Reiterated on June 1st: Sell China.

Investech's Jim Stack had a terrific call last month, reiterated on June 1st: Sell China.

“We DO want to issue a formal warning about the Chinese stock market and Shanghai Index. This market has entered a speculative frenzy, with more new Chinese trading accounts opened on Tuesday of this week than in an entire month last year! The government is clamping down on the speculation, and has raised interest rates for the 2nd time in barely two months. We suspect the pinhole will go into the Shanghai market’s parabolic rise in the very near future. If you own Chinese stocks through ADR’s or China-dominated mutual funds, we urge you to take profits now.”
-InvesTech Hotline Report – May 18, 2007

I agree with what Jim calls "Bubble Dynamics:" Once created, bubbles do not deflate gradually – they pop with quite the mess for those investors who have been participating. Fortunately, China's stock markets are not nearly as integrated into their society as ours, so a correction in their markets are much less likely to impact consumer spending and sentiment.

Housing Inventory Build Worsens

Ritholtz

Inv_housing_20070605 Last week, we noted that the Housing Freefall Continues Unabated. Conversations with Real Estate Agents prior to the NYT story anticipated that column's thesis that this has been one of the worst Springs -- the peak real estate selling season -- in decades.

The net result of this is that the inventory of unsold homes continues to build, taking the housing mess further away from its final resolution.

Today's WSJ has the details:

"Growing inventories of unsold homes continue to weigh on the U.S. housing market, portending more downward pressure on prices, the latest data show.

The number of homes listed for sale in 18 major U.S. metropolitan areas at the end of May was up 5.1% from April, according to figures compiled by ZipRealty Inc., a national real-estate brokerage firm based in Emeryville, Calif. The data cover all listings of single-family homes, condos and town houses on local multiple-listing services in those areas.

The sizable increase is notable because, on a national basis, inventories of listed homes have typically been little changed in May during the past two decades, according to Credit Suisse Group. May is one of the peak home-selling months because families with children often aim to move during the summer vacation.

Some of the biggest inventory increases last month came in the metro areas of Seattle, up 12% from April; San Francisco, 11%; Los Angeles, 10%; and Washington, D.C., 9%.

Inventories also are up sharply from a year earlier. For the 15 cities for which year-earlier comparisons were available, combined inventory was up 29% from May 2006."

As inventory continues to build, the effect on prices is inevitable. Even in the face of steady demand, economics 101 is that prices will fall. However, we seem to have diminishing demand, even as inventory ramps higher. That's a formula for prices that will fall more than just modestly.

As we noted way back in 2005, a 20 - 30% drop from the peak is hardly unthinkable.

Home_sale_price_reductions


The impact of this is already showing up in various consumer sectors.

And yet, some fools continue to insist that the housing slowdown is having zero impact on the broader economy. The best response to that silliness comes from Raymond James' chief strategist, Jeff Saut:

"Now for those pundits that insist that real estate is not spilling over into the real economy, we ask the question, “Why has the Association of Home Appliance Manufacturers’ Index posted a roughly 10% decline in shipments?”

Or, “Why is Circuit City laying off 3,400 of its best sales personnel and attempting to hire maladroit sales people at a much reduced compensation package?”

Similarly, “Why is Citigroup cutting 15,000 financial-related jobs?” And, “Why is GMAC stating that its Residential Capital subsidiary is going to hurt profits?”

Inquiring minds want to know such things.

Moreover, if the problems in sub-prime mortgages are NOT spreading, why are sub-prime mortgage companies dropping like flies, why are companies like ACC Capital closing their “call centers,” and why are delinquencies rising not only in the Alt-A complex, but in prime portfolios as well?” (emphasis added)

The answers to these queries are rather obvious: Housing is impacting the rest of the economy in a significant AND ongoing manner.

Further, its no coincidence that 1) housing prices are falling; 2) Mortgage Equity Withdrawals (MEW) are contracting; 3) Retail sales have softened notably.

Indeed, the broader risk to the economy is the impact of the real estate price declines on consumer sentiment. MEW has already declined from over $844 billion to well under $400 billion over the past 2 1/2 years. We still have the upcoming adjustable mortgages resets -- and at considerably higher interest rates.

The final chapter in the impact of Real Estate on the broader economy has yet to be written . . .

What Three Months Can Do

David Merkel
Three months ago, the global financial markets were at their short-term nadir, but few knew it at the time. Long term bond yields bottomed then as well, which should be no surprise in hindsight. Since that time, the average 10-year swap rate (what a AA-rated bank can borrow at) for the 10 nations that I track (USA, Germany, Japan, Britain, Switzerland, Canada, Australia, New Zealand, Norway, and Sweden) have risen 53 basis points (0.53%). Equity markets have rallied, and implied volatilities and corporate bond spreads have fallen.

The correlated change in the global bond markets is significant, and if it runs another one percent or so, could derail the equity markets. Bond yields would then be fair relative to equity yields, assuming that the current high operating profitability continues, which is not guaranteed, though I think it will persist long enough to embarrass those who say it must mean-revert imminently.

There is a change going on here, and as for my balanced mandates, I think it means that I toss out my long bonds [TLT] for a small loss, and keep my duration short. As for my equities, no action for now, aside from ordinary rebalancing activity. Don’t panic, but be vigilant, and use your ordinary risk control methods.

How Do You Value an Insurance Business?

David Merkel

As Paul mentioned in the comments on the last post, I answered a question at Stockpickr.com today. James Altucher, the bright guy who founded the site, asked me if I would answer the question, and so I did. Here is a reformatted version of my answer, complete with links that work:


Q: Any thoughts on how to value an insurance business? What are the best metrics to use? In particular I’m looking at small cap insurers (P&C) as potential acquisition targets. Does that change the methodology?A: That’s not an easy question, partly because there are many different types of insurance companies, and each type (or subsector) gets valued differently due to the degree of growth and/or pricing power for the subsector as a whole.

Now, typically what I do as a first pass is graph Price/Book versus return on equity for the subsector as a whole, and fit a regression line through the points. Cheap companies trade below the line, or, are in the southeast corner of the graph.

But then I have to make subjective adjustments for reserve adequacy, excess/noncore assets, management quality, pricing power on the specific lines of business that write as compared to their peers, and any other factors that make the company different than its peers. When the industry is in a slump, I would have to analyze leverage and ability of the company to upstream cash from its operating subsidiaries up to the parent company.

Insurance is tough because we don’t know the cost of goods sold at the time of sale, which requires a host of arcane accounting rules. That’s what makes valuation so tough, because the actuarial assumptions are often not comparable even across two similar companies, and there is no simple way to adjust them to be comparable, unless one has nonpublic data.

My “simple” P/B-ROE method above works pretty well, but the ad hoc adjustments take a while to learn. One key point, focus on management quality. Do they deliver a lot of negative surprises? Avoid them, even if they are cheap. Do they deliver constant small earnings surprises? Avoid them too… insurance earnings should not be that predictable. If they become that predictable, someone is tinkering with the reserves.

Good insurance managements teams shoot straight, have occasional misses, and over time deliver high ROEs. Here are three links to help you. One is a summary article on how I view insurance companies. The second is my insurance portfolio at Stockpickr. The last is my major article list from RealMoney. Look at the section entitled, “Insurance & Financial Companies.”

Now, as for the small P&C company, it doesn’t change the answer much. The smaller the insurance firm, the more it is subject to the “Law of Small Numbers,” i.e., a tiny number of claims can make a big difference to the bottom line result. Analysis of management, and reserving (to the extent that you can get your arms around it) are crucial.

As for takeover targets, because insurers are regulated entities, they are difficult to LBO. Insurance brokers, nonstandard auto writers, and ancillary individual health coverage writers have been taken private, but not many other insurance entities. State insurance commissioners would block the takeover of a company if it felt that the lesser solvency of the holding company threatened the stability of the regulated operating companies. The regulators like strong parent companies; it lets them sleep at night.

One more note: insurance acquisitions get talked about more than done, because acquiring companies don’t always trust the reserves of target companies. Merger integration with insurance companies has a long history of integration failures, so many executives are wary of being too aggressive with purchases. That said, occasionally takeover waves hit the insurance industry, which often sets up the next round of underperformance, particularly of the acquirers.

How to Sell a Securitization

David Merkel

In securitizations, a series of assets, typically ones with well defined payoffs, such as fixed income (bonds and loans) and derivatives of fixed income get placed in a trust, and then the trust gets divided up into participations of varying riskiness. The risks can be ones of cash flow timing (convexity) and/or credit. Regardless of what the main risk is, the challenge for those issuing the securitization is who will buy the riskiest participations.

When the market is hot, and there are many players gunning for high income, regardless of the risk level, selling the risky pieces is easy, and that is what conditions are like today, with the exception of securitizations containing subprime loans. When the market is cold, though, selling the risky pieces is hard, to say the least. If market conditions have gotten cold since the deal began to be assembled, it is quite possible that the will not get done, or at least, get done at a much smaller profit, or even a significant loss.

In that situation, hard choices have to be made. Here are some options:

1. If there is balance sheet capacity, keep the risky parts of the deal, and sell the safer portions. Then if the market turns around later, sell off the risky pieces.
2. If there is a lot of balance sheet capacity, hold all of the loans/bonds and wait for the day when the market turns around to do your securitization.
3. Sell all of the loans/bonds off to an entity with a stronger balance sheet, and realize a loss on the deal.
4. Reprice the risky parts of the deal to make the sale, and realize a loss.

The proper choice will depend on the degree of balance sheet capacity that the securitizer has. Balance sheet flexibility, far from being a waste, is a benefit during a crisis. As an example, in 1994, when the residential mortgage bond market blew up, Marty Whitman, The St. Paul, and other conservative investors bought up the toxic waste when no one else would touch it. Their balance sheets allowed them to buy and hold. They knew that at minimum, they would earn 6%/year over the long haul, but as it was, they earned their full returns over three years, not thirty — a home run investment. The same thing happened when LTCM blew up. Stronger hands reaped the gains that the overly levered LTCM could not.

In this era of substituting debt for equity, maintaining balance sheet flexibility is a quaint luxury to most. There will come a time in the next five years where it goes from being a luxury to a necessity. Companies that must securitize will have a hard time then. Those that can self-finance the assets they originate will come through fine, to prosper on the other side of the risk cycle. Be aware of this factor in the financial companies that you own, and be conservative; it will pay off, eventually.

Listen to Cody on Risk Control

David Merkel

Cody has an point that everyone should listen to in his post, Cody on Your World with Neil Cavuto. I still regard myself as a moderate bull here, but it is altogether wise to take something off the table here. My methods have me forever leaning against the wind. As an example, near the close yesterday I trimmed some Anadarko Petroleum as a rebalancing trade. I still like Anadarko, but at a higher valuation, it pays to take something off the table. Why? Because we don’t know the future, and something could happen out of the blue that transforms the risk profile of the market in an instant.


So, what does this mean for me? I’m up to 12% cash in my broad market portfolio, which is higher than the 5-10% that I like it to be, but not up to the 20% (or down to zero) where I have to take action. My balanced mandates are taking on cash to a lesser extent. A 5.25% yield is pretty nice.


Now, here’s where I am different (not better, but different) than Cody. Cody advocated taking 20% off the table (in his Fox interview), whereas I am forever taking little bits off the table as the market runs. My robotic incrementalism takes the emotion out of the selling and buying processes. That said, I may leave something on the table versus someone making bigger macro adjustments.


Whatever you do, it has to be comfortable for you in order to be effective. The market may go up further from here; on average, I expect it will do so, but I can imagine scenarios where it will not do so. That’s why I take a little off the table each time my stocks hit upper rebalance points; my baseline scenario may not happen, and rebalancing to target weights protects against what is unexpected. It is a modest strategy that guards against overconfidence, and will always allow you to stay in the game, no matter how bad the market gets.


I don’t have to be a raving bull or raving bear. I just have to control my risks, and over the long run, I will do pretty well. Cody will do well too; he just does it differently.

Going Through the Research Stack

David Merkel

Once every two months or so, I go through my “research stack” and look at the broad themes that have been affecting the markets. Here is what I found over vacation:
Inflation

1. Commodity prices are still hot, as are Baltic freight rates, though they have come off a bit recently. Lumber is declining in the US due to housing, but metals are still hot due to global demand. Agriculture prices are rising as well, partly due to increased demand, and partly due to the diversion of some of the corn supply into ethanol.
2. While the ISM seemingly does better, a great deal of the increase comes from price increases. On another note, the Implicit Price Deflator from the GDP report continues to rise slowly.
3. Interest rates are low everywhere, at a time when goods price inflation is rising. Is it possible that we are getting close to a global demographic tipping point where excess cash finally moves from savings/investment to consumption?
4. At present, broad money is outpacing narrow money globally. The difference between the two is credit (loosely speaking), and that credit is at present heading into the asset markets. Three risks: first, if the credit ignites more inflation in the goods markets which may be happening in developing markets now, and second, a credit crisis, where lenders have to pull back to protect themselves. Third, we have a large number of novice central banks with a lot of influence, like China. What errors might they make?
5. The increase in Owners Equivalent Rent seems to have topped out.

International

1. Global economy strong, US is not shrinking , but is muddling along. US should do better in the second half of the year.
2. The US is diminishing in importance in the global economy. The emerging markets are now 29% of the global economy, while the US is only 25%.
3. Every dollar reserve held by foreigners is a debt of the US in our own currency. Wait till they learn the meaning of sovereign risk.
4. Europe has many of the problems that the US does, but its debts are self-funded.
5. The Japanese recovery is still problematic, and the carry trade continues.
6. Few central banks are loosening at present. Most are tightening or holding.
7. There is pressure on many Asian currencies to appreciate against the dollar rather than buy more dollar denominated debt, which expands their monetary bases, and helps fuel inflation. India, Thailand, and China are examples here.

Economic Strength/Weakness

1. We have not reached the end of mortgage equity withdrawal yet, but the force is diminishing.
2. State tax receipts are still rising; borrowing at the states is down for now, but defined benefit pension promises may come back to bite on that issue.
3. Autos and housing are providing no help at present.

Speculation, Etc.

1. When are we going to get some big IPOs to sop up some of this liquidity?
2. Private bond issuers are rated one notch lower in 2007 vs 2000. Private borrowers in 2007 are rated two notches lower than public borrowers, on average. Second lien debt is making up a larger portion of the borrowing base.
3. Because of the LBOs and buybacks, we remain in a value market for now.
4. Volatility remains low – haven’t had a 2% gain in the DJIA in two years.
5. Hedge funds are running at high gross and net exposures at present.
6. Slowing earnings growth often leads to P/E multiple expansion, because bond rates offer less competition.
7. Sell-side analysts are more bearish now in terms of average rating than the ever have been.
8. There are many “securities” in the structured securities markets that are mispriced and mis-rated. There are not enough transactions to truly validate the proper price levels for many mezzanine and subordinate securities.

The Premature Return of Equity REITs?

David Merkel
Ugh. After the purchase of EOP, I felt that equity REITs had reached valuation levels that not only discounted the lifetime of my children, but eternity as well. With the purchases of Archstone Smith and the Pennsylvania REIT, we are at valuation levels near those at the EOP purchase. My metric is equity REIT dividend yields versus the 10-year treasury yield. When one has to give up 1.2% in yield to move from safe Treasuries to risky REIT equity, there is something amiss. The valuation levels embed significant assumptions for growth in rents, which is particularly dangerous when the bull cycle in commercial real estate is so extended.


As a side note, before the purchases were announced, REITs looked the worst from a technical standpoint in the financial space. Now they are the best. So much for the utility of technical analysis.

Alt-A Loan Performance Statistics Getting Worse

David Merkel

Look at this press release from Fitch. Though it is only dealing with one set of securitizations, Residential Accredit Loan, Inc., or RALI, it is interesting to see how many 2005 and 2006 deals are experiencing poor performance, and as a result, the lowest classes in those deals are being downgraded.

Just a reminder that the stress in lending is not limited to only subprime lending. All non-prime lending is affected. This is just a straw blowing in the wind… but I would lighten up on financial stocks with significant commitments to Alt-A lending relative to their overall book of business.

When Will the Goat Reach the End of the Snake?

David Merkel
Speculation. Rampant speculation. This run in the market has to end soon, right? Right?!

Look, I’m not so sure. I have a lot to write on this topic, but not so much time. Market trends have a nasty tendency to persist longer than fundamentally-based market observers would expect. Let me give you the four things that could derail the markets, and tomorrow I can detail what I have seen in the markets concerning the four potential trouble spots (and more).

1. The recycling of US dollar claims from the trade deficit ends because the US dollar falls enough to make imports dear and US exports cheap. US interest rates rise as a result, stopping the substitution of debt for equity, and in some cases, leading to the raising of new equity capital. We have seen upward adjustments in many foreign currencies so far, but not enough to change the basic terms of trade.
2. Defaults in the bond and loan markets lead to a closing of the synthetic CDO market, which in turn leads to underperformance of many hedge fund-of-funds. Bond spread widen as risk returns to lending, and the substitution of debt for equity slows to a halt.
3. New supply comes to the equity market, overwhelming cash available. This could come from private equity seeking to liquefy marginal asses at favorable prices. Alternatively, this could come from private equity investments that are unable to pay their debt coupons. It is less well known outside of fixed income investing that most insolvencies occur because companies can’t make a coupon payment, not that they can’t refinance a principal payment.
4. Rising inflation in countries providing capital to the US forces them to revalue their currencies higher, and not keep sucking in US dollar claims, which don’t provide any goods to their people who want to buy goods to support their lives.

Interest rates need to be around 1.5% higher to shut off the speculation with near-certainty (did not work in 1987… rates got much higher.). Until then, the party can go on. I have an article being developed on this topic, but I fear it is a “next week” item.

Bottom Left Hand Drawer Issues

David Merkel

Back in the saddle. I have a lot to write about, but not so much time. The insights developed over vacation will be spread out over the next week or so.

Just a quick one to get started. In general, I think insurance companies with more than $100 million in assets should have their own investment departments, and not outsource the management of assets. (Note: to any insurance CEOs reading this — would you like a chief investment officer with experience in all major fixed income classes, equity, and derivatives, and a knowledge of the actuarial side of investing as well? E-mail me, and we can talk.)

I only know one insurance asset outsourcing larger than this, but Safeco has outsourced their asset management to Blackrock. I think that it is a mistake. Why?

1. Insurance companies excel at creating tailored liabilities, taking individual risks away, and pooling them. The same should be done with assets. Anyone can hire Blackrock (a very good firm), but an intelligent management will take the time and effort to develop in-house expertise, which is usually cheaper than most third party solutions. It gives up what should be a profit center for the enterprise as a whole.
2. Third-party arrangements miss what I call “The Bottom Left Hand Drawer” issues. I worked in insurance for 17 years, and I grew to love the competent but uncelebrated people in the company that did excellent work, but management thought were expendable. Third-party relationships lack the freedom for customization that in-house management allows for. Often because accounting systems don’t get it quite right, human intervention is needed. Someone makes an adjustment off of a schedule that they keep in their bottom left hand drawer once a year, and that keeps the system running right. In a third party solution, those issues can get lost; I have personally seen it fail.
3. Penny wise, pound foolish. The explicit expense savings are easy to see, but the implicit losses from not having someone managing the investments that is totally on your side is hard to measure. Though I can’t prove it, the soft costs are large.


If I served an insurance company again as an asset manager, I would want to serve that company only, and not run a third-party asset management shop. The work of an insurance company is important enough that it deserves the undivided attention of professionals on staff.

Away for the Next Week

David Merkel

2007 is the transition year at the Merkel household. Our two oldest children go off to college in the fall, and our youngest starts home schooling at the same time. As such, this is the last time that we can rely on that we will be able to take all of our children on a trip. In the late summer of 2006, we went to visit my wife’s parents in San Diego; next week, we visit my parents in Milwaukee.

Now, I have no idea what internet access I might have while there. If I have good access, I will post in the late evenings. If not, well, you’ll hear from me next on the 29th. With that, I sign off. I have a lot of other things to write about, but little time to do so. Traveling with eight children is quite a feat, and it will take a lot of my energy to accomplish that.

On Inflation

David Merkel

Inflation is a vague concept, because the term stretches to do duty in multiple areas: wage inflation, consumer price inflation, asset inflation, and monetary inflation, to name a few. I agree with what Milton Friedman said that inflation is always and everywhere a monetary phenomenon, but where I differ is that monetary inflation may express itself in terms of inflation in the prices of goods and services, or in asset inflation. Where inflation chooses to manifest itself depends on the balance of savers vs. spenders in a country. Monetary inflation plus saving equals asset price inflation. Monetary inflation plus spending equals goods and services price inflation.

As for the last week, I have a few articles to bring to your attention on inflation:

1. Baby Boomers need to think about purchasing power risk in their old age. This doesn’t mean overdosing on stocks, but it does mean considering investment classes that are correlated with inflation, like TIPS, floating rate bonds, selected commodities, and stocks of companies that produce them.
2. I’m on record that I don’t like the way that the US government calculates goods price inflation. From the way that they deal with owners equivalent rent, to the substitution effect, to hedonics (correct in principle, but they don’t do it right), to plain mismeasurement of the proper basket of goods, and the concept of core inflation, they mess things up.
3. Barry Ritholtz and I agree on many things. Inflation is one of them. These two articles express much of what I think about what is wrong with the measurement of inflation. Far better to use a median (Cleveland Fed) or trimmed mean (Dallas Fed) to eliminate volatility than to exclude food and energy. Food and energy are crucial to our lives, and they have been running at higher rates of inflation.

Inflation is growing in many areas of the world, including those that finance our current account deficit. Buying our bonds rather than letting their currencies rise, encourages inflation in their countries, while suppressing it in the US. There will come a day when they float their currencies, and then inflation will return to the US with a vengeance. When that happens, call Chuck Schumer to thank him for his vigilance on the Chinese exchange rate, not.

Insurance Earnings So Far 1Q07 — XII (Final)

David Merkel

Only three more companies to mention since my last post, here goes:

Primary Commercial

Employers Holdings beats estimates, but on falling premium volume. North Pointe misses earnings on falling premium volume, a higher loss ratio, and expansion expenses that can’t be deferred. Their acquisition looks interesting though; should be accretive to earnings.

Personal Lines

Affirmative Holdings misses estimates badly. More premiums, but higher loss and expense ratios.

Quarter End Summary

Here are the themes of the quarter. I would expect them to persist into the next quarter, which is what normally happens, but when themes don’t persist, the adjustment to prices can be severe.

1. Though the sell side has gotten into greater agreement with the idea that the top line doesn’t matter much (an idea that I support), the buy side did not agree this quarter. In general, companies that grew their premiums were rewarded, and vice-versa for those who shrank or stood still.
2. What worked: Primary Commercial, The Bermudans, Financial Guarantors and Life Companies. With Life companies, in general, the larger companies, and the ones with greater exposure to asset management did better. With Primary Commercial insurers and the Bermudans, in general the less conservative did better.
3. What sort of worked: Personal lines and Conglomerates.
4. Indeterminate: Title Insurers.
5. What didn’t work: Brokers, Mortgage Insurers and Specialty Credit players. Credit trends were poor in the first quarter, and brokers faced shrinking revenue from shrinking premium rates.

That was the quarter as I saw it. Did you find this series valuable? If so, e-mail me at the address listed at the Aleph Blog. I have a few ideas on how to make it better, but perhaps this is too superficial to be of use. If so, tell me, and I’ll focus on other things.

Back From Bermuda

David Merkel on

My blog isn’t meant to be mostly about insurance, but I’ve been writing about it a lot lately. After this, I should have one more wrap-up post about first quarter earnings, and that should be it.

My Bermuda trip went well. Here’s what I learned:

1. On net, pricing is actually improving at present. Property rates have been improving, with 6/1 and 7/1 renewals at the same level as last year. Casualty rates continue to deteriorate across almost all lines with aviation and D&O possibly having the most overcapacity. Florida rates have been improving, because insurers are buying coverage above the Florida Hurricane Catastrophe Fund, and second event coverage as well. Demand is high. (And Florida is not charging anywhere near enough for reinsurance in their fund… a disaster waiting to happen.)
2. Everyone wants to expand their specialty businesses, whether through tuck-in acquisitions, or lift-outs of underwriting teams. At the same time, more of the business is being written standard by admitted writers.
3. Because capacity with the highly rated carriers is adequate, the class of 2005 is having a hard time gaining enough business. This is exacerbated by the insureds generally taking higher deductibles, and insurers retaining more and ceding less. Also, sidecars are less needed in such an environment; many are maturing, and disappearing.
4. “Revenge of the Nerds” could have been the theme of the meetings. Only two of the 10 companies is growing their business. Most are doing buybacks, and rest, minus Axis, are considering it. All of them are following roughly the same investment models (excluding Max Capital), and all of them are following roughly the same risk control strategy, though a few are limiting their writings at absolute limits, rather than probability based limits, which have been known to overexpose companies when rare bad events hit.
5. Conservatism is generally a good, but over-conservatism is a bad. Platinum Underwriters is too conservative, and is losing vitality by not writing business unless they are almost certain they will make a 10% ROE. They are shrinking now.
6. Finally, reserves are the biggest area of disagreement. Everyone says their own reserves are conservative, but few are willing to prove it, like PartnerRe and ACE. XL may be going that way as well, disclosing reserve triangles. In general it seems that if there are problems, it should be located in the portfolios of the heavier Casualty writers, like ACGL.

I came away relatively happy with our positions. I like Allied World, Endurance, and PartnerRe roughly equally well. I was impressed with Flagstone, and think that it could be a good buy during a wind crisis. Arch and Max Capital presented well; there are reserving questions with Arch though. XL did well, but I still wonder if they have control over their lines the way PartnerRe does. Platinum is too conservative, and Axis smacked of braggadocio, somewhat touchy and defensive. Answers were among the least clear given.
Final note, on people: The Arch meeting was a hoot. They spoke their minds and dished on everyone, though not by name (clever analysts know, though). XL’s CEO expressed contempt for MR Greenberg (”glad he’s gone”), and AWH’s CEO talked about his friendship with Greenberg, and how it is bringing AWH business. Going with Harry Fong was a plus — his 30 years of experience is unmatched, and he has a quirky way of teasing the answers out.

Trendline Deception

Jeff Miller

Every investor looks at charts. Even those who are not technical analysts check out the captivating image. A chart conveys plenty of information at a single glance.

Then there is the problem of interpretation. At "A Dash" we have tried to do some de-bunking of deceptive charts. A type that is particularly deceptive is the phony trendline.

Interest Rates and the Trend

With the ten-year note approaching a 5% yield, investors are taking note. As a round number, it attracts attention. Some also see some technical significance. The chart below, cited today by Doug Kass in his influential column on StreetInsight (subscription required and worth it for serious investors) shows one interpretation of a long-term trend.

060407_sg430664_t Doug's interpretation, represented by the white trendline, is that a thirty-year trend to lower rates has been broken.

The implication is not clearly stated, but it seems that we are to fear an upside breakout in rates.

Interpreting Trendlines

A trendline based upon a moving average covering a relevant time period can be quite helpful. What about a "trend" that takes two data points, thirty years apart, and suggests some inference?

Our conclusion: Totally bogus!

There are several problems.

* Who cares about the slope from the peak of the high-inflation era in the late 70's to the peak of a year ago? If rates had been a little higher back then, the slope would be steeper. If rates had been a little lower at the peak, it would be more gradual. Use some common sense! What difference does the exact peak thirty years ago have for today's bond prices? None.
* Such charts are extremely subjective. The red line on the chart shows a different trend connecting several peaks. What did that tell us? If you started the chart in the 90's you would have yet another picture -- totally different.
* The conclusion makes no sense. The "trend" suggests that interest rates are going to zero at some point, mostly because of the 70's extreme. That rates would level off at some point is not at all surprising, and did not signal an out-of-control breakout.
* One could pick various other peaks and draw different lines. So what? The result is in the eye of the beholder, and the person drawing the trendline.

Factors Influencing Interest Rates

Barry Ritholtz at the Big Picture had a nice summary of fundamental factors influencing interest rates. The elements include an increase in global rates, strong foreign economies, reduced chances for an imminent Fed rate cut, and a possible move by foreign governments away from U.S. debt instruments. While Barry does not like to acknowledge this, we would add recognition by investors of greater strength in the U.S. economy, shown by all of the second quarter data.

The fundamental factors are important, and interest rates may well move a bit higher. It is an important thing for all investors to watch. We certainly are.

Conclusion

The "stock yield" from forward earnings projections remains much higher than the bond yield, even with bonds hitting 5%. That is part of our thesis for stocks moving much higher in 2007.

Meanwhile, we continue to wait for those who based recession forecasts on the inverted yield curve to draw the intellectual honest and consistent conclusion that recession chances have declined. Readers may wish to watch for this conclusion or whether the recession predictors use some tortured logic to explain why this time is different.

Our conclusion is that the economy is healthy and current interest rates are still supportive of higher stock prices.

Parabola Hyperbole

Jeff Miller

As we close the books on May, the S&P 500 has a two-month gain of nearly eight percent. We have offered reasons for investors to expect this advance to continue, although we certainly cannot vouch for the pace.

With increasing frequency we are seeing comments that the U.S. market gains are "parabolic" or sometimes "straight up." We will not cite specific references to those using these terms, but if you watch for them, you will see what we mean.

Terminology often has a strong symbolic content. It may be designed to express emotion or to convince readers of something that may not stand on facts alone. At "A Dash" we have noted the pervasive use of negative symbols in discussing the stock market, and sometimes offered alternatives.

Parabolas

We strongly suspect three things about parabolas and those following the stock market:

1. Even the really smart people who are following the market carefully do not remember enough geometry to define a parabola, or to write the mathematical equation. You can check your own definition here.
2. These same folks cannot draw a parabola.
3. Everyone knows that parabolic growth is some unsustainable pace. Parabolas precede bubbles and crashes. That is the source of the symbolism.

The figure below shows a parabola of the simplest form, where Y=aX^2.
Parabola The increase in values on the right side of the chart has that unsustainable exponential quality. You can see more images of parabolas at Wikipedia.

Parabolic Growth and Stocks

When the Shanghai Composite declined over 6% before Thursday's U.S. trading, there was plenty of discussion about whether this had a significant bearing on the prospects for U.S. stocks. Some suggested that both markets were "parabolic." Now that we understand what this means in factual --not emotional -- terms, a simple chart is worth many words.

Investing Blogs

Before there were blogs there were anonymous chat rooms. Now anyone who wants to be heard can just as easily create a Web log. But writing a useful investment blog that someone will actually read isn't so easy. First, you have to have good investment ideas. Second, it helps if your ideas are embedded in insightful commentary and third, it is probably best if you post your ideas quickly. Investors will forgive lousy navigation, advertising clutter, bad grammar and really any other Web site foul. In the end the most important thing is to make investors money. We find some of the more interesting investment oriented blogs in cyberspace. We can't guarantee their results but we can testify that they are good at distilling the barrage of daily financial information and occasionally will make you chuckle.

BestWhy.com Investing Advice http://www.bestwhy.com
Random Roger's Big Picture randomroger.blogspot.com
Inventing Money inventingmoney.blogspot.com

You are welcome to recommend more! I am not interested in reading facial formal, but lack of in-depth analysis news now. I am inclined to read online-blogs of those super professionals.