The Float

Wednesday Reading

Midweek sustenance for the inquisitive crowd...

• Two important questions from MarketBeat: The New Financial Rally -- Is It Real? and Has the Commodity Bubble Popped?
• The first cartoon in Barry's pair is especially apt.
• Calculated Risk notes NYT and WSJ coverage of rising mortgage rates.
• More from CR: The states' fiscal straits are just another canary in the very dusty coal mine known as the U.S. economy.
• Good stuff from Abnormal Returns on emerging markets equities as portfolio diversifiers.

Words of Wisdom

Two useful items from two of our favorite participant-observers: Mohamed El-Erian and John Hussman. Frist, from El-Erian's interview with Advisor Perspectives (bold text in original):

Another principle you advocate is the separation of alpha and beta in portfolio construction (something we have written about in our publication). Why has this principle gained in importance and how can advisors best implement it?

The dispersion of returns among actively managed strategies has become very large. In the old days, the dispersion resembled a "fan chart." It started with relatively small dispersion in fixed income classes, to larger ones in public equities and very large ones in illiquid asset classes. Today, we are seeing much more dispersion across all asset classes. The result is, unless you are absolutely confident of your active management choices, it is better to go passive.

The cause of this greater dispersion is that markets are more volatile. We came from a period (until the middle of 2007) that was very good to investors. Risk premia across all asset classes were compressing, delivering high returns and declining volatility. As long as investors were exposed and levered they did well. Now investors can get easily caught with the wrong position in a highly volatile environment. The hurdle for active management has gone up. You have to be sure you are actually getting something. You are paying higher fees and being exposed to more risk.

And here's Hussman, on the intertwined roles of government and Wall Street in the unwinding of the credit bubble:

As with the stock market bubble of the late 1990's, it is generally true that bad investments tend to go bad. There is little to prevent that from occurring. The only question is who bears the cost. Essentially, the Federal government issued hundreds of billions in debt, much of the proceeds which tax cut beneficiaries invested in mortgage bonds, without concern about loan quality because the debt had been tied to the good faith and credit of Uncle Sam, and now we've got to issue more government debt to bail out the losses from the bad investments.

One of the reasons that the recent credit crisis has been so wrenching is that the losses are being borne by institutions that have the explicit or implicit backing of the U.S. government, so it feels like the things that ought to be safe really aren't safe. But that is no accident -- bad credit sought out those institutions and their government backing, as the inevitable result of the swap markets (as described above). In the end, the implicit and explicit backing of the U.S. government -- which allowed all of this to occur -- is also what will be called upon to clean up the mess.

Read the whole Hussman comment, especially for his take on the making of the credit bubble. We think it's one of his best efforts.

Not Less...Fewer

Just because it's good. From The New Yorker...

Monday Reading

Today's whole-lotta-nothin' seems apt--a matter of digestion, if nothing else--after last week's furious snapback...

• We've been arguing for more than a year that U.S. consumers should (and will) enter into a period of balance sheet repair. On that topic, here's an interesting piece from the AP: "Will we stick to our newfound frugality?"
• From The Economist, the backstory behind all the trouble at Fannie and Freddie.
• And here's James Surowiecki asking a semi-blasphemous question (i.e., our favorite kind): Do we need Fannie and Freddie at all?
• Two interesting posts (here and here) from Barry Ritholtz on whether last Tuesday's reversal marked a bottom for equities.
• Bank of America is trading higher after today's not-as-disastrous-as-expected earnings release (though well off its intraday enthusiasm highs), but Calculated Risk notes a few less-than-encouraging items in the B of A conference call.

Friday Reading

This weekend, like so many, seems decidedly well-timed right about now...

• Granted, the sentiment rubber band was stretched pretty tight, but those who think the tough talk about short-selling hasn't contributed to this week's rally are kidding themselves.
• Here's more on the "Get Shorty" movement from Dean Baker (via Real Time Economics).
• As ever, the housing market is all about supply and demand, and they're stubbornly out of balance.
• More here on that from Real Time Economics.
• Acknowledging the lag in policy effects, Minneapolis Fed Prez Gary Stern makes hawkish noises about interest rates.

Just How Terrible is Housing as an Asset Class?

For some time now, we've been noting that the recently-concluded housing bubble wasn't like most of the bubbles that preceded it. Unlike the railroad, telegraph, and dot-com bubbles--which, for all their short-term wreckage, created new infrastructure of immense economic value, as Daniel Gross argues in Pop!--the housing bubble has left behind virtual ghost towns, economically useless infrastructure (e.g., roads, water, and power leading to virtual ghost towns), and a brutal overhang of household and government indebtedness.

So we were pleased to see the (sometimes breathless, often prophetic) Nouriel Roubini make special note of the unproductive nature of the U.S. housing stock. Here are the key passages from Roubini, via Naked Capitalism:

Sixth, the existence of [Government-Sponsored Enterprises,] GSEs...is a major part of the overall U.S. subsidization of housing capital that will eventually lead to the bankruptcy of the U.S. economy. For the last 70 years investment in housing –- the most unproductive form of accumulation of capital -– has been heavily subsidized in 100 different ways in the U.S.: tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures.

The reality is that the U.S. has invested too much – especially in the last eight years – in building its stock of wasteful housing capital (whose effect on the productivity of labor is zero) and has not invested enough in the accumulation of productive physical capital (equipment, machinery, etc.) that leads to an increase in the productivity of labor and increases long run economic growth. This financial crisis is a crisis of accumulation of too much debt -– by the household sector, the government and the country –- to finance the accumulation of the most useless and unproductive form of capital, housing, that provides only housing services to consumers and has zippo effect on the productivity of labor. So enough of subsidizing the accumulation of even bigger [McMansions] through the tax system and the GSEs.

We're not sure that the subsidization of housing capital "will eventually lead to the bankruptcy of the U.S. economy," but we're pretty sure it's not a very good use of currently-finite resources in growing the country's real wealth. But aside from that non-trivial quibble, we think Roubini gets this under-appreciated story exactly right.