S&P indices vs actively managed funds

The March 2010 issue of Research Insights from S&P Indices puts forth some interesting results of an analysis of 5 years of data ending 12/31/2009:

"The S&P Indices Versus Active Funds (SPIVA) Scorecard reports performance comparisons corrected for survivorship bias, shows equal- and asset-weighted peer averages, and provides measures of style consistency for actively managed U.S. equity, international equity, and fixed income mutual funds... The CRSP Survivor-Bias-Free U.S. Mutual Fund Database provides the underlying data…

 Over the last five years,

  • the S&P 500 has outperformed 60.8% of actively managed large-cap U.S. equity funds;
  • the S&P MidCap 400 has outperformed 77.2% of mid-cap funds; and
  • the S&P SmallCap 600 has outperformed 66.6% of small-cap funds.
  • results are similar for actively managed fixed income funds. Across all categories, with the exception of emerging market debt, more than 70% of active managers have failed to beat benchmarks.

We're all Bozo's on this bus: the wisdom of Dodd-Frank

Updated on Friday, July 23, 2010 at 11:46AM by Registered Commenterhb

Updated on Wednesday, July 28, 2010 at 02:36PM by Registered Commenterhb

At some point Congressional imbecility becomes malfeasance. The Wall Street Journal today reports: Standard & Poor's, Moody's Investors Service and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales, each said in statements in recent days. Each says it fears being exposed to new legal liability created by the landmark Dodd-Frank financial reform law.... That is important because some bonds, notably those that are made up of consumer loans, are required by law to include ratings in their official documentation. That means new bond sales in the $1.4 trillion market for mortgages, autos, student loans and credit cards could effectively shut down.

Click to read more ...


In case you're wondering why everyone's knickers are twisted...


Only 7 basis points away

Below are the 5 year credit default swap rates for selected countries. We note the US enjoys a mere .07% pa advantage over Germany and has only .59% basis points separating us from France.

5 yr CDS / .00% pa

Counter party






United Kingdom  


















Well, a little math: if the yield on the 5 year US Treasury is 1.75% pa, and we strip out the credit risk (a novel concept for those who used to think the US Treasury represented the ‘risk free’ rate) you get something like 1.36% which on a good day should include the embedded real interest rate, inflation expectations, and counterparty risk on the swap. Think about that for a minute while we wander elsewhere.

We have John Taylor  in today’s WSJ (perhaps taking the cue from WWB?) blasting Congress for fundamental potentially fatal flaws in the putative “financial reform” legislation. We have President Obama now threatening critics with “calling their bluff” next year by “presenting some very difficult choices.”

Meanwhile we have in Daniel Henninger commenting on the decay in the rule of law, quoting Justice George Sutherland: “a statue which either forbids or requires the doing of an act in terms so vague that men of common intelligence must necessarily guess at its meaning… violates the first essential of due process of law.”

Unfortunately Judge Sutherland has come to describe much of the legal and regulatory status of modern economic and private life today. By operation of complexity or lack of clarity good faith compliance with law or regulation has become nearly impossible, a stochastic venture in the Heisenberg principle[1]. This has the consequence that enforcement has become chaotic at best or discretionary at worst. Mel Brooks is correct: “it’s good to be the king.”

Outcomes matter. Is Mel Brooks or George Washington working the levers? Allocators of capital don’t have the luxury of waiting for visions of clarity. The cash is here, what’s the trade? Take zero to negative real returns on short term, low risk assets or ponder the range of risks and uncertain returns imposed by chaotic political, fiscal, monetary, regulatory, and legal frameworks? For the bricks & mortar crowd, build the factory here or abroad, or scrap it altogether?  

Uncertainty paralyzes capital which impairs productivity. Consider the response of a risk officer when asked if the risk of the deal was acceptable:

           “Risk in & of itself is rarely unacceptable. The question is at what price?”  

Well, the Dow seems to be pushing 9,500 and the US is only 7 basis points away from parity with Germany. We, meaning the United States and its citizens, now have fewer valuable goods & services, less wealth, and our risk profile has increased. You can price it by the minute.

And let’s go back to that mysterious 1.36% we came to at the beginning of this posting ... seems like the market isn’t scared of inflation. Deflation seems to be the major concern. Keynesian economics basically claims that value is created by borrowing from Poppa to pay Peter to dig a ditch and then to pay Paul to fill it back up (you do recall Cash for Clunkers?). We are now borrowing from the unborn children of Peter and Paul to pay for the digging and filling up of holes.

The market is pricing in quality & effectiveness of governance and uncertainty of rule of law, also known as country risk, for the US. It also seems that deflationary expectations now dominate those of inflation, a sobering thought. Equities are getting significantly cheaper and that, for proper context, in face of greater risks. Treasuries are either cheap or dangerously expensive, depending on your view of the inflation vs. deflation argument. 

Our bias shows, so we may as well say it directly. You better have some cash on hand. Rebalance to get some equities cheap (buy on ugly and be prepared for uglier). Stay short & high quality on the fixed income side. We discourage trying to juice yield via duration, credit risk, or artifice. There is no free lunch, and the market will mete out a rough frontier justice to those who think so.

Farmers know the fallacy of Keynes, that crops must be grown before they can be eaten. Or taxed.


[1] We cite Tim Geithner’s plea as to Turbo Tax but leave the reader to determine the issue of good faith.


No one will it works

"It's a great moment. I'm proud to have been here," said a teary-eyed Sen. Christopher J. Dodd (D-Conn.), who as chairman of the Senate Banking Committee led the effort in the Senate. "No one will know until this is actually in place how it works. But we believe we've done something that has been needed for a long time. It took a crisis to bring us to the point where we could actually get this job done." Washington Post, June 25, 2010

This pronouncement is stunning in many respects. First, it is true.  ‘No one will know…how it works’, and Senator Dodd was not even under oath.  It is also true that it took a crisis, and one of Congress’ own doing, to bring Congress to a point where it felt it had to act. With the US on its way to losing its Aaa/AAA ratings, the economy on the rocks, record deficits and the like, Congress needed to revise the mechanic by which it monetizes its ability to regulate.

Set aside for a moment the abject imbecility that ‘no one will know…how it works’.  Consider that vague law and regulation encourage rent seeking behavior from deep pocketed market participants: take a member of Congress to lunch today and it better be good. Political favor, not efficiency or customer satisfaction become the rule (GE comes to mind). Rent seeking behavior prejudices the success of smaller, more innovative market players. Worse, vague law and regulation are the means by which government diminishes our freedoms.

We again affirm that absent reform of the national, residential real estate mortgage markets any presentation or claim of financial reform is simply manifest political fraud of the highest order.


The impact of public guarantees on bank risk taking

The Impact of Public Guarantees on Bank Risk Taking: Evidence from a Natural Experiment, a paper by Reint Gropp, Christian Grundl and Andre Guttler dated April 10, 2010, is clear and unsurprising. The abstract is below:

Abstract: In 2001, government guarantees for savings banks in Germany were removed following a law suit. We use this natural experiment to examine the effect of government guarantees on bank risk taking, using a large data set of matched bank/borrower information. The results suggest that banks whose government guarantee was removed reduced credit risk by cutting off the riskiest borrowers from credit. At the same time, the banks also increased interest rates on their remaining borrowers. The effects are economically large: the Z-Score of average borrowers increased by 7% and the average loan size declined by 13%. Remaining borrowers paid 57 basis points higher interest rates, despite their higher quality. Using a difference-in-differences approach we show that the effect is larger for banks that ex ante benefited more from the guarantee. We show that both the credit quality of new customers improved (screening) and that the loans of existing riskier borrowers were less likely to be renewed (monitoring), after the removal of public guarantees. Public guarantees seem to be associated with substantial moral hazard effects.

We need to apply this common sense to reform of Fannie and Freddie. Any reform that does not include them is simply a fraud on the American public.


An unpleasant hypothesis: the big red button?

Arthur Laffer in the June 6th WSJ article, Tax Hikes and the 2011 Economic Collapse, is a sobering read and expresses a view that is increasingly difficult to dismiss. He points to the plasticity of investor behavior in respect of tax incentives. Take a look at the graph below, excerpted from the article, and consider that the Reagan tax reductions were enacted in 1981 but did not go fully effective until 1983.



Mr. Laffer makes a compelling case that this works in reverse as well, and it's an ugly picture:



Plasticity of investor behavior is geek-speak meaning that investors tend to modify their behavior and their portfolios to accommodate changes in conditions & rules... kind of like when people move out of the way of large buses before they get hit.  Well, what fast moving buses might we have?

Rising taxes - see The war on capital: yours

Nationalization of private sectors - pick a sector. 

  • autos – nationalized
  • banking/finance - nationalized
  • health care - nationalized
  • education - in process
  • energy – in process

Declining macro returns on capital - Our scarce national capital has ceased to be allocated to highest & best economic uses. As national policy we see huge distortions of capital flows for losing propositions such as Cash for Clunkers; General Motors; Merrill Lynch (you do remember Merrill Lynch?); TARP; TARP II; pretty much everything on the Fed's balance sheet including AIG;  the counterparty payments to foreign banks & Goldman; federal funding for Acorn; or the IMF, all of which channel capital to political rather than economic purpose.  The outcome will be a lower national standard of living. Real productivity counts.

Uncertainty of rule of law & property rights - Look at the uncertainty of the rule of law and the vitiation of property rights such as in Kelo; the unprecedented & coercive settlements of claims of senior secured Chrysler & GM debt holders; the pending 'regulation' of the financial sector; or the outright unfathomable whimsy of US personal, corporate or estate tax code. 'Badges?....We don't need no badges!"

Loss of confidence- It is the loss of confidence in leadership, the current political structure, and the erosion of rule of law & property rights in the US that is currently being priced here. Risk assets in the US are now being discounted like those of a banana republic.  We all know the Euro is no longer viable as a reserve currency. The price of gold indicates the US $dollar is also under pressure.  Even Moody's has warned about the risk to the US's Aaa rating. This is how we create a scenario of declining macro productivity and increasing investor uncertainly. This is the impact of an endless loop of entitle, tax, issue debt, seek rent, and inflate. This is the process that will, in fact, turn Laffer's picture upside down.

That is where we are now.  All these trends increase investor uncertainty, raise risk premia, lower multiples, and slow or distort the capital allocation process by which scarce resources are allocated to the highest & best uses. 

Try allocating investment capital in this environment.   And in fact, right in the middle of this writing, we see Bank of Montreal come out with a rather plain but extraordinary dictum: they quit.

We advocate switching out of equity positions and going to cash. The European sovereign debt crisis appears to be nowhere near over. The global credit environment is worsening. Cost of capital is going up and availability is going down. There are large gaps between where the credit market prices risk and where the equity market is priced. Equity is lagging the deterioration in credit conditions. Moves in currency, equity and commodity markets are mirroring the moves in the credit market. Global growth, in a credit-constrained environment, will slow. Profits will be squeezed by the higher cost of capital. (Focal Points, June 8, 2010, Go To Cash- In Plain English by Mark Steele

This is a non-trivial pronouncement from a generally sober Canadian institution of global stature ... these guys aren't radicals ... and it seems they'll watch from the sidelines for now.  A client in the large scale excavating business asked recently in respect of portfolio management, "Every machine & piece of equipment I own has a big red button on it, an emergency shut down. Where's our red button?" 

Seems like BMO just hit theirs. They got spooked and fear that the European soverign crisis will migrate to the fragile European inter bank markets, seeing tells in CDS spreads and the US$/Euro currency swap spreads (already in process).  In their scenario the contagion starts in Europe, spreads to the Asian banks, which then in turn kills any global recovery. The central banks then run out of food, water, ammo, money, and ideas, and select European sovereigns & financials start to run short on US $ funding. The Fed will try to hide the symptoms, so watch the the currency swap spreads. The outstandings of foreign banks in the US commercial paper markets is the simple form of the canary in the coal mine.

Fortunately, we have our big red button, too (not yet, Bill!).  Before anyone jumps, I suggest you (always) read Jim Paulsen's latest where he raises the notion of 'irrational pessimism'.  He's the CIO, of Wells Capital Management, and one of the best in the business.  Bob Doll, chief equity strategist for BlackRock makes good, though less convincing to my eye, relative argument in support of The Bullish Case for US Equities.

I think it's premature for the red button, but note caution and diversification are never bad things.  We constantly talk about getting the risk budget right, how it translates to the appropriate asset allocation.

Many individuals and institutions simply can't afford to get it wrong. Most models assume normal distributions of returns and serial, stable correlations across asset classes over time.  And in times of market stress, of course, those don't hold so well, and the only thing that rises is correlation.  Keurtosis just makes a mess of everything,  and all the bets come off. What makes the asset allocation process so problematic these days is that the primary determinants are now politically driven. Unintended consequences ... you know, the thrashing about of idiotic, pompous politicians can induce powerful non-linear responses of chaotic systems to create Black Swan like events. Think of Congress, the Administration, and Alfred E. Newman chiming in, "What's this button for, Captain?"

And talk about distortions, keep your eye on these:

Tax driven selling pressure: There may very well be significant selling pressure for the balance of this year brought to bear by tax regulations. Investors with embedded long term capital gains in their portfolio will see this as the last year to monitize long term gains at the 15% rate, and they will. Additionally, this year offers the last chance to roll over traditional IRA's to Roth IRA's. Investors who will probably elect the conversion will likely be executing in aggregate for size. So you have a large pool of time constrained sellers of the net tax liability due on conversion.  All should should plan their tax and liquidity book well in advance.  A fellow doesn't want to be the last one through the door in December, particularly if the banks, foreign or otherwise, are having a tough time with year end liquidity. 

Fixed income dilemma: Short rates offer little to negative returns, but our thought (or more accurately, bias) is that now is not the time to buy duration or risk in search of yield. Be patient, stay short to intermediate term with a bias to high & investment grade credits.  Any retake of aggregate demand will stoke inflation fears, and people will find out what duration means. The counter trend is that the Euro is no longer viable as a reserve currency, which presumably will stoke the bid for US Treasuries (buy a drunk a drink?) and any further geopolitical conflict will drive the 10 year Treasury to less than 3%. Just to make things worse, just as you see the concern shift from deflation to inflation, you will likely see the correlations of bond and stock markets reverse.

So, two days after BMO tells the world to go to cash, the market is up ~200 points ... ummm, make that 270 now.  Perhaps a bad day for them, but if they're in cash they can go home early. Go figure.


(WWB does not offer legal or tax advice and nothing herein shall be so contrued.)



The Fed and the May 6th crash: more monkeys & darts?

Mark Spitznagel in today's WSJ piece, excerpted below, has got it exactly right.  We encourage all to read it in full and also in conjunction with our posting, No Better than Monkeys Throwing Darts, in which Larry Swedroe recounts William Sheridan's research on 'expert' economic forecasting.

Whenever markets are manipulated by regulatory fiat there are unanticipated consequences, systemic or otherwise. The wealth transfer, perhaps one of the largest of all time, from investors to borrowers effected by the artificial manipulation of low to negative real rates is having untoward consequences on market function and risk allocations.  One suspects there are many more unanticipated consequences yet to come.


"The profitability of an investment is simply its return on capital beyond the cost of that capital. It is against this spread that investors must assess risk. So when the Fed distorted the cost of capital following the 2008 collapse by lowering it for many by roughly 2% (to about 0% for banks), it had the same effect as the 2% higher aggregate dividend yield for stocks or higher credit spreads for investment grade bonds. Suddenly what was toxic looked cheap.

The Fed lured everyone to buy everything and anything that was risky—and did so itself with outright purchases of risky assets like mortgage-backed bonds. Anyone eager for easy profits fell right in line, bidding up dangerous assets like clockwork. Sensing safety in numbers, the herd quickly followed, and in no time the market had consumed the Fed's gifted 2% profit spread and then some.

The Fed has managed to align every little market fault right with each other such that they all succumb to the very same stresses at the very same time. Meanwhile—no surprise—the world remains a very seismically active place. What's extraordinary is that the Fed continues this intentional deception about the real cost of credit, even as we've repeatedly witnessed the consequences of this policy.

Left alone, the market works naturally, with waves of buy-order ruptures and waves of sell-order ruptures. Sometimes mini-ruptures coincide to form much larger ones, such as on May 6. But searching for a discrete trigger for such events is futile. To find the real source of the system's excessive fragility, the regulators will need to look much closer to home."

Do we want thin markets or thick markets? It's not a tough call.


What a shock!

The Houston Chronicle reports

Texas doctors are opting out of Medicare at alarming rates, frustrated by reimbursement cuts they say make participation in government-funded care of seniors unaffordable.

Two years after a survey found nearly half of Texas doctors weren't taking some new Medicare patients, new data shows 100 to 200 a year are now ending all involvement with the program. Before 2007, the number of doctors opting out averaged less than a handful a year.

“This new data shows the Medicare system is beginning to implode,” said Dr. Susan Bailey, president of the Texas Medical Association. “If Congress doesn't fix Medicare soon, there'll be more and more doctors dropping out and Congress' promise to provide medical care to seniors will be broken.”

More than 300 doctors have dropped the program in the last two years, including 50 in the first three months of 2010, according to data compiled by the Houston Chronicle. Texas Medical Association officials, who conducted the 2008 survey, said the numbers far exceeded their assumptions.

This is currently an under reported phenomena nationally, and one which will accelerate with the advent of our new national health care. Look for doctors, patients, and companies in the US to migrate away from the new nationalized system (think of the Post Office with operating rooms) into a few variations which will include a luxury service for the ultra rich; off-shore medical care competing on unregulated price, quality, and value; and some other variations we haven't thought of yet. Those who can not afford the off-plan services will be forced to use the national plan as there will be no affordable options. 

The proper word is monopoly, and we need look only to the quality of education delivered via the educational monopoly to the children of the major urban school districts. It is the proper model through which one can envision the glide path of our national health care.

Meanwhile we are left to ponder the fate of a whole new set of villians, at least as presented by our government.  You may cast your vote for these Texan docs, Goldman, or the greedy oil companies. 




The war on capital: yours

As our clients are concerned with the creation and preservation of wealth, we thought it might be helpful to present some very basic concepts as to the impact of taxation has on valuation. The linkage is not well understood, so read this, and you'll know more than most Senators.

Let's start with a corporation which, through some stroke of effort and luck, manages to be profitable:

Net Income before tax    $      100.00
Corporate tax @ 35%    $       (35.00)
Net Income after tax    $        65.00
less dividend (30% payout)    $       (19.50)
Add to retained earnings    $        45.50


Out of their $100 in pre tax profits, we assume they pay the corporate tax rate of 35%. We ignore state & foreign taxes for simplicity, which is just as well because you can't figure them without retaining a Wall Street law firm.  We further assume that an individual shareholder receives the dividend and must pay taxes (which we illustrate below at the prospective rates as indicated in today's Wall Street Journal).

    Current New
Dividend Income  $         19.50  $         19.50
Personal tax      
Current 15.0%  $          (2.93)  
New 43.4%  $       _______  $         (8.46)
Dividend after tax  $         16.58  $         11.04
% increase in tax   289%
after tax dividend income as % of current 67%


Let's focus: the after tax value of dividends to that individual is now 67% of what it was before.  You used to have a $1.00 of spendable income, you will have 67 cents. 

This will adversely impact every man, woman & child in the United States who plans on retiring; educating their children or themselves; providing for elder care, theirs or others; or simply accumulating enough wealth to buy a small boat or a fiancée a wedding ring ... you may recall the quaint notion in our distant past, the pursuit of happiness?  We see here simply a transfer of wealth, a 'taking' by fiat.

Back to the markets

Most valuation models of equity markets can ultimately be tied to the company's ability to deliver cash to its owners. Gordon's Dividend model defines equity value as a function of the present value of all the dividends the stock pays.

Gordon's model can be stated as

P_0 = \frac{D_1}{k-g}.

where P = the price or value; D = the dividend; k = cost of equity; and g = expected growth rate of D.

We're going to keep it simple. If you are the only shareholder of the whole market (kind of like Warren?) and your dividends are now only 67% of what they used to be, what do you think happens to the value of what you own? Yup, it goes down and by a bunch.  The value of the components of the S&P 500 as of Weds March 28 was $10,763,310 (source: The dividend yield was approximately 1.93% or $207,969.  Well, individuals have to pay taxes, so let's pay the taxes, hold the macro assumptions the same (without commenting on their validity) and see what happens to the implied value:

    After taxes  
    Current New
S&P $ Dividend yield   $     207,969  $         176,774  $       117,710
Cost of Equity   6.7% 6.7%
Growth rate of dividend   5.1% 5.1%
Value per model    $    10,763,310  $    7,167,098
$ Value of S&P 3/28/10  $    10,763,310  $               -  
% of S&P value 3/38   100% 67%


That 67% should look familiar to you by now. Your cash flows, if you think about it, are exactly what happens if someone takes 33% of your stock: you only have 67% of it left.  This is what is known as a tax on capital. This is what it does.

We should not get lost in the technical weeds: the purpose of this exercise is indicative. Analysts (aka 'propeller heads') can and should raise a host of problems/issues in this analysis, including but not limited to

  • many tax payers are, at least for now, not taxable including pensions etc.
  • a 5% growth rate is extremely optimistic, to be kind, and not static
  • a 6.7% cost of equity is low  
  • has the market has already priced this in? or
  • has the market already priced in changes to or a reversal of this tax?

We know enough, however, to conclude broadly that this tax is not good for equity values and potentially very bad. It is certainly detrimental to individuals who were planning on dividend or interest income from savings to retire, educate their children, provide elder care, or otherwise pursue happiness. As a matter of course these changes will increase the ability of politicians to monetize their ability to dispense economic privilege through manipulation of the tax & regulatory code and will increase the price of that service... yes, you may read that as a rational increase the in the cost of corruption and the value of rent seeking behavior. And certainly, the value of barter & black market activity will greatly increase.

As to markets, investors will modify their behavior and seek:

  • municipal debt
  • investment vehicles where income is not subject to double taxation
  • tax shelters in Roth & regular IRA's, but they will have less capacity to do so
  • opportunities to arbitrage tax rates

One important tactical issue for planning: the coming increase of tax rates on long term capital gains goes effective next year and may induce a wave of selling.  If you're relying on the sale of assets with embedded long term gains to fund college, retirement, or anything else, you might want to consider the timing of your sales.  In addition to the selling induced by the higher capital gains tax, there may very well be a wave of selling induced by the conversion of regular IRA's to Roth IRAs. It could get very crowded in the fourth quarter, and you don't want to be the last in line waiting to get out before year end. This could be non-trivial. 



On your knees & pledge allegiance

Based on the facts as I have come to understand them, I don't think the SEC has a case against Goldman. That’s not to say the SEC can’t make a boatload of trouble, or that they don’t have a specific agenda. They clearly do. It's also not to say that adverse facts might not show up. 

As far as I can tell, the identity of the securities in the portfolio was known to any investor who cared to look at the offering memo. The loan selection agent attested that it picked the reference loans (there was no cash product, this was synthetic). No one attested, as far as I know, that the loan selection agent did not select the loans. Everyone will attest that everyone had more opinions than fingers on each and every loan and tranche. Evidently, AIG liked some of them sufficiently well to write some CDS protection on them.

To do synthetics you need counterparties on both sides of the trade (and everyone, particularly institutional investors, knew this). Remember the old Venn diagram? The transaction takes place in the intersection of price, risk & liquidity views. This occurs in the private cash markets all the time, and is in fact necessary for complex and illiquid deals. When the rubber ultimately hit the road, everyone seems to have had access to the same information on the portfolio. 

Long is OK, short is NOT OK?

A sale is an expression of a view on price and risk with some liquidity preference baked in it. So is a purchase. The notion that a broker-dealer should not facilitate the expression of differing views of price or risk or liquidity preference leads to some very strange places. How is it that a broker-dealer whose mission is to service the needs of the putatively 'most sophisticated' investors in the world should be prohibited from:

  • the sale of any share of stock below the price at which they underwrote it?
  • the sale of a bond of any sovereign client at less than the original offering price? Or the forward sale of its currency below the current spot price?
  • the sale of any put option or futures contract on any bond or share of stock of any client whose securities they underwrote?
  • or any expression of a view of a future price or volatility of any loan, security, or derivative contract that is less than the current market or the originally underwritten price?

There may be more relevant facts as to the relationship between the loan selection agent than are currently visible, but as it stands now, I see defective business judgment in allowing Paulson effectively 'observation rights' at the front end of the underwriting process. This isn’t the Goldman of old, but again we note, the identity of the securities in the portfolio was known to any investor who cared to look.

There appears to be something else at work, and it starts with a revisionist view of how the mortgage market worked out.  Congress, of course, engineered & regulated the whole deal. You may remember the Community Reinvestment Act, Franklin Raines& Fannie, Freddie, Sallie, the Office of Federal Housing Enterprise Oversight (“OFHEO”), Barney Frank, Chris Dodd, and, oh, so many more!  Hmmm… we need a donkey on which to pin the tail and not just any donkey.

Call me old fashioned, but I thought the SEC used to try cases in court, not on TV or the front pages of the NY Times or the Wall Street Journal. If they've got a fraud case, put the hammer down and bust 'em. Otherwise this smells like regulatory & legislative manipulation.  Where’s my donkey?

It’s noteworthy that the SEC went after a Vice President…. a lowly, stinking Vice President? Seems they don’t have a case or won't or can’t bust senior people who can donate their way out of it.... that they just want to send a message to everyone that no matter what or who, and without regard for the processes and vetted market practice (and dare we say regulated?) at the time, we can retell the story to suit our needs. 

Don't get me wrong, this market stank.  And I am no friend of Goldman, but nowhere are we hearing that Congress set it up this way. Congress designed and mandated the regulatory framework & gave the rating agencies their monopoly power. The SEC, the FDIC, and the Fed presided over the failure of the control environment. The regulators knew it, and senior management ran the printing presses. This was all bought & paid for...and not by Vice Presidents at Goldman or junior auditing people. You need to ask: where did the originators of all this defective product get the juice? From whence the override on credit quality? The answer is Congress.

So, driven by the infinite wisdom of Congress, we created large concentrations of aggregated risk created by politically allocated capital; declare them unsafe after they’ve blown up; have the taxpayers underwrite the whole deal while allowing sovereign entities and foreign banks (the larger counterparties to AIG) to walk with no haircut whatsoever; and now propose to aggregate risks into larger, more concentrated pools of risk, and kick in $50 billion of contingent capital for grins.

Banks will become large zombies. Capital & risk will be allocated by political process and rent seeking behavior (green finance perhaps?). Think of large scale financial organizations who are protected from failure and whose creditors impose no discipline as they look to sovereign or semi-sovereign implied guarantees (GSA's anyone?). This, of course, creates organizations with the quality standards & acumen of General Motors. Innovative capital will try to move offshore, and taxpayers once again will pay the tab for any unpleasant long tailed risk that eventuates.

Oh, by the way, don’t even think about criticizing the financial reform bill.

This is how Alfred E. Newman manufactures six sigma events. Have you taken a look at municipal CDS spreads lately or perhaps state pensions?



James Grant on the US Treasury, rates, and the dollar

James Grant is a long time observer (and chronic bear) on interest rates and has an interesting interview on Bloomberg.  And the folks at Zero Hedge point out

Grant has put together a Treasury prospectus (which we will post as soon as we procure it) which as Jim puts it "is a compendium of the salient facts about the Treasury as if it were an issuer that did not have a printing press... All you need to know about the credit risk of the US." The first risk factor, via the GAO, "improper payments that should not have been paid by the Treasury totalled $98.7 billion, equivalent to 5% of Treasury outlays." Keep in mind the UST raised $333 billion in net debt in March, as we pointed out yesterday.

The Treasury prospectus will no doubt be a barn burner, and we recall Nassim Nicholas Taleb's quote not too long ago, “every single human being should bet U.S. Treasury bonds will decline."

Keep watching long Treasury's.


Through a glass darkly

"Our views on the way a government should run the economy can be described as “libertarian”: that is to say freedom to develop trade and industry within the framework of a strong and clear law. The most important part of the case for this economic freedom is not the way it produces greater prosperity but its consistency with certain fundamental moral principles of life itself. Each soul or person matters; man is imperfect; he is a responsible being; he has freedom to choose; he has obligations to his fellow man.

Morality is personal. There is no such thing as a collective conscience, collective kindness, collective gentleness, collective freedom. To talk of social justice, social responsibility, a new world order, may be easy and make us feel good, but it does not absolve each of us from personal responsibility. We don’t carry out our moral commitment by taking up a public stance on these things, but only by choosing to do something about them ourselves. You can’t delegate personal morality to your country. You are your country."

Thoughts on the Moral Case from the Margaret Thatcher Papers in Cambridge (courtesy of a Chicago based reader)


Important reading on broker dealer obligations or lack of them...

Jason Zweig's article in the WSJ, Brokers Win, Investors Lose Key Reform is an important read for those who wish to understand the actual risks of dealing with the broker/dealer community on an uninformed basis. However, I found Jan Sackley's comments on the article compelling, and I present them in whole below (with some nominal formatting changes).  For my thoughts see Comments below for this posting or go here.


The question on the table is whether or not Congress should require that individuals and firms that hold themselves out as providing financial advice to investors and others who seek financial management assistance (remember that some people do not "invest" in any securities but still require financial advice), should be held to a fiduciary standard so that the citizenry can be assured of a certain level of objectivity and professionalism untainted by the financial reward to the adviser.

If such a requirement is adopted, today's brokers could not be called "advisors", "consultants", or other titles that imply to the average consumer that the broker is an objective advisor. Rather, the broker should be correctly perceived by the public as a seller of products and services as a representative of his or her firm, and an insurance agent as a seller of insurance policies and annuities.

In contrast, the fiduciary-advisor is the customer of the brokers and agents. The fiduciary-advisor utilizes the services of brokers to fulfil their client’s wishes with respect to the purchase or sale of investment products. Or, the client could make his or her own selection of which broker or agent to use to buy (or sell) securities or purchase insurance products. The fiduciary-advisor and the broker should not be one and the same professional in a client relationship.

In other words, brokers and insurance agents would provide for the execution of trades or sell products to fiduciary advisors and individual consumers as their customers. If a fiduciary advisor is in the picture, they are an intermediary working on behalf of the consumer. Or, the consumer who does not want to pay an advisor for advice could go directly to the broker to have their transactions executed. It should be made clear to these consumers that the broker is not responsible for the consumer’s investment choices nor for the ongoing monitoring of those choices.

The concept of a "single" or "uniform" fiduciary standard implies that some regulator could simply author rules that are the “be all and end all” for fiduciaries. This misunderstanding is inconsistent with the reality that acting as a fiduciary is a behavioral concept, not a rules concept. Yes, there are certain guidelines that are articulated in regulations (and some statutes) from those agencies that regulate financial institutions that provide fiduciary services. Examples include

and, of course, SEC rules for registered investment advisors. In addition, Erisa fiduciaries must comply with both IRS and DOL rules on fiduciary behavior. States have statutes and rules as well.

In spite of all of these rules, all of the banking regulators (the states, FDIC, OCC and OTS) expect bank fiduciaries to act (behave) in accordance with common law principles, including those articulated in Scott on Trusts. I am not convinced that the SEC has this same expectation, or conveys it adequately in their rules, but that is a separate issue. Common law principles are often the decisional measures when a case is adjudicated, whether the "fiduciary" is a bank, a registered investment advisor, an executor of an estate, or any other financial fiduciary.

The debate about brokers possibly being held to a fiduciary standard must recognize that the business model followed today by brokerages is not consistent with common law fiduciary principles. The questions about commissions and proprietary products are non-starters; fiduciaries do not "sell" and thus do not (or should not) earn commissions. Proprietary products fall under the well-established Duty of Loyalty: mitigation requires full disclosure and well-informed consent, a specific statutory exemption, or a regulatory exemption that has been thoroughly vetted and open to comment.

It is puzzling why certain members of Congress do not want to provide our citizens with the comforting knowledge that someone called an “advisor” or a “consultant” is expected to put the customer’s needs at the forefront without any conflict created by compensation methods. Of course there will always be bad fiduciary apples, but at least the barrel would have a consistent framework.

Jan Sackley, Principal
Fiduciary Foresight, LLC
Risk Management and Regulatory
Compliance Consultants


Reproduced with the permission of the author, for which we are grateful.



Dynamite in the hands of children

The problem of the deficit and out of control spending is not as complex as many would make it.  The "deficit problem" for any government is not one issue, but two components:

  • Debt: if you have debt you have to pay it back, and the more you have, the more it costs
  • Investment: if you borrow money, what you do with it determines the generation of wealth, the economic outcome

So, by simple analogy, if you borrow money and buy a bottle, well, let's make it a case, of Château Ausone St. Emilion 1998, and throw a kicking party, the next day all you have is a headache and the debt to pay back. You may have joie de vivre, but you are impoverished. On the other hand, if you borrow the same amount of money and buy productive assets, the next day and for all future you will have the economic production of those assets. You may be dour, but you are creating wealth, the extent of which is determined by the economic productivity of the asset in which you invested.

To modify this example for sovereign states, you simply need to make the dollars bigger (add zeros !?!) and the time frames longer. A simple, but essentially correct analogy.

Even Moody's , continuing its tradition of better late than never, has noticed that all is not right with the fiscal house of the United States:

a small start to the big task of returning to a sustainable debt trajectory...Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the Aaa government bond rating

Nassim Nicholas Taleb of Black Swan fame is perhaps a little less delicate in his comments to Bloomberg:

“every single human being” should bet U.S. Treasury bonds will decline

“Deficits are like putting dynamite in the hands of children...they can get out of control very quickly.”

If Moody's, Taleb, and WWB agree on the Debt component of the deficit problem, we can declare consensus and move to the government's actions on the Investment side.  Our readers are already familiar with our analyses of Cash for Clunkers and the stimulus package.  More technical readers will recall our noting Mr. Robert J. Barro's comments that "the available empirical evidence does not support the idea that spending multipliers [for governmental stimulus programs] typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending." That's economist-speak meaning we bought the case of Chateau Ausone St. Emilion and threw the party, or more specifically, that the whole concept of 'stimulus' just doesn't work in the first place.

As a consequence, our nation will face a significantly reduced standard of living, our children will have diminished economic opportunities.

Investors will ask, "Ok, we got it. What do we do now?"

Those who know us also know that we are not inclined to modify long term investment strategies based on tactical issues or short term data. We are concerned about the broader, longer term issues and confess, in spite of much effort and open ended strategy sessions with people whose opinions we value, we're not at all sure we've got it figured out.  Humility is probably not a bad starting point.

We're clearly in for a run of greater uncertainty across all kinds of dimensions: 

  • domenstic & foreign fiscal, monetary & tax policy;
  • less certain property rights & rule of law in the US;
  • increasing loss of confidence in broader agency processes of all stripes, both sovereign & corporate; 
  • geopolitical instability, conflict & terrorism; 
  • credit risks of sovereign, municipal & financial entities;
  • an increasing dependency ratio domestically; and 
  • instability of the US tax code.

So, one implication is that investment strategy must accommodate uncertainty. Don't think you've got it figured out: you don't. Emotional responses to spot data are rarely constructive and generally very expensive.

Our view has been and remains that asset allocation is fundemental and must accomodate a prudent assessment of risk in face of uncertainty. Liquidity reserves are important and even though short rates are near zero, cash may be viewed in one sense as a call option on cheap assets. You also need it to not go bankrupt.

We do think one needs be cautious about fixed income strategy. The Fed is, of course, trying to drive investors out the yield curve into the killing fields of future inflation. It creates a dilemma: stay short & earn nothing or go long & get slaughtered. It's a real problem for the elderly or others living on fixed income, including many endowments. We thank Bernake for the invitation, but we'll pass. We've had a creeping bias to higher quality, short duration, and TIPS for some time and intend to keep it. 

Inflation risk is on everyone's mind. We are inclined to favor the view that equities over time tend to be the most effective source of real returns. While not a perfect solution, it is a sensible one and arguably a 'least bad'.  TIPS can be an important component of fixed income strategy, but a low real return is still a low real return. We also note that inflation indexing can be 'rigged' by those who tally what inflation is and also note that indexing works in reverse. Note tax inefficiencies for taxable accounts: inflation adjustments on TIPS are taxable.  We're not prepared to place a massive spread trade (buy TIPS/sell nominal long treasuries) but are intrigued with the idea. Nor are we ready to recommend inflation swaps or the purchase of dividend strips. We're not so sure that the people who may put you into these trades will be around to take you out....some of you may remember the firms formerly known as Bear Stearns or Merrill Lynch?

Rising tax rates will drive many to the municipal market, but stay out of the kill zone. Municipal credit & structural risk is non-trivial: note that Pennsylvania considers Chapter 9 bankruptcy protection as an option now. More will follow and many will start to trade like declining emerging markets debt. If you play in this sector, you'd better know your stuff as to credit & structural risk, market liquidity & execution. If not, we suggest you stay with a credit savvy mutual fund.

Equity allocations should be built for the long term. We retain our focus on highly diversified beta driven portfolios and cost efficiency. We haven't changed our approach, although we're always exploring new information. We simply don't buy the notion that short term trading generates sustainable value. We do think it's reasonable to revisit overall portfolio allocation strategy and suggest that any process be grounded by analytics. Emotion can be very costly, as can these four words: "this time it's different."

Longer term we as a nation must hope for and demand more responsible fiscal, economic and regulatory policies ... shall we just say responsible governance?

"Everyone wants to live at the expense of the state. They forget that the state lives at the expense of everyone."  Claude Frédéric Bastiat


We're from the government, and we're here to help

I tried to subscribe to the Dept. of Labor's emailing of employment statistics and came across this little gem. You have no idea how helpful your government can be.  May I suggest you sign up some friends for the full monte?

You may also be interested in information from these agencies 

By the way, it's a big file, so it may take a bit of time.


Part of the conversation, if you want to call it that

“I don’t go because it has become so partisan and it’s very uncomfortable for a judge to sit there,” he said, adding that “there’s a lot that you don’t hear on TV — the catcalls, the whooping and hollering and under-the-breath comments.”

“One of the consequences,” he added in an apparent reference to last week’s address, “is now the court becomes part of the conversation, if you want to call it that, in the speeches. It’s just an example of why I don’t go.” - Clarence Thomas on why he stopped attending State of the Union speeches (NYTimes 2/3/10)


"I'd cheat to keep these bastards out..."

Just heard this outburst by Ed Schultz of MSNBC on the job advocating voter fraud to defeat Scott Brown in tomorrow's special election in Massachusetts.

Regardless of one's political views, the advocacy of criminal behavior by a national media outlet to subvert our election process should not be tolerated by people of any political party or by the board of directors of any responsible media company that values its consumer constituency or its credibility.
Shareholders will evaluate this information and act accordingly. I intend to communicate my thoughts to the board of GE and invite readers to do the same. Contact data is provided below as is a graph of GE's stock price relative to the S&P 500 the source of which is the Investor Relations area of GE's website:
Contact info for GE Corporate Investor Communications:
Trevor A. Schauenberg
Vice President, Investor Communications
General Electric Company
203 373 2424

More on the negative multiplier

excerpted from Don't Like the Numbers? Change 'em in the WSJ

"The Obama administration claims a dubious "Keynesian" multiplier of 1.5 to feed the Democrats' thirst for big spending. The administration's idea is that virtually all their spending creates jobs for unemployed people and that additional rounds of spending create still more—raising income by $1.50 for each dollar of government spending. Economists differ on such multipliers, with many leading figures pegging them at well under 1.0 as the government spending in part replaces private spending and jobs. But all agree that every dollar of spending requires a present value of a dollar of future taxes, which distorts decisions to work, save, and invest and raises the cost of the dollar of spending to well over a dollar." - Mr. Boskin is a professor of economics at Stanford University and a senior fellow at the Hoover Institution.

If you read our earlier posting  Views on the economic stimulus package: is it effective? you begin to wonder. It seems the whole premise of Keynesian stimulation is questionable, if not discredited. Negative multipliers bring us to the result contemplated by our posting The car guys weigh in on Cash for Clunkers : take it out back and burn it.

What, then, is the purpose of such magnitude of effort and inefficient dissipation of taxpayer resources by policy makers?  


No better than monkeys throwing darts

"William Sheridan was an economist called in to testify in front of Congress on near term inflation. He got the brilliant idea to say, “You know what? I ought to check the track records of these other geniuses like me who have previously been called to testify on the outlook for inflation and see if they got it right.” And guess what he found? He found these geniuses had no better forecasting record than what is called naive forecast.  In economic terms, that means if inflation is currently 3%, you project 3%.  In other words, they were no better than monkeys throwing darts..." - Larry Swedroe, Principal & Director of Research, BAM Advisor Services, in Jan/Feb 2010 Journal of Indexes, Is Buy & Hold Dead?

Can we include the Fed as well?  How about those that predict when intermediate or long term becomes near term?