below 1500. The usual response was a blank stare and incredulous statements about how it “couldn’t go that low!”

Same here. Once the losses start going past the trillion point get back to me, I may bother to put a more precise estimate on it, though by then you probably will not care.

Or, to put it the way I put it in response to a discussion of what we were going to do based on our outlook for the market and how bad that outlook should really be:

It seems to me that debating whether a building you are about to fall off of is 30 or 60 stories high is a bit irrelevant, the answer is still “step away from the ledge.” I don’t think it changes what we should be doing now to know exactly how bad it is going to get.

Is this priced into the market? No, a thousand times no. On a related note, Barry Ritholtz looks at what happens after big one month sell-offs. In the past a rebound, but he asks good questions for those tempted to trade this for a bounce.

Technorati Tags banks, credit markets, economy

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MBIA has been downgraded by Moody’s all the way to A2. Ambac is AA3. That makes their insurance useless, and in all probability that means they are now nothing more than vehicles for paying off the claims of their existing contracts. The Muni issuers will terminate their contracts, the underlying credits are already better than these two companies ratings. If they don’t, it means their situation has likely worsened. That leaves them with only the highest risk Muni bonds in their portfolio remaining.

The other part of their business is already pretty much dead. As long as the number of defaults doesn’t increase they will probably have enough money to pay off the claims for expected losses on their credit default swaps. The problem? Expected losses are rising. Most prominently on various mortgage backed securities.

Likely outcome- These two go under eventually, a number of mortgage backed securities and other fixed income securities will eventually go under without MBIA and Ambac being able to pay the claims, those who purchased the insurance will be pressured and some may default themselves down the road. This is not cataclysmic. This is a big issue and will make things worse.

Suggested readings:The end of MBIA and Ambac?, Downgrades Come Easy, Upgrades Come Hard, Upgrades to AAA? — Forget It., On the MBIA, Ambac Downgrades; Regulatory Comments on MBIA, MBIA Downgrade Increases Collateral Requirements; Clarification on CDS Acceleration in Insolvency/Custodianship, MBIA: Moody’s Twists the Knife

Technorati Tags AMBAC, MBIA, monoline insurers

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From the New York Times:

Earlier this year, Mr. Bush derided a modest plan to provide $4 billion to states and localities to buy foreclosed properties, saying that buying up empty homes helps only “the lenders or the speculators.” Actually, it protects entire neighborhoods and local economies from the effects of foreclosures by preventing a greater buildup of unsold homes and a further drop in prices.

This site is not about politics, but before I discuss this some disclosure is necessary. I am a fan of free markets. I do not however belong to that group of fans who believes that the market left to its own devices comes up with an optimal outcome (however one might define optimal.) There are a number of reasons to favor free markets, that isn’t one of them.

Still, one reason to favor markets, and all the pain and inequity they come with, is that even if one believes that well thought out policies could cure whatever evils (however one wishes to define them) that the market (or our world in general) afflicts us with, it is highly unlikely that we will ever get such policies. This kind of solution is exhibit 10,549 of that truth.

I only address the politics of this, because as investors we are forced to analyze things which will undoubtedly rub some peoples political beliefs the wrong way, and this is one place where I cannot avoid it, no matter how much I might wish to do so.

The absurdities

So what exactly have our leaders in Washington, and pundits on the board of the Times, come up with?

First let us deal with the absurd aspects of this plan. The government buys up a bunch of foreclosed properties that are theoretically driving down the prices of other homes. Uh, does anyone else see the big gaping hole in this logic? After the government buys them, they are still abandoned! Unless the government just takes them off the market indefinitely (thus restricting supply) rather than sell them, how does that solve the problem of excess inventory?

What it does do is allow the lenders to get a price higher than they would if the homes had to sell at a price that people could actually afford. So, bankers and other lenders get bailed out, taxpayers have a bunch of homes they have to sell at prices lower than they paid for them. Personally, I would rather have out taxes not be used to bail out lenders.

One problem homeowners are facing is abandoned homes becoming a drag due to lack of maintenance. Will the government keep all these homes up? As little faith as I have in the lenders, the profit motive will likely make them better stewards (if only marginally, given the enormity of the issue) than the state.

A Little Reality

Most important, is that we investors need to avoid falling for simple sounding solutions that will in the end not help that much. The ultimate problem with housing is not greedy lenders (greed is nothing new) or deadbeats, government policies (a personal favorite post of mine) or incompetent regulators (though all had their role in getting us to this point.) It is that housing prices are too high.

For reasons stated above this particular solution is not going to help keep prices high, but what if they could? Is that really good? Housing is extremely unaffordable in many markets. Prices will come down. Is dragging that out the best answer? I find that in isolation a dubious, and at best a marginal, good. Given the cost, in tax dollars, inflation, misallocation of resources and the moral hazard of lenders and borrowers believing that risk can be taken with some portion of it underwritten by the state, the benefits should have to be huge. As investors we should be skeptical that the end result will be good for the rest of the economy.

The same problem comes even with trying to keep interest rates low. Let us assume that these various measures, combined with low interest rates, slows, or even temporarily halts, the decline in housing prices.

Much as with claims about the “fed model” there is the belief that lower interest rates will allow people to afford a home that they could not a higher rate, ( also that lower prices will result in demand curves that shift) etc. All of these arguments miss a key point. Interest rates change. A stock price that is “justified” by todays interest rate, says nothing about whether it will be similarly “justified” in the future. Nor does a high price being “justified” by low current interest rates mean you will get a satisfactory return. It just means it will be better (actually that isn’t a given either) than a bond yielding 3% (or whatever the low rate happens to be.)

So it is with housing. Absent a speculative bubble such as we just went through in housing, low interest rates might encourage people back into the market. It might halt the slide in housing prices from going back to an economically reasonable level as fast, or temporarily. However, those buyers will not be selling to people with similarly low rates in the future. In an efficient market (stop giggling Barry and Jeremy) markets would see through temporary low rate periods and price housing at sustainable levels that vary little around interest rates. I suspect in this instance gun shy homeowners will (or even lower.) At the end of the day however it doesn’t matter even if they do not. All that means is that down the road prices will fall when interest rates go up and prospective buyers cannot afford them any longer. The same for being able to “afford” a house at a lower credit score. Prices still have to be affordable for succeeding groups of home buyers. In much of the country they just are not. This not just “gonzo” pundits beating some fantasy bear drum, but yes Jeff, “real” economists such as Martin Feldstein (who has some trenchant comments on the health of the economy and misreading of the GDP data as well)

I’ll tell you what worries me. We saw house prices overshoot by 60% relative to costs of building and relative to rents. And I worry about the possibility that they will keep falling; they will spiral downwards. In the same way that they went much too high, they could go much too low. And if that happens, then we are going to see individuals feeling a lot poorer, cutting back on their spending, defaulting on mortgages, and we’re going to see the holders of those mortgages see their assets, their capital being cut and therefore their ability to make loans being cut.

Incoherence

Bill Gross should know better, but unfortunately he doesn’t seem to realize that after decrying the destructive potential of housing prices rising faster than inflation and incomes, that keeping them from correcting that rise is destructive as well, and unlikely to work.

So let us end with one more political (if non partisan) note. If all these policies could help keep prices up, if other policies suggested are effective as well, what have we done?

Encouraging people to buy houses at prices that were economically too burdensome, and likely to eventually lose value, is what got us into this mess in the first place.

Why is it a virtue for the government to do exactly what we are criticizing mortgage companies, banks and even the fed for encouraging home buyers to do in the past? Isn’t the end result just the same thing if possibly a bit more drawn out? Investors beware.

Update: Dean Baker (another “real” economist) takes up some similar themes:

Have the NYT editorial writers not noticed this bubble or do they think the housing bubble was a good development that the government should try to foster?

The level of incoherence of the housing policy advocated by the NYT is astounding. Why on earth should Congress act to keep house prices above their market level?

House price supports will not work in the long-run. If we keep house prices high, builders will construct more houses and the over-supply will grow even larger. In this way, a house price support program is like a farm price support program, except we have a $20 trillion stock of housing. The market for most farm products is in the tens of billions of dollars annually.

A house price support program will end up costing the government billions and possibly tens of billions of dollars. Is it better for the government to spend this money (most of which will be paid to banks) supporting house prices than to pay for health care, child care or good rental housing?

Furthermore, since house prices will eventually fall to their market clearing levels, will the NYT policy even help moderate income homeowners? They will be paying far more in housing costs for the years they still in their home than they would to rent a comparable unit. This will be diverting money that they may have otherwise used for their kids health care and child care or other necessary expenses. And, since the house price will fall, they will never accumulate any equity.

Jon Henke also smells the whiff of the farm support program.

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Technorati Tags housing, interest rates, Martin Feldstein, media, New York Times

Tags: housing, interest rates, Martin Feldstein, media, New York Times

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Goldman’s Murti Says Oil `Likely’ to Reach $150-$200

Do you remember when Murti was derided for making the call that oil was going to have a superspike? I do, and I was one of the skeptics, though only for a brief while.

Crude oil may rise to between $150 and $200 a barrel within two years as growth in supply fails to keep pace with increased demand from developing nations, Goldman Sachs Group Inc. analysts led by Arjun N. Murti said in a report.

New York-based Murti first wrote of a “super spike” in March 2005, when he said oil prices could range between $50 and $105 a barrel through 2009. The price of crude traded in New York averaged $56.71 in 2005, $66.23 in 2006 and $72.36 in 2007. Oil rose to an intraday record $120.93 today on speculation demand will rise during the peak U.S. summer driving season.

No prediction from me, but I can see reasonable arguments for oil going up or down significantly. Longer term though, barring some unforeseen technological breakthrough that can be rapidly deployed, energy costs will stay high. Owning some exposure to energy as a hedge makes sense in any case.

Hat Tip: Barry Ritholtz.

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Technorati Tags Asset Allocation, Energy, oil

Tags: Asset Allocation, Energy, oil

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That is All About Alpha’s assessment of 130/30 funds (definition here.) Which seems about right to us.

Few active managers, even if they actually outperform their benchmarks, can overcome the expenses associated with doing so. The reason is not necessarily that they cannot do a good enough job of picking investments that can outperform, but that constrained to only going long they can’t make a big enough bet on what they like, or don’t like, to move the needle sufficiently! Here is a nice examination of this issue.

The Alpha male has several nice posts up on this in addition to the ones above. On appropriate benchmarks:

After launching 130/30 index, S&P says best yardstick is actually a long-only index and Survey of hedge fund professionals: 130/30 “minor discussion within larger context”

The evolution of these vehicles:

The new face of 130/30? and Reality Check: “130/30? and “quant” not synonymous

For a discussion of the actual alpha that theoretically might be received by investors read this post on an interesting study:

130/30 in the 1930s

Most importantly, for those unfortunate enough to have been exposed to Chuck Jaffe’s execrable column on 130/30 strategies (or their brethren) I recommend Media turns hostile: 130/30 now “dubious” “overblown” “faddish” “hype”. The Alpha Male is more generous with Jaffe than I would be, but that is probably a good thing.

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Technorati Tags 130/30, alpha, alternative strategy, investing

Tags: 130/30, alpha, alternative strategy, investing

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While spending increased in March by 1.8% over a year ago, adjusted for inflation it was way down. The only reason sales were positive was gasoline, though food sales were positive. Even there, that is mostly due to inflation and rising prices of food and staples.

Technorati Tags consumer spending, Economic Indicators, Energy, Inflation, the economy

Tags: consumer spending, Economic Indicators, Energy, Inflation, the economy

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Personally I think we have been negative since November. Given the large positive number in the third quarter, the barely above break even number in the fourth quarter virtually guarantees that the economy went negative sometime in November and December. However, if we are not, it is highly likely coming. Here is a graphic which should put it in perspective. From Moody’s we get this look at freight (Click to enlarge)

That is a pretty stunning collapse. Few things correlate with economic activity more than freight, and for rather obvious reasons.

While I have been very negative on the economy shorter term for some time, I will say I doubt this will be a particularly deep recession. On the other hand, I also expect it to be rather drawn out. Obviously I could easily be wrong on both counts.

I will repeat what I have said over and over, in a probabilistic world we cannot know the future, but we can say that the risks are rather high and we should all consider lowering the amount of risk we face. That means more cash in our savings accounts, more defense in your portfolios (if you are going to take risk, make it risk that doesn’t correlate with US financial markets) and reducing debt.

With both financial markets and housing prices I would be wary. Your situation may differ, but I keep hearing people say things must be attractive at this point. Housing is a much better deal than it was, etc.

That is exactly right, but I suspect that this also likely holds true. It is approximately 4 1/2 hours from Baton Rouge to Shreveport. Alexandria lies halfway between. When my children ask me how far we still have to go, while I undoubtedly have far less distance to go than when I started, I still have just as far to drive as I have already driven.

In many areas of the financial markets and housing things may be less expensive than they were, but they are still way too expensive and there is a lot more bad news coming down the pike.

Technorati Tags economy, freight, investing, markets

Tags: economy, freight, investing, markets

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I have been busy getting prepared for our yearly investment conference, which we completed last week, and now the implementation phase, but I will try and get back to posting more regularly over the next few days. Please keep checking in. As all the work preparing for, and acting on, our new asset allocation for 2008 is still in progress it will be a slow ramp up, but as that winds down Risk and Return should have a lot to think and write about.

If 2008 is half as successful for our tactical asset allocation decisions as was 2007, we should have a very nice year indeed. We still feel an absolute return bias is the proper mindset going forward, and represents the best trade off between risk and return.

We will have a review of our outlook going up Monday.

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We should start out with some humor:

A robber in a ski mask blamed the bank for what he was about to do, The Associated Press reported Feb. 22.

“You took my house, now I’m going to take your money!” the assailant hollered. Talk about a reverse mortgage!

The FBI plans to review the bank’s foreclosure records for clues.

The suspect is presumed to be ARM’ed and dangerous.

The New York Times reports that bailing out homeowners is becoming increasingly talked about. This graphic explains why:

Alan Blinder wants the Feds to enter the mortgage business as they did in the great depression. Hat tip: Greg Mankiw

Edmund Andrews worries that Mortgage bailouts could create moral hazard issues. Uh, you think?

Tanta is pretty unimpressed, though she does give us some thoughts on the issues around making mortgage securitization less of a disaster than it has been this time around.

Dean Baker points out that plans to buy up the mortgages does carry some risk. Throw in his lack of conviction that raising the ceilings for the mortgages that Fannie Mae and Freddie Mac can purchase in areas with high-priced homes will help.

This post on worries about the credit worthiness of Fannie and Freddie shows the markets are pretty unsure about them as well.

Mark Thoma gives his thoughts here and here.

Yves Smith has the most realistic reaction to all these proposals for solving these issues. They probably will not work, expose us to moral hazard, and would be far more expensive than Alan Blinder believes. Many of the solutions look at this as a temporary problem of credit markets and people who couldn’t afford their homes. That is true, but more fundamentally homes need to come down in price. Plans that assume the need to stabilize home prices, or help out borrowers who are over extended, are building in failure. Prices will likely not stabilize, and probably shouldn’t. James Hamilton seems to agree as well:

To the extent that analysis is correct, a “pause” in the foreclosure process will be helpful only if house prices are finished falling. But house prices decline sluggishly in response to market pressure, given the unwillingness of many sellers to acknowledge the magnitude of their capital loss. Even if the number of homes sold were to rebound tomorrow, there would remain a large inventory of unsold homes that will continue to push prices down.

Calculated Risk looks at the merits of the various home price indexes. James Hamilton weighs in on the topic as well.

The National Association of Home Builders remains cautious about the market going forward despite a slight up tick in activity. The fact that permits fell, starts were flat, and for single families at the lowest level since 1991 might have something to do with it (pdf.).

As abandoned homes pile up neighbors in Minneapolis are being urged to “adopt” their neighbors homes .

Barry Ritholtz lets us know about Rotten Neighbor.com .

Some believe this whole mess is part of a fundamental shift in the American landscape, with cites doing better, suburbia declining and taking on some of the characteristics of decaying inner cities. Extreme, but some of it has a ring of truth as urban living becomes more desirable and desired.

But we could be Britain!

Britain’s housing market is a “house of cards” that is set to implode after years of reckless mortgage lending, chronic oversupply of new flats and widespread fraud, a leading analyst said yesterday. (The Times) (via Barry Ritholtz )

Now for a Little discussion of the past

One of the ongoing debates over the last few years has been the economic impact of home equity withdrawal through home equity lines of credit and loans, cash out refinances, etc. How important was it? Was it sustainable?

I think those of us who worried about it can claim that it is now fairly clear it wasn’t sustainable. So let us go down memory lane and look at what was of such concern by the end of 2005:

Notice the two previous big drops came with pretty large economic downturns. The drops worsened the downturns and the downturns worsened the drops. That seemed pretty obviously something to be concerned about, but we negative Nellie’s were told to pipe down time and again. By this Summer that trend was reversing :

The problem for the market:

One would expect to see profit margins coming under pressure, even without the mortgage meltdown. Historically a housing downturn has been bad for the economy, despite claims by some that it would be “contained” and is a small part of the overall economy. Once again, that is without the mortgage and credit market meltdown we are now experiencing:

Nevertheless people still argued that Mortgage Equity withdrawal was somehow different than other debt because it was being used on improvements. Well that economic engine has gone into reverse:

ORLANDO, Fla. – Those fancy home fix-ups touted in cable TV shows and home magazines are losing their luster with consumers.

With the shakeout in the housing market, homeowners are worried they won’t get their money back from high-dollar redos.

And lenders are less willing to finance pricey home improvements.

That has caused a decline in nationwide remodeling.

“We saw a downturn in 2007, and 2008 looks every bit as tough for the industry,” said Kermit Baker, a researcher with Harvard University’s Joint Center for Housing Studies. “After some almost record-breaking growth, the market has stalled.”

Per capita home remodeling expenses in the region that includes Texas jumped almost 50 percent between 1996 and 2006. But since then, spending for home upgrades has fallen.

In a quarterly comparison, nationwide home remodeling expenditures have fallen about 10 percent since their high in 2006.

Researchers blame the downturn in the overall housing market for dampening the desire for home redos.

“Homeowners have been scaling back on their remodeling plans as the overall market has weakened,” Mr. Baker said.

“Homeowners are concerned that they may be overimproving their homes relative to their neighborhood and prices in the market.”

Studies back up those concerns. Average returns on a home remodeling project have fallen from 82.5 percent in 2003 to 70 percent last year.

With home prices depressed in many neighborhoods, homeowners are especially worried that they won’t get the bucks back they spend on luxury features such as saunas, European cabinetry and imported tile floors.

“There are some signs that the emerging weakness may be greater at the upper end of the market,” Mr. Baker said. “We are seeing more of a return to basics.”

That means less costly improvements and standard maintenance, he said, rather than “some of the sexier kitchen and bath projects.”

Tanta goes back over the argument at length at Calculated Risk, but obviously it has not been sustained. Nor was any where near all the equity withdrawn going to improvements on homes, so we can expect declines across a range of goods and services.

Tellingly, banks and lenders now agree on that fact:

Last year, 34 percent of borrowers said they used their home equity lines to pay off other debt and 29 percent used them for home renovation, according to a survey of lenders by BenchMark Consulting International. Another 31 percent used them to pay for other things, such as medical bills, weddings or vacations.

Paying off other debt in many cases only meant freeing up the ability to run those credit accounts up again. The assumption being that home appreciation would continue so they could do it again, or just plain didn’t have any plan at all. So the banks are now freezing people’s Home Equity Lines of Credit :

Larry F. Pratt, chief executive of First Savings Mortgage in McLean, said most mortgage documents he has seen give lenders wide latitude to suspend or freeze credit lines.

“A layperson would not recognize the language because it’s not that blatant,” Pratt said. “It talks about deterioration of the value of the asset or the value of the collateral. . . . It’s not boilerplate language by any means.”

Across the nation many borrowers are upset. This will put a crimp in consumer spending moving forward.

Hat tip: as always some of this is from Abnormal Returns. Even if not, go there.

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Technorati Tags bailout, credit crisis, Economics, economy, home equity, home equity loans, housing, subprime

Tags: bailout, credit crisis, Economics, economy, home equity, home equity loans, housing, subprime

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