My post last night attracted a number of intelligent comments.  I want to expand on what I said.

1) The Baby Boomers are different that other US generations.  They are less provident, willing to sacrifice the future for the present.  Not only do they save less, but they raid existing savings to fund current needs.  They are also more prone to investment scams.  When will Boomers realize that the amount that they can expect from investments with safety is not much higher than what long Treasuries yield?

2) My comment from last night, “The US is bad off demographically, but most of the rest of the world is worse off.  The US has a problem because it has not been saving, but that is largely because much of the rest of the world is neo-mercantilist, and is subsidizing export industries, and the US buys.” needs more explanation.

• The US has its birth rate at replacement rate, which is unique among developed nations, and is largely due to the influence of Mormons, Muslims, Orthodox Jews, Evangelicals, recent immigrants (legal or not), and homeschoolers.  (Personal observation: even non-religious homeschoolers tend to have more kids on average.)
• The rest of the world is worse off — China’s demographic problem is huge, but at least they save to compensate for it.  Europe is not quite as bad off, but nothing kills fertility quite so well as peace, moderate prosperity (meaning well-off with two working, not one working) and a decline in religious faith.

3) From a reader:

Can you please reconcile these two seemingly conflicting statements:

“[Boomers] will need to labor longer, and they should do so” and “To the extent that this causes labor shortages, the US will see greater employment prospects for its people”

Sorry that I wrote it that way.  There will be a balancing act that occurs in the economy around 2025 — wealthy Boomers retire, poor Boomers continue work.  The relative size of each cohort will determine what the effect is on the economy as a whole.  Beyond that, there is a third factor, immigration.  The US is more friendly than most places to legal and illegal immigration.  That helps solve our demographic problems, but it insures that my children learn Spanish.  If wages rise too much, immigration (and offshoring) will rise as well.  (It is akin to wealthy retired Boomers saying to their children, “You don’t have to care for us, we’ve found people who will do it more cheaply.”

4) Another reader comment:

Jeremy Siegel (Stocks for the Long Run) offers a pretty thorough and generally optimistic take on the Baby Boomer retirement issue in his latest book “The Future for Investors.” At the risk of oversimplifying a complex analysis, Siegel’s bottom line is that while there are not enough younger generation Americans to absorb the Boomers stock and bond assets at current prices, investors in emerging countries, like China and India, will more than make up for that and will end up buying the Baby Boomer’s paper assets as the Boomers sell them off to fund their retirements. The upshot is that foreigners will end up owning a lot of our companies by the year 2050. A potential snag, says Siegel, is whether America will be willing to let this happen, or will pass laws or adopt polices to discourage the transfer of US assets to foreign countries. This remains to be seen, but he is optimistic. On the other hand, the implications for the typical Baby Boomer’s most important asset, his or her house, is rather dire, because homes can’t be sold as readily  to foreigners, for obvious reasons. Siegel doesn’t provide an answer for the housing market, which is outside the scope of a book on stock investing in any event.

There is the political question around how much US corporations we would allow to be owned by foreigners.  I don’t know where the breaking point is there, but the answer will have an impact on the value of the US dollar.  As for homes, if we slow down the growth of the housing stock, and condemn more of the existing housing stock, we will eventually solve the excess housing problem.  As it is now, we have foreigners speculating on the value of residential US real estate.

5) One final note that I omitted last night.  Medicare is the big issue here, and we will begin to feel it over the next five years.  At least one election in the next decade will have Medicare as its top issue.  The Social Security problem is one-quarter the size of the Medicare problem.  No wonder Bush, Jr. did not try to deal with Medicare, but made the problem worse by adding the drug benefit.

6) I don’t see the emerging markets getting rich enough, fast enough, to do the wealth exchange necessary for the developed world on favorable terms for the developed world.

That’s all for now.  More comments, send them on.

Three notes on the blog itself.  1) I will be guest-blogging for one post at another site on Thursday.  Won’t say where, but watch for “The Fundamentals of Real Estate Market Bottoms.”  It will be reposted here Thursday evening.  2) I can’t paste certain bits of code in my blog because of a WordPress limitation introduced in version 2.5.  As of now, that won’t be remedied until version 2.9, which as far as I can tell, is a huge update, and is at least half a year off.  3) I have not left RealMoney, though I have not posted there in a while.  I started this blog so that I would have a site with my own distinct voice, and so that I could have greater creative freedom to write about things dearer to me that I felt would not fit the RM audience.  Also, I felt that I had run out of articles to write, simply because I held myself to a higher standard, and didn’t want to write articles just for the sake of putting something into print.  RM readers deserve better.  I will come back to posting at RM, I just don’t know when, amid my current busy-ness.

I last mentioned portfolio moves a little more than a month ago.  Here are my moves since then:

Rebalancing Buys:

• Ensco International
• Nam Tai Electronics
• Cemex
• Assurant
• Industrias Bachoco
• Charlotte Russe
• Valero
• Cimarex

Rebalancing Sells:

• Universal American
• OfficeMax
• International Rectifier
• Jones Apparel
• Smithfield Foods
• Group 1 Automotive
• Shoe Carnival

For a six-week period, that ’s a decent number of trades, at least for me.  My methods are designed to try to not trade frequently, but to trade to minimize risk and maximize return in a majority of situations.  For those not familiar with my rebalancing trades, I keep a fixed set of target weights in a largely equally-weighted portfolio.  When a security gets more than 20% away from its target weight, I buy (after review) to bring it back to target weight, or sell to bring it back to target weight (take some money off the table).

There have been three other actions during this time. 1) National Atlantic’s merger went through.  A loss for me, but I ain’t missing them at all.  2) After the buyback announcement, I traded my holdings in Anadarko for holdings in Devon Energy.  I like the valuation, and the Natural Gas exposure better at Devon.  3) I tendered all my MetLife shares for shares in RGA.  I like RGA a lot here and am willing to make it a double-weight in my portfolio. In the current tender offer, I should get approximately 10% more value in RGA shares for my MetLife shares, subject to a number of conditions listed in the prospectus.  Also, RGA is a unique company that makes its profit mainly from mortality, which is not correlated with other financials.  It is a well-run company, and deserves to be valued at a significant premium to book value.

Full disclosure: long RGA MET DVN SCVL GPI SFD JNY IRF OMX UAM XEC VLO CHIC AIZ IBA CX NTE ESV

I read your blog frequently, and I always find it very insightful and realistic, and without invective, which is refreshing. I’d like to pose a question to you, to which you can probably provide a good answer.

Given the current pessimistic mood of the U.S. economy and financial markets, I’ve been trying to figure out where the light at the end of the tunnel will be for U.S markets. But I get stuck at this point: Baby Boomers retiring. Their portfolios are the ones that have grown over the past 30+ years, and they will soon be drawing upon those savings as a source of income at a steady rate, and one that allows them to live at similar quality of life as when they retired. I have read plenty (I think) on the current state of Social Security, but I’ve seen nothing on the private pillar of retirement.

This future, steady drawdown must have some effect on U.S. equity markets, correct? Enough to keep markets moving sideways? Downwards for the long-term?

As an early 30-something who has been financially responsible (no consumer debt, no mortgage, high savings rate), I’m trying to figure out what might happen to my savings long-term, and how heavily a portfolio should be weighted with U.S. securities.

Could you possibly point me in the right direction where I can find some literature or statistics on how Boomer’s retirements will affect U.S. markets?

So went a recent question from one of my readers.  I’ve been studying this topic for 20 years, and writing about it for 15 years.  The questions are difficult, and the answers are not clear.  Let me point you to one thing that I have written on the topic: Society of Actuaries Presentation.

The US is bad off demographically, but most of the rest of the world is worse off.  The US has a problem because it has not been saving, but that is largely because much of the rest of the world is neo-mercantilist, and is subsidizing export industries, and the US buys.

Remember the lesson of the mercantilist era: the consumers won.  Those that tried to get gold got gold, and at a high cost in terms of other goods.  In the same way, the neo-mercantilistic nations are sucking in dollars that are worth less and less.  On page 32 of my presentation, it is amazing that the net debt position of the US has been flat, because our debts are worth less dur to the decline of the dollar.  What a boon it is to be the world’s reserve currency.

Now, as for the “retirement” of the Baby Boomers: there will be some stagnation in our equity markets to the degree that retirement causes liquidation of assets.  That said due to low savings rates, it is quite possible that retirement dates will be extended for most Baby Boomers.  They will need to labor longer, and they should do so, after all, at age 65 the average retiree is not within ten years of death.

To the extent that this causes labor shortages, the US will see greater employment prospects for its people.  In Japan that seems to be happening now.  But America welcomes immigrants (legal or illegal) in a greater way than most countries do.  That will mute any gains for unskilled labor in the US.

My advice for you is to look at global demand.  Rather than looking at investing with countries as a first screen, consider it through the lens of industries.  Look to which industries are benefiting from increased global demand, and if they are at reasonable valuations, buy them.

I know this is not a full answer, but it is the best medium-to-short answer that I can give you.

That said, my question is: do I buy the property reinsurers here?  My initial guess is yes, because it has been a weak hurricane season so far, and the beginning and end of the seasons tend to be correlated.  But, it is too early to take action.  What I am more likely to do is wait until my next reshaping at the end of September, and make some shifts then.  Perhaps Gustav and some other hurricanes will prove my thesis wrong by then.

So, how are valuations for the reinsurers?  Cheap, but pricing is weak, because capital is plentiful.

Source: Yahoo Finance, Bloomberg

If I were looking to move tomorrow, I would consider IPC, Flagstone, and Validus among the “pure play” property reinsurers. Among the diversified players, I would consider PartnerRe, Endurance, Allied World, and Aspen. Note that the book value of PartnerRe is understated because they don’t discount their loss reserves. For conservative players, PartnerRe is compelling because of their strong balance sheet, very diversified book of business, and strong management. PartnerRe, Endurance, Flagstone, IPC and Allied World score some extra points in my book because of their conservative cultures.

I’m not doing this trade tomorrow, but with good weather, and continued pessimism over financials, this trade could look very good near the end of September.

Full disclosure: no positions

After writing parts one and two of what I thought would not be a series, I have another part to write.  It started with this piece from FT Alphaville, which made the point that I have made, markets may not need the ratings, but regulators do.  (That said, small investors are often, but not always, better of with the summary advice that bond rates give.  Institutional investors do more complete due diligence.)  The piece suggests that CDS spreads are better and more rapid indicators of change in credit quality than bond ratings.  Another opinion piece at the FT suggests that regulators should not use ratings from rating agencies, but does not suggest a replacement idea, aside from some weak market-based concepts.

Market based measures of creditworthiness are more rapid, no doubt.  Markets are faster than any qualitative analysis process.  But regulators need methods to control the amount of risk that regulated financial entities take.  They can do it in three ways:

1. Let the companies tell you how much risk they think they are taking.
2. Let market movements tell you how much risk they are taking.
3. Let the rating agencies tell you how much risk they are taking.
4. Create your own internal rating agency to determine how much risk they are taking.

The first option is ridiculous.  There is too much self-interest on the part of financial companies to under-report the amount of risk they are taking.  The fourth option underestimates what it costs to rate credit risk.  The NAIC SVO tried to be a rating agency, and failed because the job was too big for how it was funded.

Option two sounds plausible, but it is unstable, and subject to gaming.  Any risk-based capital system that uses short-term price, yield, or yield spread movements, will make the management of portfolios less stable.  As prices rise, capital requirements will fall, and perhaps companies will then buy more, exacerbating the rise.  As prices fall, capital requirements will rise, and perhaps companies will then sell more, exacerbating the fall.

Market-based systems are not fit for use by regulators, because ratings are supposed to be like fundamental investors, and think through the intermediate-term.  Ratings should not be like stock prices — up-down-down-up.  A market based approach to ratings is akin to having momentum investors dictating regulatory policy.

Have the rating agencies made mistakes?  Yes. Big ones.  But ratings are opinions, and smart investors regard them as such.  Regulators should be more careful, and not allow investment in new asset classes, until the asset class has matured, and its prospects are more clearly known.

With that, I lay the blame at the door of the regulators.  You could have barred investment in novel asset classes but you didn’t.  The rating agencies did their best, and made mistakes partially driven by their need for more revenue, but you relied on them, when you could have barred investment in new areas.

In summary, I still don’t see a proposal that meets my five realities:

• There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
• Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.  The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.  The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
• New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
• Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
• Ratings can be short-term, or long-term, but not both.  The worst of all worlds is when the ratings agencies shift time horizons.

And because of that, I think that solutions to the rating agency problems will fail.

On Saturday, the Wall Street Journal had an article called Food Makers Scrimp on Ingredients In an Effort to Fatten Their Profits. Good article, but I’m here to draw a different conclusion than the article did.  How much impact does substituting cheaper ingredients in prepared food have on the CPI if the product price does not change?  No effect, but you are likely getting a lower quality good.

I don’t have troubles with the theory behind hedonic adjustment.  I have troubles with how it works in practice, and I wonder whether it can be done properly at all, as I wrote in my RM article Solid Foundation for Inflation Fears.

One requirement for doing hedonic adjustment right, is that both the new and old goods must be offered side-by-side for a while, and that people can clearly tell the differences between the old and new goods.  At that point, the economist can take the prices paid and quantities bought of both goods, and make a hedonic adjustment.

But typically, that doesn’t happen.  The old product disappears when the new product appears, and when features are upgraded, companies loudly announce the enhancements (and in a soft voice, the higher price).  When features/ingredients are downgraded, the companies say little to nothing.

But mere technical measurement of quality changes does not capture the perceived quality difference to the consumer.  Consider a soft drink company that changes its bottle size from 16 to 20 ounces (25% bigger), while raising the price 33%.  The consumers may say in their heads, “I only buy one bottle per day, and I don’t need the extra four ounces, but I have to buy one bottle of my favorite soda; I can’t buy 80% of a bottle, and this is it.”  The consumers aren’t 6.7% worse off in this example; the inflationary effect should be higher.

Same thing for computers.  Any comparison of features will overstate the perceived improvement, because for most needs of companies and individuals, computers run about the same — marginally improved hardware, and software that eats up a lot of resources, leading to little extra benefit.

With a little sympathy toward those who calculate the CPI, I will say that I think their job is tough.  Capitalist economies are diverse and dynamic.  They sample a smallish portion of what goes on, often on a static basket of goods that is infrequently updated, and try to generalize to the large, diverse, dynamic economy that we live in.  It is tough, and I know they have to do it for a wide number of reasons.  They use shortcuts.  They have to, in order to get their jobs done.  But those shortcuts bias the calculation of the CPI downward.

My advice would be this: aside from products where quality differences can be plainly figured (both goods trading side-by-side, with differences clearly identified), drop the hedonic adjustments.  This is one of the reasons why US inflation is so much lower than much of the rest of the world, and the government should be more honest about the value of our currency.

In closing, as an aside, can you imagine a question given at the Presidential debates that went something like this: “Senator, the leading bond manager of our country, and many leading financial writers (e.g. James Grant, Barry Ritholtz) have argued that the way that the government calculates the CPI is flawed, and understates the change in the cost of living.  If elected President, what would you do about this?  Further, how would it affect who you appoint to the FOMC?”

That one would probably even make Obama pause.  McCain? I like the guy, but I don’t know what he would say.  What it would point out, is how little scrutiny is really given to a core statistic that affects our lives in many ways, because it affect indexed payments, and helps define how fast the economy is really growing.  If I am correct in my assertion in the degree of understatement of the CPI, then we have been in recession for some time already.

And, for me, though I am doing well, all my friends are less well off than me.  From what I can gauge, I don’t see many whose standard of living is rising now.  So it goes.

“Get financing when you can, not when you have to.”  Warren Buffett said something like that, and it is true.  My biggest early investment loss was Caldor, which Michael Price lost a cool billion on.  A retailer that could not hold up to Wal-Mart, Target, and Sears, Caldor expanded in the early 90s by scrimping on working capital.  Eventually a cash shortfall hit, and their Investor Relations guy said something to the effect of, “We have no financing problems at all!”  The vehemence cause the factors that financed their investory to blink, and they pulled their financing, sending Caldor into bankruptcy, and eventually, liquidation.

Caldor had two opportunities to avoid the crisis.  It could have merged with Bradlees and recapitalized, leaving it stronger in the Northeastern US.  It also could have done a junk bond issue, which was pitched to them eight months before the crisis, but they didn’t do it.  In the first case, the deal terms weren’t favorable enough.  In the second case, they thought they could finance expansion on the cheap.

Caldor is forgotten, but the lessons are forgotten today as well.  Today, overleveraged financial companies wish they had raised equity or long-term debt one year ago, when the markets were relatively friendly and P/Es were higher, and credit spreads were lower.

I know I am unusual in my dislike for leverage in companies, but on average less levered companies do better than those with more debt.  Caldor went out with a zero for the equity.  A few zeroes can really mess up performance.

Capital flexibility has real value to good management teams.  I don’t mind exess cash hanging out on the balance sheets of good firms.  Hang onto some of it, and maybe during a crisis you can buy a competitor at a bargain price.

But for the financials today, who has the wherewithal to be a consolidator?  Most of the industry played their capital to the limit, and are now paying the price.  Either the door is shut for new capital, or they are paying through the nose.

I don’t see anyone large who fits that bill of being a consolidator.  Maybe some of the large energy companies that have been paying down debt would like to diversify, and buy a bank.  Hey, feeling lucky?!  Lehman Brothers!

Look, I’m being a little whimsical here, but the point remains — run your companies with a provision against adverse deviation.  Be conservative.  For those that invest, avoid companies that play it to the limit, unless you are an investor with enough of a stake that you can control the company.

I’m going to be reviewing a few books on quantitative investing.  Many of these will not be suitable for everyone, and as I do these reviews, I will try to indicate what level of math skills you will need in order to benefit from the book.  For today’s book, you can get most of it if you can remember your Algebra 1, and understand basic statistics.  Knowing regression helps, and a little calculus wouldn’t hurt, but this book is mainly qualitative.  It describes,and there are many graphs, but formulas are not on every page.

Investing By The Numbers has been out a while (1999), and though it is a good book in my opinion, it never sold big.  Oddly, a lot of investment actuaries bought the book because of a review in the Investment Section newsletter, Risk and Returns.  I have one of the few signed copies.  When I met Jarrod Wilcox when he gave a talk to the CFA Society of Washington, DC, he was genuinely surprised when I asked him to sign my copy of the book.

Jarrod Wilcox, Ph.D., CFA, held important roles at PanAgora Asset Management and Batterymarch Financial Management.  He runs his own shop now, focusing on liability-driven investing, something that I have written about at RealMoney, and at this blog.  What do I mean by liability driven investing?  Just that your asset allocation should reflect when you will most likely need the money.

This book does not have one big overarching idea to guide it.  Instead, it has many models to share from different situations in the market.  There is something for every quantitative equity investor here, and I will mention the areas where I benefited the most:

• Along with a few other books, including some from the Santa Fe Institute, this book confirmed to me that one has to look at investment using an ecological framework.  Many strategies are competing for scarce returns.  Often the best strategy is the one that has few following it, and the worst one is the crowded trade.
• Why do value methods tend to work?
• How do you avoid traps in calculating models?
• How do investors with different goals and expectations affect the market?  What happens when you get too many momentum investors?  Too many growth investors?
• Difficulties with the Capital Asset Pricing Model [CAPM] and Arbitrage Pricing Theory [APT].
• If the market tends toward equilibrium, the forces guiding it are weak.
• Behavioral finance as a means of bridging investment theory and reality.
• Market microstructure: how do we minimize total trading cost?  Minimize taxes?
• How is the P/B-ROE model derived?
• How to model market anomalies?
• When do different valuation methods pay off well?
• How does international diversification help?  (Bold in 1999, but a bit dated now.)
• How to manage foreign currency risk in an equity portfolio?
• How do neural nets work and what challenges are there in using them?

As a young investor using quantitative methods, I found the book useful, and still use a number of its findings in my current investing. Again, this is not a book for everyone — you have to want to do quantitative investing from primarily a fundamental mindset in order to benefit for this book.

Full Disclosure: Anytime anyone enters Amazon.com through any link on my site and buys anything there, I get a small commission.  This is my version of the tip jar, but best of all, it doesn’t cost you a thing, if you needed to buy it through Amazon already.

I like to think that I have a pretty strong stomach for risk.  I am used to losses.  I have my sell disciplines, and I act on them.  I also try to be forward-thinking about risk; not just reacting, but trying to anticipate what the markets are likely to deliver.  Every now and then, I get a surprise.  Here’s the surprise, which I got from The Big Picture (Barry’s blog).  Institutional Risk Analytics does some good work, and this article is representative of their work.  In it, they describe the two risks facing the large banks — risks from their assets, and risks from their derivative books.

The second link made me pause.  I know things are bad, and I can’t vouch for Institutional Risk Analytics’ risk based capital model for banks, but the level of notional derivatives exposure at many of the major banks to their tier 1 surplus made me pause.  There are two claims on surplus — losses from direct lending, and losses in the derivative books.

Those who have read me for a long while know that I think the derivative books at the investment banks are mismarked and possibly mishedged.  When accounting rules are not well-defined, and instruments are illiquid, even well-meaning managements tend to err in their favor in the short run.

This is significant in a number of ways, but the main one was pointed out in the first link, that with the continuing failure of small banks, how will the FDIC make depositors secure if a large-ish institution fails, when reserves are relatively low?  They need to raise their fees that they charge solvent banks to replenish their coffers.  They are also bringing back retirees with experience in dealing with insolvent banks.

So, are the banks in trouble?  Some of them are experiencing stress, and that is coming through higher credit spreads on their debt.  Given the higher costs entailed in funding for banks, it is all the more important in your investing to look for companies that don’t need much external finance.  After all, many banks may find it harder to lend.  Consider the difficulties in funding InBev’s purchase of Anheuser-Busch.  Large banks are straining at their limits.  They don’t have enough parties to sell loans off to, nor do they want to hold onto so much of the risk.

The bank loan and and bond markets are closely connected.  Troubles in one tend to spill over to the other.  Loans have a higher priority claim, so the yields are lower than for bonds.  As it is, investment grade corporate bonds, particularly financials, are facing higher yields.  The high yield market has slowed considerably.

So, what does this imply?  The banks are hunkering down.  They are scrutinizing all risk exposures.  They aren’t expanding lending, which is showing up in MZM, M2, and my M3 proxy.  Credit is getting tough/sluggish.

Money Supply

And the degree of leverage that banks are willing to use versus the Fed’s monetary base is dropping, and hard (the graph covers 28 years).

Bank Leverage

So, I’m not optimistic here. I believe in the value of “long only” money management as having better chances of risk control than hedged strategies, but this is making me queasy. What it makes me think, is that the FOMC’s next move is a loosen. It hurt to say that, particularly given my dislike of inflation, but the solvency of the financial system comes ahead of inflation in the Fed’s calculus, even though loosening won’t help much.

With that, I am looking to continued problems in banks, and perhaps for the economy as a whole.  Our next president will have a fun time with this…

Just a quick post to give a mid-quarter view of my main industry rotation model.  The recent moves in the market have knocked many energy sector industries out of the hot zone (red), but any bounce in financials has not knocked them out of the cold zone (green).  I’m still not ready to play in the depositary and credit sensitive financial companies, my insurance exposure is cheap, and earning money with low-ish risks.  That said, this is the type of environment that reveals which insurers have been taking on too much risk with marginal bonds.

industry-ranks-8-21-08

Remember that my industry ranks can be used in two modes: momentum mode (look at the red zone), and value mode (green zone).  I spend most of my time in the green zone, looking at industries where I think pricing power will return.  For me, the red zone is more useful for sale decisions.  When an industry is running hot, I delay selling out in entire, and content myself with trimming positions in order to limit risk when the eventual turn happens.