12/29/10…risky business

…everyone is preoccupied with risk…something Americans love to discuss but are very poor at assessing. Rather than look at statistics we use our gut feelings which are most of the time wrong and as a result we don’t invest (gamble?) wisely.

Insurance companies are the best at it with reams of statistical data on everything yet even they can screw up badly. While TB doesn’t admire Michael Milken he does believe that he had a thorough understanding of risk…he showed that when people were buying junk bonds with double digit returns if the bonds didn’t default for five years they could earn as much as if they had bought low yielding U.S. treasuries. Unfortunately, he misused this and formed syndicates that ripped off the average investor and often the issuers themselves…once again greed at work.

It was the use of much of the junk bond proceeds however that was particularly appalling. Leveraged buyouts of companies with overfunded pension funds that were then raided and defeased with guaranteed investment contracts (GIC’s), how do they get to use the word ‘guaranteed’ when nobody else can? Because the insurers convinced Congress that no other investment could defease a pension fund in the same way. But not only did they pay low rates, some like Fred Carr’s Executive Life were among the ‘in crowd’ with Milken and loaded up with those very same junk bonds…and when they defaulted in mass, destroyed the very pension funds that were ‘guaranteed’ and the poor pensioners, like employees of Pacific Lumber and others.

As with AIG, where were the regulators??? It all stems from the holding companies so while the insurance subsidiaries were sound the holding companies were not.

Now let’s look at how the stock market evaluates risk. Despite the proverbial boilerplate that ‘past performance is no guarantee of future performance,’ whether it is hemlines, Super Bowl winners, or seasonal effects, Wall Street is always convincing us that it is time to buy!

Yesterday, they were pounding the ‘January effect’ which says that as January goes, so goes the year…after all they have 50 years or more of data supporting that ‘factoid.’ Really? How short are their memories? IF you acted on that in 2009 you would have sold near the bottom and missed the huge rally after it bottomed out in March…likewise this year – choppy as it was – also 2005…and 2003. 2000 while correct would no doubt have ‘whipsawed’ you into believing the best was yet to come.

Thankfully insurance actuaries do not pay attention to this kind of malarkey. It is meaningless drivel. Are 50 or even 100 points of any value in predicting anything when there are that many exceptions? Yet there was no mention of exceptions yesterday…only the January effect.

TB received a lot of comments on yesterday’s discussion of municipal bonds. All agreed with TB that Whitney is wrong…and that is enough to scare TB into believing HE is wrong. Seriously, muni bond yields are attractive now (in the long end ONLY), but that doesn’t mean they won’t stay attractive, yet the Bond King (Bill Gross) and others insist now is the time to buy them…and they may well be right…but for the income, not necessarily the capital gain aspect. Still if you can earn 6% tax free (or with BABS in an IRA or 401(k), they can be attractive but if you buy small size blocks you are going to be taken to the cleaners when you go to sell them…after all 30-40 years is a long time!

What is the best investment you could ever have made in a security for the long-term? 30 year zero coupon treasuries (Tigers/Cats/Lions) back in 1981 when long treasuries were yielding more than 10%…14% comes to mind. All you had to do was hold them (in a non-taxable account of course so you don’t have to pay tax on the accruals), and you had a 13% semi-annually compounded yield that would be coming due next year!

On the other hand had you bought the underlying bonds, which soared to premiums of 150 or more…nobody thought about the transfer of reinvestment risk for credit risk…especially those who bought those high premiums.

This goes for muni’s too. IF you buy a bond at a high premium, part of your interest payment is actually a return of principal and if you buy a 10% coupon to yield 5% you have to invest that coupon at the yield to maturity over the life of the bond or you will not get the yield you think you are getting…there are a lot of bonds trading at 5% or even 10% premiums in the short end of the curve that will not deliver the yield to maturity in this environment.

Conversely, a deep discount bond reduces the exposure to interest rate risk as it comes back in the form of capital gain…but that comes at the expense of more credit risk.

The point of the above is there is no free lunch…and those buying bonds that mature long after they will be with us may be taking on more risk (for their heirs) than they think they are. This is not to say it is wrong to do so but that along with the need to sell the bonds must be factored into the investment decision.

Happy Investing!

Now to yesterday’s markets. Bonds were weaker, dollar was weaker, gold closed at $1405.60 and crude closed above $91. Stocks however put in their usual lackluster performance after being down much of the day but surging back to close unchanged – mas o menos – on another low volume day despite being the close of the year for hedge funds.

12/17 2.02B – Quadruple witching! Highest volume since 6/25/10

12/20 829M

12/21 811M

12/22 784M

12/23 617M

12/27 468M – 2nd lowest of 2010, 11/26’s 428M was THE low of year and 3rd lowest since the 12/24/09 319M day which was lowest in decades!

12/28 560M

. . . - - - . . .    . . . - - - . . . (S.O.S.)

Hope you find today’s column thought-provoking. As always, you aren’t expected to agree with TB, but you shouldn’t listen to those who tell you all is rosy either…make your own choices.

Have a great day!


Trader Bill thinks it is clear to anyone reading these missives that they are merely commentaries...as he sees it...and do not necessarily reflect the views of anyone other than his own. Information is gathered from sources he has found reliable, but no guarantees of accuracy are implied. These are merely observations of events in the marketplace offering in an attempt to offer a non-mainstream viewpoint. Copyright TBD Capital LLC, December 29, 2010.


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