HY Spread vs Real Fed Funds Rate

that certainly looks like further spread tightening would not
be unjustified but we'll see where it all leads to.



(c) Moody's

Fortress Said to Be Chosen to Take Over Zwirn Hedge-Fund Assets

By Pierre Paulden, Katherine Burton and Jody Shenn

April 29 (Bloomberg) -- D.B. Zwirn & Co.’s $2.5 billion in hedge-fund assets will be taken over by Fortress Investment Group LLC, the New York-based manager of about $29 billion, people familiar with the decision said.

Zwirn’s board and some of its biggest investors chose Fortress, a New York-based private equity and hedge-fund manager, to liquidate the assets. Fortress was picked from nine candidates including a group headed by Irish financier Desmond Dermot, the people said. They asked not to be identified because the discussions are private.

Daniel Zwirn, 37, who runs the New York-based company, told investors in February 2008 he planned to wind down his flagship D.B. Zwirn Special Opportunities Fund LP. The fund makes loans to companies including those that have trouble getting financing elsewhere. Zwirn decided to close the fund when investors asked to withdraw more than $2 billion after a delay in the release of the fund’s 2006 financial audit.

Fortress’s takeover would mark the end of Zwirn’s involvement with his seven-year-old firm, which managed $5.5 billion at its peak. Zwirn, who will be paid $1.95 million by the fund in deferred compensation from 2008, used $13 million of his own money to run the company since October, the people said.

Brian Maddox, Zwirn’s spokesman, and Lilly Donohue, a Fortress spokeswoman, declined to comment.

The transfer of assets to Fortress must be approved by a majority of investors. Fortress will keep Zwirn’s remaining employees, the people said.

Remuneration

Fortress, founded in 1998, will be reimbursed for costs of winding down the fund, plus 1 percent of the fund’s net assets, the people said. It also will get 5 percent of any profit it makes. Zwirn’s investors will pay more than $21 million in one- time fees associated with the liquidation of assets.

The fund also will set aside $15 million to pay any future claims or fines. The U.S. Securities and Exchange Commission started investigating the company after Zwirn told investors in early 2007 that an internal probe found improper financial transfers and expense accounting.

Zwirn previously was a managing director and senior investment manager overseeing special opportunities for Highbridge Capital Management LLC. Earlier, he was a portfolio manager at MSD Capital LP, the money manager for Michael Dell, founder of Round Rock, Texas-based personal-computer maker Dell Inc.

How do I think could a distressed exchange offer for banks look like?

Some readers asked me how I think a distressed exchange offer for
banks look like? Basically not much different than how a coercive
exchange works when applied to other corporates but here are my
thoughts:

1) it will be coercive (since no bondholder would be willing to
exchange bonds)

2) it will to a very large extend wipe everything subordinated to senior
debt incl.
all types of pref. stock, hybrid securities, subordinated debt etc.. This
shock to holders of such kind of instruments will most likely shut down
the market for this type of instruments but the capital structure of banks
will most likely tend to become much more simple (including senior and
common) anyhow

3) regulators will have to push banks to do such exchanges because they won't
do it on their own. one key prerequisite is that those banks with a need to
re-capitalize mark their assets down to market, book all loss reserves
needed and show full transparency (yes we can).

4) this will show the amount of equity capital needed to bring the bank on a
firm footing (min of 10% equity)

5) during the time of an exchange offer government should guarantee all
depositors, all counterparts (incl. CDS) and continue to support the bank
to fund its operations

6) the exchange offer should include new debt which is senior (maybe secured)
to the old senior debt. If changes in the cap and or corporate structure are
needed to achieve this so be it. However, most banks do not operate under
the most strict debt covenants which block them from achieving this.

7) the exchange offer should put pressure for a limited amount of time on
bondholders to exchange as many bonds needed to re-capitalize the bank.
There are more ways to do this but one example would be. Each bondholder
exchanging old debt gets new (senior secured) debt with a haircut plus equity.
bonds not willing to exchange will be subordinated by each other bond
exchanging.

8) after a sufficient number of bonds exchanged from debt to new debt plus equity
the temp government can be released and the show can go on.

I think this is attractive since no more tax-dollars or increased government
debt would be involved. Some may fear that insurance companies will get wiped
out since they hold a lot of bank debt but the same scheme could be applied to
those who can't stand this.

Bonds: Why Bother? Written by Robert Arnott

Monday, 27 April 2009 15:58

(Editor's note: The following originally appeared as part of the May/June 2009 issue of the Journal of Indexes, "Rethinking Fixed Income." A complete list of the issue's stories can be found here.) For four decades, from time to time, we hear this question: Why bother with bonds at all? Bond skeptics generally point out that stocks have beaten bonds by 5 percentage points a year for many decades, and that stock returns mean-revert, so that the true long-term investor enjoys that higher return with little additional risks in 20-year and longer annualized returns. Recent events provide a powerful reminder that the risk premium is unreliable and that mean reversion cuts both ways; indeed, those 5 percent excess returns, earned in the auspicious circumstances of rising price-to-earnings ratios and rising bond yields, are a fast-fading memory, to which too many investors cling, in the face of starkly contradictory evidence. Most observers, whether bond skeptics or advocates, would be shocked to learn that the 40-year excess return for stocks, relative to holding and rolling ordinary 20-year Treasury bonds, is not even zero. Zero “risk premium”1? For 40 years? Who would have thought this possible? Most investors use bonds as part of their investment tool kit for two reasons: They ostensibly provide diversification, and they reduce our risk. They’re typically not used in our quest for lofty returns. Most investors expect their stock holdings to outpace their bonds over any reasonably long span of time. Let’s consider these two core beliefs of modern investing: the reliability of stocks as the higher-return asset class and the efficacy of bonds in portfolio diversification and in risk reduction. On careful inspection, we find many misconceptions in these core views of modern finance. Also, the bond indexes themselves are generally seen as efficient portfolios, much the same as the stock indexes. We’ll consider whether this view is sensible by examining the efficiency of the bond indexes themselves, and speculate on what all of this means for the future of bond index funds and ETFs. The Death Of The Risk Premium? It’s now well-known that stocks have produced negative returns for just over a decade. Real returns for capitalization-weighted U.S. indexes, like the S&P 500 Index, are now negative over any span starting 1997 or later. People fret about our “lost decade” for stocks, with good reason, but they underestimate the carnage. Even this simple real return analysis ignores our opportunity cost. Starting any time we choose from 1979 through 2008, the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor. In fact, from the end of February 1969 through February 2009, despite the grim bond collapse of the 1970s, our 20-year bond investors win by a nose. We’re now looking at a lost 40 years! Where’s our birthright … our 5 percent equity risk premium? Aren’t we entitled to a “win” with stocks, by about 5 percent per year, as long as our time horizon is at least 10 or 20 years? In early 2000, Ron Ryan and I wrote a paper entitled “The Death of the Risk Premium,”2 which was ultimately published in early 2001. It was greeted with some derision at the time, and some anger as the excess returns for stocks soon swung sharply negative. Now, it finally gets some respect, arguably a bit late … It’s hard to imagine that bonds could ever have outpaced stocks for 40 years, but there is precedent. Figure 1 shows the wealth of a stock investor, relative to a bond investor. From 1802 to February 2009, the line rises nearly 150-fold.3 This doesn’t mean that the stock investor profited 150-fold over the past 200 years. Stocks actually did far better than that, giving us about 4 million times our money in 207 years. But bonds gave us 27,000 times our money over the same span. So, the investor holding a broad U.S. stock market portfolio was 150 times wealthier than an investor holding U.S. bonds over this 207-year span. So far, so good. That 150-fold relative wealth works out to a 2.5-percentage-point-per-year advantage for the stock market investor, almost exactly matching the historical average ex ante expected risk premium that Peter Bernstein and I derived in 2002 in “What Risk Premium Is ‘Normal’?” Those who expect a 5 percent risk premium from their stock market investments, relative to bonds, either haven’t studied enough market history—a charitable interpretation—or have forgotten some basic arithmetic—a less charitable view. A 2.5 percentage point advantage over two centuries compounds mightily over time. But it’s a thin enough differential that it gives us a heck of a ride. From 1803 to 1857,4 stocks floundered, giving the equity investor one-third of the wealth of the bond holder; by 1871, that shortfall was finally recovered. Oh, by the way, there was a bit of a war—or three—in between. Forget relative wealth if you owned Confederate States of America stocks or bonds. Most observers would be shocked to learn that there was ever a 68-year span with no excess return for stocks over bonds. Stocks continued their bumpy ride, delivering impressive returns for investors, over and above the returns available in bonds, from 1857 until 1929. This 72-year span was long enough to lull new generations of investors into wondering “why bother with bonds?” Which brings us to 1929. The crash of 1929–32 reminded us, once again, that stocks can hurt us, especially if our starting point involves dividend yields of less than 3 percent and P/E ratios north of 20x. It took 20 years for the stock market investor to loft past the bond investor again, and to achieve new relative-wealth peaks. Then again, between 1932 and 2000, we experienced another 68-year span in which stocks beat bonds reasonably relentlessly, and we were again persuaded that, for the long-term investor, stocks are the preferred low-risk investment. Indeed, stocks were seen as so very low risk that we tolerated a 1 percent yield on stocks, at a time when bond yields were 6 percent and even TIPS yields were north of 4 percent. From the peak in 2000 to year-end 2008, the equity investor lost nearly three-fourths of his or her wealth, relative to the investor in long Treasuries. It's also striking to note that, even setting aside the opportunity cost of forgoing bond yields, share prices themselves, measured in real terms, are usually struggling to recover a past loss, rather than lofting to new highs. Figure 2 shows the price-only return for U.S. stocks, using S&P and Ibbotson from 1926 through February 2009, the Cowles Commission data from 1871–1925, and Schwert data5 from 1802–1870. Out of the past 207 years, stocks have spent 173 years—more than 80 percent of the time—either faltering from old highs or clawing back to recover past losses. And that only includes the lengthy spans in which markets needed 15 years or more to reach a new high. Most observers will probably think that it’s been a long time since we last had this experience. Not true. In real, inflation-adjusted terms, the 1965 peak for the S&P 500 was not exceeded until 1993, a span of 28 years. That’s 28 years in which—in real terms—we earned only our dividend yield … or less. This is sobering history for the legions who believe that, for stocks, dividends don’t really matter. If we choose to examine this from a truly bleak glass-half-empty perspective, we might even explore the longest spans between a market top and the very last time that price level is subsequently seen, typically in some deep bear market in the long-distant future. Of course, it’s not entirely fair to look at returns from a major market peak to some future major market trough.6 Still, it’s an interesting comparison. Consider 1802 again. As Figure 3 shows, the 1802 market peak was first exceeded in 1834—after a grim 32-year span encompassing a 12-year bear market, in which we lost almost half our wealth, and a 21-year bull market.7 The peak of 1802 was not convincingly exceeded until 1877, a startling 75 years later. After 1877, we left the old share price levels of 1802 far behind; those levels were exceeded more than fivefold by the top of the 1929 bull market. By some measures, we might consider this span, 1857–1929, to have been a seven-decade bull market, albeit with some nasty interruptions along the way. The crash of 1929–32 then delivered a surprise that has gone unnoticed, as far as I’m aware, for the past 76 years. Note that the drop from 1929–32 was so severe that share prices, expressed in real terms, briefly dipped below 1802 levels. This means that our own U.S. stock market history exhibits a 130-year span in which real share prices were flat—albeit with many swings along the way—and so delivered only the dividend to the stock market investor. The 20th century gives us another such span. From the share price peak in 1905, we saw bull and bear markets aplenty, but the bear market of 1982 (and the accompanying stagflation binge) saw share prices in real terms fall below the levels first reached in 1905—a 77-year span with no price appreciation in U.S. stocks. Stocks for the long run? L-o-n-g run, indeed! A mere 20 percent additional drop from February 2009 levels would suffice to push the real level of the S&P 500 back down to 1968 levels. A decline of 45 percent from February 2009 levels—heaven forfend!—would actually bring us back to 1929 levels, in real inflation-adjusted terms. Page 3 of 5 My point in exploring this extended stock market history is to demonstrate that the widely accepted notion of a reliable 5 percent equity risk premium is a myth. Over this full 207-year span, the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: Inflation averaging 1.5 percent trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical. Does that mean that we should expect history’s 2.5 percentage point excess return or the 5 percent premium that most investors expect? As Peter Bernstein and I suggested in 2002, it’s hard to construct a scenario that delivers a 5 percent risk premium for stocks, relative to Treasury bonds, except from the troughs of a deep depression, unless we make some rather aggressive assumptions. This remains true to this day. Bonds And Diversification If 2008­­–09 teaches us anything, it’s the truth in the old adage: “The only thing that goes up in a market crash is correlation.” Diversification is overrated, especially when we need it most. In our asset allocation work for North American clients, we model the performance of 16 different asset classes. In September 2008, how many of these asset classes gave us a positive return? Zero. How often had that happened before in our entire available history? Never. During that bleak month, the average loss for these 16 asset classes—including many asset classes that are historically safe, low-volatility markets—was 8 percent. Had that happened before? Yes; in August 1998, during the collapse of Long Term Capital Management (LTCM), the average loss was 9 percent. But, after the LTCM collapse, more than half of the damage was recovered in the very next month! By contrast, in the aftermath of the September 2008 meltdown, we had the October crash. During October, how many of these asset classes gave us a positive return? None. Zero. Nada. How often had that happened before in our entire available history? Only once … in the previous month. How bad was the carnage in October 2008? The average loss was 14 percent. Had so large an average loss ever been seen before? No. As is evident in Figure 4, October 2008 was the worst single month in 20 years for three-fourths of the 16 asset classes shown. For most, it was the worst single month in the entire history at our disposal. The aftermath of the September–October 2008 crash was, unsurprisingly, a period of picking through the carnage to find the surviving “walking wounded.” As Figure 5 shows, the markets began a sorting-out process in November/December 2008. Some markets—the safe havens with little credit risk or liquidity risk—were deemed to have been hit too hard, and recovered handily. Others—the markets that are sensitive to default risk or economic weakness—were found wanting, suffering additional damage as a consequence of their vulnerability to a now-expected major recession. The range between the winners and the losers was over 3,000 basis points, nearly as wide as in the crash months of September/October, but more symmetrically around an average of roughly zero. By the time the year had ended, bonds were both the best-performing assets and among the worst-performing assets. Consider Figure 6. The best-performing market on this list was long-duration stripped Treasuries—an asset class used in many LDI strategies—rising over 50 percent in that benighted year. The worst-performing asset is a shocker. It’s an absolute-return strategy—represented as a way to protect assets in times of turbulence—that takes short positions in stocks and long positions in bonds! In a year when the bond aggregates rose 5 percent and stocks crashed 37 percent, this strategy leverages that winning spread. Investors used these convertible arbitrage hedge fund strategies as a source of absolute returns, a safe haven especially in a severe bear market, and got an absolute horror show. Of course, it was unhelpful that the Convertible Bond Index went from 100 basis points below Treasury yields to (briefly) 2,400 basis points above Treasury yields. Nor was the brief SEC prohibition on short-selling over 1,000 different stocks helpful. Now, as the convertible arb hedge funds deal with their clients’ mass exodus, the convertible bonds are looking for a new home; after all, even if these hedge funds are disappearing, their assets are not. In 2008, the markets demonstrated that bond categories can be far more diverse and less correlated with one another than most investors previously believed. Indeed, in 2008, that was arguably even more true for bonds than for the broad stock market categories. The Efficacy Of Bonds This brings us to the second core belief of most investors: the efficacy of bonds for diversification and risk reduction. One little-known fact is that the classic 60/40 balanced portfolio has roughly a 98 percent correlation with stocks. Figure 7 shows the monthly returns for a 60 percent S&P 500/40 percent BarCap Aggregate portfolio against the returns for the S&P 500 over the past 40 years. The 60/40 portfolio gave us 38 percent less risk than the S&P 500. A 38 percent allocation to T-bills would have served as well for risk reduction. However, the 60/40 portfolio gave us an intercept (at zero stock market return) of 2.0 percent per annum, 1.4 percent better than a 38 percent T-bill allocation would have delivered. These data clearly show that—at least over the past 40 years—the BarCap Aggregate has been a far better way to reduce portfolio risk than cash. The slope of the yield curve is usually steep enough that the bonds do reward us well beyond their theoretical position on the CAPM market line. Diversification is another matter. Let’s assume that the goal of diversification is to reduce our risk by taking on new, uncorrelated risks in order to seek equitylike returns at bondlike risk—our industry’s holy grail—rather than merely to invest some of our money in low-volatility markets.8 Most would suggest that other risky assets should serve this purpose—if they offer an uncorrelated risk premium (e.g., if that risk premium is related to risk, not to beta). Conventional mainstream bonds do not serve us well in this regard, though many alternative bond categories do offer something closer to this definition of true diversification. Consider Figure 8, which is a classic risk/reward chart spanning the 10 years from March 1999 through February 2009. Thankfully, nothing on this graph offers equitylike return, other than stocks themselves: Everything else has performed far better. Much as we just determined, our 60/40 investor did barely better than the linear capital market line suggests (although stocks dragged our 60/40 investor perilously near the zero-return line for the 10 years ended February 2009). But, the conventional bonds (represented by the BarCap Aggregate) bring our risk down more because of their own low volatility rather than because of an uncorrelated risk premium. Over this decade, we had an array of asset classes at our disposal, many of which produced respectable returns; one even edged into double digits. A naive portfolio holding all of these asset classes equally would have delivered 5 percentage points more return, at a lower volatility, than our 60/40 investor. We can achieve true diversification by holding multiple risky markets with uncorrelated risk premia, and so lower our risk without simply relying on low-volatility markets. Achieving true diversification requires broadening our horizons well beyond conventional allocations to stocks resembling the S&P 500 and bonds resembling the BarCap Aggregate. Mainstream bonds alone don’t get us there. The Problem With Bond Indexes Let’s finally examine the mean-variance efficiency of the bond indexes. In 2001, Argentina’s debt swelled beyond 20 percent of the major Emerging Markets Bond indexes. Mohamed El-Erian, then manager of Pimco’s Emerging Markets Bond product suite, was repeatedly asked by other investors and observers, “How can you have no holdings in Argentina when it’s over 20 percent of your benchmark index?” He famously replied, “because it’s over 20 percent of the index and yet its fundamentals are rapidly deteriorating.” Why buy bonds from issuers that have already borrowed more than they can hope to repay? And yet, the more debt that a company or country issues, the more that a market-value-weighted bond index will “own” of that company’s debt. El-Erian’s succinct observation is kindred to the oft-cited cliché that banks will only lend you money if you don’t need it.9 The bond investor’s favorite investment ought to be with a borrower who can readily afford to repay the debt. The thoughtful observer will notice that, in this regard, bond indexes are no different from any other indexes. Consider when Cisco was nearly 4 percent of the S&P 500 (with barely 20,000 employees worldwide) and Nortel exceeded 30 percent of the Canadian market—both at the peak of the Tech bubble in 2000; consider when GM and Ford together comprised 12 percent of the U.S. High-Yield Bond Index in 2006, and when Yukos was 17 percent of the Russian stock market in 2003. In each case, that hefty weight reflected (among other things) the fact that the price was—with the blessings of hindsight—far too high, masking troubles that became evident quickly enough. Let’s start with the simple precept that we want to own more of any assets that we expect will deliver the highest returns. If that’s so, then if we own twice as much of an asset that has recently doubled in price—as we do in our cap-weighted index portfolios—the asset logically must be more attractive after doubling than it was at half the price. Such is the “Alice in Wonderland” logic of conventional cap-weighted indexes. One difference between stock and bond investors is that bond investors viscerally understand that if a creditor issues more debt, we don’t necessarily want to own more of that issuer’s debt. By contrast, many equity market investors are comfortable with the idea that our allocation to a stock doubles if the share price doubles; most bond investors are not. This is one of the reasons that bond index funds have not caught on nearly to the extent that stock index funds have. Our research on the Fundamental Index® concept, as applied to bonds, underscores the widely held view in the bond community that we should not choose to own more of any security just because there’s more of it available to us.10 Figure 9 plots four different Fundamental Index portfolios (weighted on sales, profits, assets and dividends) in investment-grade bonds (green), high-yield bonds (blue) and emerging markets sovereign debt (yellow).11 Most of these have lower volatility and higher return than the cap-weighted benchmark (marked with a red dot). And, the composite of the four indexes (marked with a grey dot) has better risk or reward characteristics than the average of the single-metric noncap indexes. Unsurprisingly, the opportunity to add value is greatest in emerging markets, substantial in high yield and less impressive in investment-grade debt, where the gap between fair value and price is likely to be small. Investors clearly want index exposure to bond markets (bond index funds and ETFs), but are wary of the fact that conventional bond indexes will load up on the most aggressive borrowers’ bonds. Index products can be constructed in ways that make the portfolio less vulnerable to the indexers’ Achilles’ heel: overrelying on the overvalued and vulnerable assets. The Fundamental Index concept is an elegant and simple way to do so. Equally weighted portfolios, minimum variance portfolios, maximum diversification portfolios and other structured products may do as well, or even perhaps better. But, the key is to get the price out of the weighting formula. Conclusion We manage assets in an equity-centric world. In the pages of the Wall Street Journal, Financial Times and other financial presses, we see endless comparisons of the best equity funds, value funds, growth funds, large-cap funds, mid-cap funds, small-cap funds, international equity funds, sector funds, international regional funds and so forth. Balanced funds get some grudging acknowledgment. Bond funds are treated almost as the dull cousin, hidden in the attic. This is no indictment of the financial press. They deliver the information that their readers demand, and bonds are—at first blush—less interesting. The same holds true for 401(k) offerings, which are overwhelmingly equity-centric. If 80–90 percent of the offerings provided to our employees are equity market strategies, is it any surprise that 80–90 percent of their assets are invested in stocks? And is it any surprise that they now feel angry and misled? Many cherished myths drive our industry’s equity-centric worldview. The events of 2008 are shining a spotlight, for professionals and retail investors alike, on the folly of relying on false dogma. For the long-term investor, stocks are supposed to add 5 percent per year over bonds. They don’t. Indeed, for 10 years, 20 years, even 40 years, ordinary long-term Treasury bonds have outpaced the broad stock market. For the long-term investor, stock markets are supposed to give us steady gains, interrupted by periodic bear markets and occasional jolts like 1987 or 2008. The opposite—long periods of disappointment, interrupted by some wonderful gains—appears to be more accurate. For the long-term investor, mainstream bonds are supposed to reduce our risk and provide useful diversification, which can improve our long-term risk-adjusted returns. While they clearly reduce our risk, there are far more powerful ways to achieve true diversification—and many of them are out-of-mainstream segments of the bond market. Capitalization weighting is supposed to be the best way to construct a portfolio, whether for stocks or for bonds. The historical evidence is pretty solidly to the contrary. As investors become increasingly aware that the conventional wisdom of modern investing is largely myth and urban legend, there will be growing demand for new ideas, and for more choices. Why are there so many equity market mutual funds, diving into the smallest niche of the world’s stock markets, and so few specialty bond products, commodity products or other alternative market products? Today, investors are still reeling from the devastation of 2008, and the bleak equity results of this entire decade. They have already begun to notice that there were opportunities to earn gains, sometimes handsome gains, in a whole panoply of markets in the past decade—most of which are still difficult for the retail investor to access. We’re in the early stages of a revolution in the index community, now fast extending into the bond arena. In the pages of this special issue of the Journal of Indexes, we see several elements of that revolution. In the months and years ahead, we will see the division between active and passive management become ever more blurred. We will see the introduction of innovative new products. The spectrum of bond and alternative product for the retail investor will quickly expand. We will shake off our overreliance on dogma. And our industry will be healthier for it. Endnotes 1) I use the term “risk premium” advisedly. The “risk premium” is the forward-looking difference in expected returns. Differences in observed, realized returns should more properly be called the “excess return.” Many people in the finance community use “risk premium” for both purposes, which creates a serious risk of confusion. I use the term here—wrongly, but deliberately—to draw attention to the fact that the much-vaunted 5 percent risk premium for stocks is at best unreliable and is probably little more than an urban legend of the finance community. 2) Our paper, “The Death of the Risk Premium: Consequences of the 1990’s,” Journal of Portfolio Management, Spring 2001, was actually written in early 2000. 3) For much of this section, we rely on the data that Peter Bernstein and I assembled for “What Risk Premium Is ‘Normal’?” Financial Analysts Journal, March/April 2002. We are indebted to many sources for this data, ranging from Ibbotson Associates, the Cowles Commission, Bill Schwert of the University of Rochester and Robert Shiller of Yale. For the full roster of sources, see the FAJ paper. 4) We used 20-year bonds whenever available. But, in the 1800s, the longest maturities tended to be 10 years. Also, in the 1840s, there was a brief span with no government debt, hence no government bonds. Here, we used railway and canal bonds, which were generally considered the safest bonds at the time, as these projects typically had the tacit support of the government. Think of them as the “Agency,” and GSE bonds of the 19th century. 5) Schwert, G. William, “Indexes of United States Stock Prices from 1802 to 1987.” Journal of Business, vol. 63, no. 3 (July): 399–426. 6) It’s not unlike trying to forecast future stock and bond market returns on the basis of the experience of the current decade. The folly of this exercise is a mirror image of our industry’s reliance on the splendid 1982–2000 experience to shape our return expectations, as far too many investors, actuaries, consultants and accountants actually did in 2000. 7) While it’s simple arithmetic, it bears notice that a 120 percent bull market recovers the damage of a 46 percent bear market with precious little room to spare, amounting to a few tens of basis points a year. 8) Never mind the fact that a passive investment in 20-year Treasuries would have delivered exactly this over the past 40 years! 9) This clearly was not true during the lending bubble of 2005–2007. 10) See Arnott, Hsu, Li, Shepherd, “Valuation Indifferent Weighting for Bonds.” Journal Portfolio Management, pending publication. Please note that there are U.S. and international patents pending on this work; we respectfully request that anyone wishing to explore this idea honor our intellectual property. 11) Because measures like sales and profits are meaningless for sovereign debt, we use a different set of weighting metrics, still in keeping with the spirit of using measures that correspond to the size of the issuer. For countries, we define size using population, area, GDP and energy consumption.

Missing the early bull market can be costly.

The bull-market versus bear-market-rally debate has been going on for a while. A few analysts have been advising caution and riding out the current uncertainty, suggesting investments in gold, TIPS or some fixed income /cash variant. For instance, this Yahoo video featuring John Mauldin has him suggesting that new bull markets go on for years and years (suggesting we’ll have plenty of time to be sure). Thus it’s better to be a few months late than a few months early.

Here’s what he says:

The great bull markets last for decades, so you'll have plenty of time. Those who bought at "the bottom" in 1974 had to suffer through the rest of the 1970s. So stop sitting on the edge of your seat waiting for that perfect moment to buy and just remain cautious for a while.

Well, maybe not. Here’s a few facts courtesy Fidelity:

• While bull markets have often lasted for multi-year periods, a significant portion of the gains have typically accrued during the early months of a bull market rally.


• Within six months, more than one quarter (27%) of an entire bull market’s performance (on average) was already in the books.


• The first 12 months of the average bull market has provided more than 40% of an entire bull market’s price appreciation, yielding on average 45% for investors.


• Those who choose to re-enter after a few months of positive performance—when the climate feels “safe”—may miss a sizable portion of a bull market’s overall gain.

Here's a chart showing the huge returns in the first few months of a new bull market.



Investing from the mid contraction point versus the mid expansion point can lead to very different results.



At the beginning of this bear market, when sentiment was bullish and this was just a bull market correction, charts like this were all over the place, warning investors against trying to time the markets. It’s a telling sentiment indicator that one does not hear too much from the long term buy-and-hold investors. This bear market has been hard on investor psychology.

Stock markets reward investors precisely because the investors are willing to invest despite the uncertainty. Hence the equity risk premium. In fact, if you miss the beginning of a new bull market, investing in bonds will outperform buy-and-hold indexing over the economic cycle.

Market timing is hard! Precisely because you need to get it right twice: knowing when to sell, AND when to buy back. Investing for the long term during volatile times like these feels hard. But this is exactly when one needs to be focusing on the long term.

GM exchange structure and some thoughts on banks

The GM exchange offer is in my view a harbinger on what
we are likely going to see when it comes to the next round
of bank recapitalizations. Haircuts! The exchange is structured
in favor of workers and less than perfect for bondholders. Governments
ability to protect bondholders is limited and decreasing. What does this
mean for banks? Tax payers have injected and guaranteed a lot up to this
point. The next round of bills will in my view be on bondholders. No clue
how they will call and how and over which weekend they like to do it but
it will be a debt for equity swap and bondholders giving up part of their
debt in exchange of equity and thereby recap the banks. The too big to
fail and toxic asset discussion will go away after that. Too big to fail
can to a large extend be solved by establishing a clearing house for all
off-balance sheet instruments (Lehman would not have failed if they had
this in place). it is not true that the toxic assets can't be valued and
can't be traded. The US is far ahead in the process while Europe is not
fully awake on all the issues. However, if US banks are restructured in
the way as I have suggested European taxpayers will recognize and follow.
Bondholders in financial institutions should be aware of this. I would
like to avoid any outright longer dated financial institutions exposure and
seek protection for the portfolio in this regard over the next view month.
Credit default swaps (of protection) on European insurance companies (they
are higly exposed to this theme) look very, very cheap (especially compared
to US peers). 

Another View: Seeing Value in Beaten-Down Loans

Jack Yang, a managing partner at Highland Capital Management, which manages $30 billion in debt investments, offers his views on the current state of the bank loan market.

The global financial crisis has generated unprecedented volatility in the loan market, with credit spreads near their highest levels in history. The collapse of the subprime mortgage market had a contagion effect on all structured products including collateralized loan obligations, or CLOs, which are backed by bank loans.

This has resulted in one of the most rapid and severe periods of asset deleveraging in history.

Technical factors, such as the suspension of the CLO market, historically one of the largest buyers of loans, and forced selling by hedge funds and banks have driven prices down to levels never seen before.

The fall in the loan market has far outpaced the deterioration in fundamentals, even assuming that global economic fundamentals continue to worsen.

In October 2008, more than $3 billion in loans were auctioned off as CLOs and other financing programs unwound. Massive deleveraging in the market drove the S&P/LSTA Leverage Loan Index down a previously unthinkable 29.1 percent at the year’s end, before seeing positive momentum with returns of 9.8 percent through the first quarter of 2009.

Measured by implied default rates, loan valuations are cheap.

With the average price of loans around 65 at the end of March, the implied default rate, according to S&P Leveraged Commentary & Data, is roughly 45 percent, far exceeding the previous actual default peak of 8.2 percent in 2000 and the current 4.8 percent default rate, as measured by the number of issuers.

While it is anticipated that defaults will rise above previous peaks, we believe it is highly unlikely they will come close to the level implied by current prices and spreads.

This record disparity between actual and implied defaults means loans’ current risk premium should offer a sizable cushion against rising defaults. Loan prices are now trading about five points below their historical recovery rates of 70 percent (1990‐2008) 30 days after default, and well below their 80 percent historical recovery rate after a workout.

By both measures, today’s levels are difficult to justify based on fundamentals.

The extreme market stress has obscured the market’s fundamentals. Over the past 10 years, loans trading above a price of 90 have comprised the lion’s share of the market. At the end of first quarter 2009, 53 percent of loans are priced below 70, unlike the previous correction in October 2002, when only 15 percent of the market traded below 70.

We believe this disparity is attributable to the more technical and illiquid nature of today’s market rout as a result of indiscriminate, motivated selling, as opposed to the fundamental nature of the prior recession. In the absence of well‐reasoned credit analysis, good and bad credits are being grouped together.

Investors with strong credit research capabilities and experience in evaluating recovery values can potentially purchase high-quality assets at what may prove to be fire-sale prices resulting in significant absolute and relative performance.

The extreme turmoil in the credit markets has caused the price levels of higher‐rated assets to converge with those of riskier assets. We believe it is very difficult to justify today’s current valuations in loans, even if it is assumed that global economic fundamentals will continue to worsen. While a direct path to recovery is unlikely, we see no reason to overlook the current potential risk‐return profile of bank loans.

As in previous cycles, we anticipate the market’s healing will begin with the highest‐rated asset classes, and then move down the capital structure with increasing signs of economic stability, market improvement, and ultimately, liquidity.

Jack Yang is a managing partner at Highland Capital Management. He is based in New York.

Once a cure for insomnia, hedge fund operations now keeping everyone awake at night

Hedge fund operations have been thrust onto the front pages over the past 6 months as a result of some high profile cases of fraud, proposed new regulations and redemption gates. So we’ve come to Grand Cayman this week to find out how the hedge fund community is responding to these pressures. Much of this year’s “GAIM Ops” program focuses on due diligence, liquidity, third party administration and compliance - all of which have suddenly become key sources of competitive advantage in the post-Madoff world.

We’ll try to live-blog part of this one for you (as we did for Battle of the Quants in NY in February) so stay tuned. In the meantime, here is a round-up of stories that have caught our eye recently…

Power to the Hedge Funds! Long demonized, they may be the model firms of the future (Newsweek): It has become very rare for a mainstream media outlet to endorse the hedge fund industry. Is Newsweek’s piece last week a sign that mainstream anti-hedge fund rhetoric is waning? You be the judge.

“The industry’s total capital plunged by $600 billion to $1.33 trillion as of the end of the first quarter of 2009, during which investors yanked another $104 billion out of them, according to data released Tuesday.

“But here’s the key point: the fallout happened very quietly-with no systemic risk discernible. Compared to the overlong horror movie we’ve been watching-Night of the Living Dead Banks-what happened in the hedge-fund world sounds almost healthy and clean. After all, that’s the way capitalism is supposed to work: incompetents go out of business, smart guys clean up. And overall, the hedge-fund industry has shown remarkable resiliency in the face of the catastrophe, turning in a gain of 0.53 percent in the first quarter.”

Demand for Hedge Fund Separate Accounts ‘a Knee-Jerk Reaction’ (Bloomberg): A couple of weeks ago we wondered if the sudden popularity of managed accounts might actually have a negative effect on many investors. Now some experts are questioning the very basis for the trend.

“Hedge fund investors’ growing demands for separate accounts may be an overreaction to increasing redemptions and fraud, participants said at an industry conference in Hong Kong this week.

“‘I think the demand for managed accounts is to some extent a knee-jerk reaction to the liquidity mismatch that the industry has had,’ said Au King-lun, chief executive officer of the Hong Kong office of Financial Risk Management, a London-based fund of funds manager overseeing $10 billion.”

According to a forecast from Casey Quirk and Bank of New York Mellon last week, funds of funds will soon represent only 43% of HF assets. This, after making up nearly half in 2007 (see chart below from report).

This may have been a pretty good call. Data released by HFR last week shows that 85% of redemptions in Q1, 2009 were from funds of funds. That means that the funds of funds seem to have been sitting on idle cash waiting for redemption day - essentially creating a buffer between the single managers and the redeeming investors. Critics will wryly suggest that funds of funds do have some redeeming qualities after all (at least, last month).

Bank cutbacks aid hedge funds (Financial Times): Not only are banks providing hedge funds with less competition for talent (see, for example, “Star commodities traders ditch banks for hedge funds“), not now they’re leaving the best trades for them too.

European pension funds increase weightings in non-traditional asset classes (Mercer): More evidence that alternative investments aren’t going away any time soon…

“Following last year’s unprecedented market conditions, European pension schemes are increasing their allocation to non-traditional asset classes to manage their risks more effectively, according to Mercer’s annual European Asset Allocation Survey. The survey of over 1,000 European pension funds with assets of €400 billion found that 35 percent of UK schemes and 60 percent of European schemes (excluding the UK) expect to introduce new investment opportunities into their portfolio to help manage future investment risk.

“Tom Geraghty, European head of Mercer’s investment consulting business commented: ‘Despite being innately diverse in history, culture and regulatory requirements, European pension funds have all felt the effect of the last year’s market turmoil. The banking crisis and collapse of Lehman Brothers highlighted the operational risks associated with the investment of institutional assets and brought counterparty credit risks more into focus. Funds are now looking at ways to manage the risk inherent in their schemes, mainly through further diversification of their assets.’”

25 Years to Bounce Back? Try 4½

By MARK HULBERT

HISTORICAL stock charts seem to show that it took more than 25 years for the market to recover from the 1929 crash — a dismal statistic that has been brought to investors’ attention many times in the current downturn.

But a careful analysis of the record shows that the picture is more complex and, ultimately, far less daunting: An investor who invested a lump sum in the average stock at the market’s 1929 high would have been back to a break-even by late 1936 — less than four and a half years after the mid-1932 market low.

How can this be? Three factors have obscured this truth from investors: deflation, dividends and the distinction between the Dow Jones industrial average and the overall stock market. Let’s consider them one by one:

DEFLATION The numbers show that from a peak, on a closing basis, of 381.17 on Sept. 3, 1929, the Dow needed until Nov. 23, 1954, to return to its old high. But that’s in “nominal” terms, without adjusting for the effects of inflation or its opposite, deflation.

The Great Depression was a deflationary period. And because the Consumer Price Index in late 1936 was more than 18 percent lower than it was in the fall of 1929, stating market returns without accounting for deflation exaggerates the decline.

DIVIDENDS These payouts played a big role in the 1930s. When the Dow hit a low of 41.22 on July 8, 1932, for example, the dividend yield of the overall stock market was close to 14 percent, according to data compiled by Robert J. Shiller, the Yale economics professor.

So ignoring dividends, especially when yields were so rich, also exaggerates the losses of a typical equity investor.

THE DOW VS. THE MARKET Many researchers consider the overall market — defined as the combined value of all publicly traded stocks — as the best gauge of a typical investor’s experience. The Dow is made up of just 30 stocks, which are weighted in the index according to their price rather than their relative market capitalization.

Perhaps the most celebrated illustration of the Dow’s failure to represent the overall market traces back to a 1939 decision to delete International Business Machines from the Dow 30 list. I.B.M. wasn’t restored to the index until 1979. Norman Fosback, editor of Fosback’s Fund Forecaster newsletter, has estimated that the Dow would have been more than twice as high in 1979 had I.B.M. stayed in the index continuously.

It’s unclear when the Dow would have returned to its 1929 pre-crash high had I.B.M. not been deleted in 1939. In response to a request, an analyst at the indexes division of Dow Jones said that it was unable to determine the answer. But because I.B.M.’s stock was one of the best performers during the 1940s, greatly outpacing the Dow itself, it’s certain that its inclusion would have markedly accelerated the index’s recovery.

So when did the overall stock market really make it back to its pre-crash peak? Just four years and five months after its mid-1932 low, according to data provided to Sunday Business by Ibbotson Associates, a division of Morningstar.

That seems remarkably fast, given that the stock market lost more than 80 percent of its value from its 1929 high to its mid-1932 low.

But the quick recovery of the 1930s is consistent with the typical experience after other bear markets in the United States.

DETERMINING the precise length of such recoveries is a problem, given the many definitions of a bear market. Whatever definition is used, however, the typical recovery time is quite quick.

In fact, according to a Hulbert Financial Digest study of down markets since 1900, the average recovery time is just over two years, when factors like inflation and dividends are taken into account. The longest was the recovery from the December 1974 low; it took more than eight years for the market to return to its previous peak, which was reached in late 1972.

None of this, of course, guarantees that stocks will have a quick recovery from the market decline that began in October 2007. But it suggests that the historical record isn’t as bleak as it looks.

Why I Fired My Broker

With his 401(k) in ruins, our correspondent visits investment gurus, hedge fund managers, and a freakish Arizona survivalist with one question in mind: How can the ordinary investor recover?

by Jeffrey Goldberg

Also see:

Video: "The Con Game"

Jeffrey Goldberg tells Bob Cohn why he bought gold, stocked up on lanterns, consulted a survivalist—and finally fired his broker.

For most of our adult lives, my wife and I have behaved in the way responsible cogs of capitalism are supposed to behave—we invested in a carefully calibrated mix of equities and bonds; we bought and held; we didn’t overextend on real estate; we put the maximum in our 401(k) accounts; we gave to charity; and we saved, but we also spent: mainly on gasoline, food, and magazines. In retrospect, we didn’t have the proper appreciation for risk, but who did? We were children of the bull market. Even at its top, my investment portfolio was never anything to write home about. Its saving grace was that it was mine. And I imagined that when we did cash out, at 60 or 65, I would pass my time buying my wife semisubstantial pieces of jewelry and going bass fishing like the men in Flomax commercials.

Well, goodbye to all that. I took a random walk down Wall Street and got hit by a bus.

How am I sure it’s goodbye? The signs are rampant, but one has become stuck in my mind: a video of Richard Bernstein, the chief investment strategist for Merrill Lynch (sorry, I mean the Merrill Lynch division of Bank of America, which, by the time you read this, may be the Bank of America division of the United States Government), advising Merrill clients such as myself that one of the best financial strategies to adopt now would be to extend my “investment time horizon.”

“If one were to trade the S&P 500 for one day, the probability of losing money is about 46 percent,” Bernstein states. “However, as one extends that time horizon from one day to one month to one quarter to one year to 10 years, the probability of losing money decreases as the time horizon lengthens.”

To which I would add this observation from Keynes: “In the long run, we are all dead.”

This is what I heard Bernstein say: give up. You’re not going to make money on your investments in the next 10 years, or 15, or 20, so you should stop worrying about your portfolio and go to the movies like everyone else.

I called Bernstein and asked him if he was, in fact, advocating a form of Stoicism. He said I was misinterpreting his views. “This is not some sort of psychological compensation device. What I’m saying is that in looking for investment ideas, we should be looking over a five-, six-, seven-year time period. You have to give an investment strategy time to reach gestation.”

But my investment strategy gestated for 15 years. And then it died.

As I write this, the markets are back down to 1997 levels. In Japan, they’ve sunk to 1983 levels. I pointed out to Bernstein that 1983 was 26 years ago. The investor who bought Japanese equities in 1983 and held on to them has stayed absolutely flat. “That’s not correct,” Bernstein said. “That doesn’t take into account dividend payments.”

Even with all those munificent dividend payments, my net worth has dropped by a third, and new vistas of worry open up for me each day.

I’m not complaining, by the way, and not only because I have no right to complain. I make more money than most Americans. I will ungrudgingly pay more taxes if it means keeping people in their homes—even the schmucks in overleveraged McMansions. My wife and I are lucky. We have substantial equity in a small but perfectly nice house in Washington, D.C., a city that is now, among other things, America’s financial-services capital, which should help keep real-estate prices steady. I have a late-model minivan. Most important, I have a job (and in the thriving magazine industry, no less!). If I lose my job, then I’ll complain (at which point, of course, I’ll no longer have a public venue for my complaints). But for now, no whining: just confusion and bemusement and fear, along with an uncharacteristic sense of paralysis. In the past six months, I’ve bought and sold virtually no equities. And I rarely take the pulse of my 401(k).

I called a psychologist to find out what could explain this weird passivity. Daniel Kahneman is a Nobel Prize–winning innovator in the field of behavioral economics. He explained that my feelings of paralysis were to be expected.

“You no longer know the world you live in,” he said. “You played by the rules, the rules benefited you. The world functioned according to some regularities. Right now, it’s unclear what rules apply. There is a new regime. What seemed prudent earlier has disappeared. I’m surprised Americans aren’t more panicked. Americans seem to accept a level of insecurity in their lives that Europeans wouldn’t tolerate. Paralysis is one response to this level of insecurity.”

This might explain why my wife and I have taken no action to fix our finances. Although it’s also the case that we haven’t heard from our Merrill broker in nine months. The last time he called was well before the day in September when the government encouraged the shotgun sale of Merrill to Bank of America, to keep Merrill from collapsing.

I should have seen the signs of dysfunction much earlier. It was more than a decade ago that our first Merrill Lynch adviser put us in a company called Boston Chicken. A Merrill analyst described it as “the restaurant concept of the ’90s.” It went bankrupt in 1998. Only later did I learn that Merrill had underwritten the initial public offering for Boston Chicken stock, and so had an interest in selling the company to its customers. There were other brilliant pieces of advice—long-term “buy and hold” recommendations that emerged from the Merrill analysis factory: Qualcomm; Sun Microsystems; Nokia; and Citibank, of course, which has recently dipped as low as a dollar a share. The full-service trading fees at Merrill—$80, $100, $130, for modest chunks of stock—were high, but we were told that we were paying a premium for quality research.

In many cases, we were. Bernstein, the chief strategist, has actually been bearish for much of the past decade. Given his recent disposition toward market pessimism, I asked him why he didn’t tell Merrill’s clients to dump their equities seven months ago. “I said it as best as I could within reasonable professional standards,” he said. “I’m not going to yell ‘Sell, sell, sell!’ I’m not going to go out and be irresponsible.”

I imagine that many of Merrill’s clients are now wishing that Bernstein had been more irresponsible. Of course, even if he had said something, my financial adviser might not have relayed the message.

I haven’t depended solely on Merrill Lynch for advice. I believed I could find investments for myself. I stayed away from mutual funds because I couldn’t figure out who ran them. And I applied Warren Buffett’s famous dictum—Don’t buy something you don’t understand—to my trading, so I bought, in our Merrill Lynch account, such companies as Johnson & Johnson and Procter & Gamble and Illinois Tool Works and Caterpillar, and these have been kind to us, until now. (I also bought the Internet company Ariba, because I heard about it from a guy who heard about it from a guy. It went up to about $1,000; I didn’t sell, of course, and now it’s at $8.) And every so often, I would follow the recommendations of the financial magazines, SmartMoney in particular, because for a long while I was an ardent consumer of financial pornography. No more. In the harsh light of recession, I find it hard to believe I listened to a magazine that, in August 2007, recommended American Express at $63 a share (a “conservative way to make hay from global credit-card growth”), which as I write this is selling for $13 a share; Wynn Resorts, $94 then, $20 now; HSBC, $93 then, $25 now; Washington Mutual, $36 at the time, seized by the government last September—rendering the stock worthless.

It turns out that my crucial mistake was believing that the brokers and wealth managers and cable-television oracles who make up the financial-services industrial complex actually had my best interests at heart. Or so say the extremely smart—and wealthy—people I asked to help me figure a way out of my paralysis. One of these people was Robert Soros, the deputy chairman of the fund started by his father, George. I went to see him at his office, where he spent two hours performing an autopsy on my assumptions.

“You think a brokerage should be a place you go to pay commissions for fair and unbiased advice, right?” he asked.

“Yes,” I said.

“It’s not. It never has been.” He then cited another saying of Buffett’s: “‘Wall Street is a place where whatever can be sold will be sold.’ You are the consumer of their dreck. What they can sell to you, they will sell to you.”

“But they told us—”

“They lied.”

He went on: “You should be disheartened and disappointed. But don’t kid yourself. You’re a naive capitalist. They were never your advisers. Do not for a moment think that a brokerage firm is your friend.”

“So who’s my friend?”

“You don’t have one. This is the market.”

“Okay, that’s Merrill Lynch. What about the others?”

“They’re not your friends,” Soros said patiently.

“What about Chuck Schwab?”

“All brokers move products based on volume and commission,” he said.

I had a benevolent, advertising-induced understanding of Schwab. It was the billboards: “I’ve got a lot less money. And a lot more questions. Talk to Chuck.” And: “It’s not just money. It’s my money. Talk to Chuck.”

I thought that perhaps Schwab, a discount broker, might be able to answer the question Soros could not: Why had my full-service financial adviser stopped calling me?

I did what I was told, and called Chuck. His spokesman intercepted the call. I explained that I was trying to understand the role financial advisers play in the life of the small investor, but the spokesman, Greg Gable, said that Chuck would not, in fact, talk.

“We’re not going to be able to help you out,” he said.

Finally, I went to another highly successful financial adviser, named Larry Gellman, who is an iconoclast and a critic of his industry. He came up with a plausible reason why Merrill did not actually seem to care about my financial future, or the financial future of my children.

“Throughout the late 1990s, investors were firing their brokers and money managers because they didn’t own enough tech and Internet stocks, so everybody got loaded up at the tech party right before the cops came,” Gellman said. “Most of them were busted and never even got a drink. Some of them got lawyers and came after their brokers. So the brokerage firms all came away saying, ‘Never again.’

“If the head of Merrill Lynch and every other investment firm had their way,” he continued, “no individual broker would ever recommend an individual stock or bond to a retail client again. They have essentially gotten out of the brokering-and-advising business and gone all in on the ‘wealth management’ business. The new model is to gather assets from wealthy people and then place those assets with a whole bunch of managers who will manage different pieces of it in diversified styles so you don’t lose it all at once. And by the way, people with less than $10 million need not apply.

“People like you are in a sort of purgatory because no one would ever come out and tell you that he doesn’t want your business anymore,” he said. “You had to figure that out by yourself.”

There’s quite a bit I have to figure out by myself now, which was one reason why, on a cold night in February, I turned up at the apartment of my friend Boaz Weinstein, who was hosting a gathering to talk about charity in a time of financial cataclysm. Weinstein lives in a not-overly-luxurious-but-luxurious-enough building on Fifth Avenue. It is not the sort of building I could ever afford, but I tell myself I am not inclined to live on Fifth Avenue anyway; long-term exposure to liveried elevator operators would eventually bring me to Marxism.

“Do you like this job?” I asked the operator in Weinstein’s building. He was a sagging man of 65 or 70; his eyes were rheumy and his nose spider-webbed with disintegrating capillaries.

“It’s a job,” he said. He paused. “I’m retired.”

“But you’re working,” I said.

“Yeah. I’m working.”

The coatrack in the hallway outside Weinstein’s apartment was crowded with sensible coats. The passed canapés inside were utilitarian, as passed canapés go. These were my kind of rich people, I thought, not the piggy kind, no John Thains or Stephen Schwarzmans in the bunch, certainly no Bernard Madoffs. (I met Madoff once. He wasn’t very nice. I think he judged me too poor to bother robbing.) We had gotten together to talk about charity, but I was hoping to learn about my own economic future. These were people who were calculating present values as 10-year-olds; people who had actual Swiss bank accounts; people who short Treasuries on their BlackBerrys; and one person, Weinstein himself, who won a Maserati in a poker tournament.

The writer Jonathan Rosen has described New York now as having a posthumous feel, but this was not entirely the case in Weinstein’s apartment, which was vibrating with superficial good cheer. Economic disintegration provokes in some people strange feelings of lightness. Of course, some of the people gathered there—say, those who spent the past year short-selling bank stocks—were experiencing the strange feeling of lightness that comes from acquiring huge, stinking piles of money. But on the whole, anxiety lurked beneath the bonhomie. Within 10 minutes of my arrival, two friends separately and quietly suggested I buy gold, and right now.

“You have to guard against the massive debasement of the dollar,” one said. I explained to him my theory of market peaks—that the moment I buy a stock or a commodity is the moment it peaks. In any case, I would need substantially more of those soon-to-be-debased dollars to buy gold. But his arguments seemed sound.

Then another friend approached. “You don’t want to be long gold. The dollar is the currency of last resort for the entire world. There’s little chance of debasement.” His argument also seemed sound. Everyone seemed to be in possession of sound arguments. Even people on CNBC sometimes seem to be in possession of sound arguments.

Weinstein stood up to make introductions. He was one of the early innovators in the field of credit-default swaps, and he earned billions of dollars for his former employer, Deutsche Bank—and tens of millions for himself—until last year, when his trades cost the bank $1.8 billion (though some of the bank’s positions rebounded by $600 million). I am in no position to judge what happened; Weinstein’s attempts to explain to me the workings of credit-default swaps have not borne the fruit of enlightenment.

Bill Ackman, the founder of Pershing Square Capital, was to lead the discussion. Ackman is tall, prematurely gray, and immoderately self-assured, the sort of winning figure who could be elected to the Senate one day, if the country ever decides to stop hating hedge-fund managers. Weinstein introduced Ackman as a perspicacious investor, which he is, generally. Early in the current crisis, he suggested publicly that the decision of the bond-insurance company MBIA to guarantee billions of dollars of complicated mortgage investments would come to no good. But, like Weinstein, Ackman was not having the best year; one of his funds was betting solely on the resurgence of the Target corporation’s stock, and Target’s performance was not covering Ackman in glory.

“I thought this was a perfect time to talk about philanthropy and investing, because they’ve merged; they’re both tax-deductible at this point,” Ackman said, opening his talk. He spoke mainly of the psychic rewards of charitable giving, and of specific projects he supported. He asked for questions, which mainly concerned his prodigious charitable giving. Then someone asked a question about Ackman’s reputation:

“It used to be that in America, if you were a successful businessman, you were well-regarded. Now it seems that you are an evildoer if you’re successful, particularly in the financial world. Your profile is getting bigger. Do you think that’s good, or do people say, ‘He should be spending more time in the office and not so much out there’?”

Ackman responded: “A lot of hedge-fund managers I know are incredibly charitable and also fundamentally great people. But the press—first of all, you don’t make that much money working for the press. Take The New York Times. The New York Times doesn’t make that much money, and the people who work there don’t make that much money. So you think about people who work for the press—generally, they resent people who have financial success. A combination of that, plus some bad actors in the business, is a negative. Why did I go on Charlie Rose? Why have I been a little more public? Part of that is to blunt some of the negative associations with our industry.”

Hmmm. Yes, well.

It only seemed right for me to stick up for my fellow ink-stained proles, so I decided to make an intervention. But then I thought, This is Bill Ackman standing before me. He’s a great investor. Maybe he can give me some advice.

So this is what came out of my mouth: “What do you tell the ordinary mortal—say, the person who works in the press that you talked about—what do you say to the person who has $20,000, $50,000, $100,000, or $200,000, maybe, parked somewhere doing nothing? What is your advice right now for that person?”

I looked around. The wizards in the room were having difficulty calculating figures of such humble size. I had thought $200,000 sounded like a large and unembarrassing number. But the room reacted as if I had asked, “Bill, I have 75 cents in my pocket. Do you think I should buy Twizzlers or a big red gumball?”

Ackman answered: “First, it depends on when you’re going to need the money. I’ve always said that if you want to take risk—any risk—you have to be prepared to put your money away for five years or more. If it’s that kind of money, I would give someone a couple of alternatives. Do you have enough money in the bank that if you were to lose your job, you’ve got a good window to get reemployed? You’ve got to make sure you have a safety net. Buy a house. I think it’s a great time to buy a house. But put a 20 percent down payment, get a good mortgage from Fannie and Freddie … It’s one of the best investments you could make. The rest of the money, either invest in a very broad index fund—a Wilshire 5000 type of index fund—or if you want to do a bit of homework, I’d invest in a few great unlevered businesses that earn attractive returns. In my opinion, McDonald’s, Visa, maybe Berkshire Hathaway.”

I think Ackman might not have been accustomed to talking to people like me, which would help explain why he sounded suspiciously like … a Merrill Lynch financial adviser.

He was, however, infinitely more compelling on the macro questions, and this was where the evening took a dark turn. “One of the things that’s interesting about the last year is that you realize how much of our capital system is based on confidence—business confidence,” he said. “If I’m confident I can refinance my debts when they come due, I’ll spend money. If I’m not confident I can refinance my debts when they come due, I’m not spending any more money. So if I can’t renew my home-equity loan and I’m not sure I can keep my job, I can’t spend. And you get into this death spiral.”

I asked him, “What’s the chance we’re going into that death spiral?”

“We’re in it!” he said. “Whether we’re going to die or not is another question.”

“What’s the percentage chance we’re going to move to a barter economy?” I asked.

“I think it’s small,” Ackman said.

“Small”? I had been hoping for “Zero.” “Zero” would have been a fine answer, and not because I have nothing to barter except for a stack of old SmartMoney magazines, but “Zero” because, by the time my 12-year-old turns 18, I would like to be able to use my portfolio of stocks and bonds as a flotation device, and not as kindling.

THE WAY I SEE IT, it’s all a con game,” Cody Lundin was saying. “What I mean is that Wall Street has always been an illusion. Now it’s an illusion that’s crumbling. Wall Street is like someone who’s having heart trouble. It’s in constant need of resuscitation, but after a while, it just doesn’t work anymore. People think that Bernard Madoff was unique, that he was an illusion, but he’s just an extension of the same illusion, the same con game. This is one of the reasons I don’t like to have any debt. When you have debt, you become part of this illusion, and sometimes you get trapped by it.”

We were standing outside in a foot of snow in the mountains above Prescott, Arizona. Lundin was arguing so cogently against the American culture of easy credit, in tones far more thoughtful than one hears on cable television, that I forgot for a moment that he wasn’t wearing shoes, or socks. He was standing in the snow barefoot. Also, in shorts.

“It’s all about regulating core body temperature.” For long hikes in the snow, he wears three pairs of socks, without shoes. He suggested I try this.

Other things Lundin asked me to try include making fire with sticks, eating mice—“a free source of protein in survival scenarios”—and living without electricity for a week to “see where it hurts.” Lundin himself eats mice and rats he traps at his off-the-grid passive-solar house in the wilderness, because “why waste free protein?”

Lundin is a freak; twin blond braids fall from his bandanna-covered head, giving him the appearance of a stoner Viking. But in the event that the economy crumbles, and civilization with it, I would appoint him my financial adviser. He is my favorite survivalist, the author of a book on getting by in the wilderness and another on urban preparedness, and a teacher of primitive-living skills. Survivalist, of course, has ugly political connotations. A long time ago, I visited a place called Elohim City, on the Oklahoma-Arkansas border, that was home to a group of white supremacists. Their racism was repulsive, and their anti-Semitism wasn’t too pleasant, either. But I was impressed with one aspect of their lifestyle. On a tour, they showed me a vast storeroom filled with beans. Pinto beans, lima beans, all sorts of beans, vacuum-packed in garbage-can-size vats. Three years of food, for when the revolution comes. I knew, of course, that I didn’t need three years of beans in my house, but I took the lesson: it’s not the worst thing in the world to have a couple of weeks of food and water on hand, just in case a natural or man-made emergency is more than FEMA can handle.

Lundin is not a racist; in fact, he’s an Obama supporter, and he resents the racist associations attached to survivalism. Nor does he wish for the grid to go down. He says he enjoys electricity and indoor plumbing. He tends to think, though, that civilization is a thin film, and that in times of economic distress, it’s smart to be prepared for the day when Safeway runs out of milk. “This isn’t something I hope for. But what if the illusion does really crumble, and we have to move as a society to something else?”

I asked Cody how he invests his money. “I don’t believe in the intangible economy; I believe in the tangible economy. When I have extra money, I buy tools, food, or land. I like to be able to see what I’m buying. And I really don’t like debt, so I’d rather not have certain things than be in debt to anyone. I just feel better knowing that I don’t owe money, and I feel good knowing that I can take care of myself. That’s the American way, to be able to be self-reliant.”

For the record, I don’t think the grid is buckling under the weight of consumer debt or the mistakes of AIG. But we’re in a strange moment in American history when a mouse-eating barefoot survivalist in the mountains of Arizona makes more sense than the chief investment strategist of Merrill Lynch.

“People need a plan, they need skills, and they need supplies. What would happen if the ATMs stopped working for a couple of days? People would panic. But you won’t panic if you’re prepared to ride out a disturbance.”

Even out West, he says, people in the cities are unequipped to go for more than a day or two on their own. The Mormons, who are strongly encouraged by their church to keep a year’s supply of food in their homes, are an exception. “I know some people who say that if things go to hell, they’re just going to go to some Mormon’s house and steal all his shit. But that’s not right.”

“Also, many Mormons keep guns.”

“Yeah, there’s that.”

The curious thing about listening to Cody Lundin is that in his ideas I heard echoes of ideas I’ve been hearing from people very much dependent on the financial grid. Bill Gross, the founder of Pimco, the world’s leading bond trader (and, according to a September 2008 ranking by Forbes, America’s 227th-richest person), suggested that thrift—not mouse-eating thrift, but more moderate forms of thrift—is quickly becoming the norm, as a result of society’s massive over-leveraging.

“Risk-taking went over the edge,” he told me. “We are inventing something new. We’re very afraid. We know from the Depression that people who lived through it didn’t change their mentality for the rest of their lives. They were sewing their socks. They refused to take a lot of chances. My sense is that it will take 10 or 20 years to find that spark of risk-taking in people again.”

When I told Seth Klarman, one of the country’s leading value investors, about my visit with Cody Lundin, he said, “It’s always smart to prepare for disaster. In investing, that means holding disaster insurance. In your personal life, it makes sense to have inexpensive disaster protection, so come what may, you’re ready for any eventuality. I like to store some extra bottled water in the basement, but my wife thinks it’s too much clutter. I told her I’d share my water with her anyway.”

While I’d choose Cody Lundin to serve as my off-the-grid adviser, I would choose Seth Klarman as my on-the-grid adviser, if only he were taking clients.

Klarman was hired out of Harvard Business School to manage a $27 million fund that, as of early this year, had grown to $14 billion. He is also the author of one of the more expensive books in the world, Margin of Safety. An out-of-print guide to value investing, it sells for as much as $2,500 per copy on the Web.

Klarman is an acolyte of Ben Graham, the original value investor. Value investors—Warren Buffett is the most famous—seek out distressed, underappreciated assets, buy them, and wait until the rest of the world realizes that they’re worth something.

“The overwhelming majority of people are comfortable with consensus, but successful investors tend to have a contrarian bent,” Klarman said over lunch one day in an empty Boston restaurant. “Successful investors like stocks better when they’re going down. When you go to a department store or a supermarket, you like to buy merchandise on sale, but it doesn’t work that way in the stock market. In the stock market, people panic when stocks are going down, so they like them less when they should like them more. When prices go down, you shouldn’t panic, but it’s hard to control your emotions when you’re overextended, when you see your net worth drop in half and you worry that you won’t have enough money to pay for your kids’ college.”

One theme of Margin of Safety is that people like me aren’t equipped to be investors. “No one knows what he’s doing unless he’s a full-time professional,” he said. “As in many professions, full-time experts have an enormous advantage. Investing is highly sophisticated and nuanced. The average person would have an incredibly hard time competing.”

I asked Klarman if he wasn’t working against his own financial interest by arguing that average people aren’t qualified to be investors.

“Most people on Wall Street do well enough,” he said. “It’s regrettable that anyone would want a client to take risks beyond what the client could handle.”

He agreed with Robert Soros that the financial-services industry treats the small investor not as a client but as a source of ready cash. “The average person can’t really trust anybody. They can’t trust a broker, because the broker is interested in churning commissions. They can’t trust a mutual fund, because the mutual fund is interested in gathering a lot of assets and keeping them. And now it’s even worse because even the most sophisticated people have no idea what’s going on.”

After 15 years of pabulum, I was enjoying, in a perverse sort of way, receiving straight talk from masters of finance.

“Everybody these days is a just-in-time investor. People say, ‘I’m going to leave my money in the market as long as possible, and then pull it out of the market just before I have to write the tuition check.’ But I think we’re seeing that the day you need to pull it out of the market, the market might be down 50 percent. It’s critical not to be greedy. Avoid leverage and don’t invest money that you can’t stand to lose.”

“I haven’t leveraged myself,” I said.

He asked me if I had a mortgage. Yes. He then asked me if the amount of money I had invested in the stock market was greater than the amount I owed on my mortgage—could I liquidate what remained of my portfolio to pay off my mortgage? I could.

“So you are leveraged. Why are you keeping your money in the market?”

“Because—”

“It’s because you think you’re going to make more money in the market than you’re paying in interest on your mortgage.”

“Yup.”

“Well, are you?”

“Uhh, no. But I’m getting the mortgage-interest deduction.”

“Yes, the interest is deductible. But if you had capital gains in the market, you’d pay taxes on those. In the aftermath of this financial crisis, I think everyone needs to look deep within themselves and ask how they want to live their lives. Do they want to live close to the edge, or do they want stability? In my view, people should have a year or two of living expenses in cash if possible, and they shouldn’t use leverage anywhere in their lives.”

“But if I dump my portfolio now, I make my losses real.”

“How are you going to feel if the market drops another 50 percent?”

Klarman went on, “Here’s how to know if you have the makeup to be an investor. How would you handle the following situation? Let’s say you own a Procter & Gamble in your portfolio and the stock price goes down by half. Do you like it better? If it falls in half, do you reinvest dividends? Do you take cash out of savings to buy more? If you have the confidence to do that, then you’re an investor. If you don’t, you’re not an investor, you’re a speculator, and you shouldn’t be in the stock market in the first place.”

Several years ago, I went to a party at a hedge-fund manager’s loft in Lower Manhattan. The elevator opened directly into the loft, which was as big as Mussolini’s office. An Austin Powers bed was parked to one side.

I left the party with a friend of mine, David Segal, who is now a business reporter at The New York Times. As we walked to the subway, he said, “You know, we should get one of those hedge funds.”

“Absolutely,” I said. “Where do we get one?”

“I don’t know. Maybe we can find one on the street. But we need one.”

“Yes, we do.”

When I think back on that conversation, I realize that it represents for me the apex of hedge-fund mania. Which is to say, when two reporters realize they should get into the hedge-fund business, it might be somewhat late to get into the hedge-fund business.

Seth Klarman is right. I’m not an investor. Very few people in America actually are. I never had the knowledge or the time to master the stock market. I thought I knew how to manage the danger, which is why I invested to a disproportionate degree in the Dow 30. I’ve learned, however, that it’s quite possible to ride the Dow 30 a far way along the risk curve. And I’ve learned another thing: I once believed that a buy-and-hold strategy would make me rich. This was a mistaken belief. “The economy comes in cycles,” Robert Soros said. “If you believe that the economy is not cyclical, then buy-and-hold is for you.” He taught me a Wall Street expression: “An investment is a trade gone bad.”

Though the past six months of my financial life have been marked mainly by paralysis, I have, in fact, made a couple of decisions. I’ve decided to deplete the world’s supply of gold by two ounces. (Attention all Atlantic-reading burglars: it’s not in my house.) You’ll be pleased to know that the price of gold fell $70 the week after I bought.

And my wife and I have decided to fire our Merrill Lynch financial adviser. We’re not firing him because we realized that his company couldn’t manage its own money, much less ours, and we’re not firing him for his bad advice. I was the one, after all, who pulled the trigger on the purchase of 100 shares of AIG. (It would have been good of him to warn us about what was coming, but that would have necessitated him knowing what was coming.) We’re also not firing him because his research chief wants us to elongate our already too-long time horizon. And we’re not firing him because John Thain, his former CEO, spent the fees we paid his company on a $35,000 commode. We’re firing him mainly because he fired us. He never said he was firing us. He just stopped calling. Eventually, I stopped calling him. I got the message.

Our main job now is finding someone to advise us. This is a very difficult task.

I asked Bill Gross what he thought I should do. He was somewhat dyspeptic. “The system is rigged,” he said. “It’s difficult for the average investor to even conceptualize what we’re talking about. For this reason, I think financial advisers are still worthwhile, but the average investor can no longer pay them what they felt they were worth. You should find someone who isn’t overpromising or overcharging.”

This search is made more difficult because we don’t have enough money to make ourselves interesting to most of the best advisers, and the typical adviser is not sufficiently independent-minded to be effective.

“There’s enormous pressure to provide conventional advice,” Klarman explained, “and tremendous pressure against providing unconventional advice. Advisers only recommend what’s conventionally palatable. They tend to say 60 percent stocks, 40 percent bonds, and they’re not likely to move away from that, no matter how extreme valuations are. They’re not likely to move away from it when the market is really high, or really low. A big part of the problem is that there isn’t a perfect answer to any of this. No one can tell you how to allocate your assets 100 percent of the time. The average investor is not getting Warren Buffett to look at his portfolio; he’s getting a printout from a computer model.”

Unconventionality makes me nervous, but less so than conformity. I’m finished with conformity. In picking an adviser, I’m also looking for someone who is unleveraged; someone who is putting his own money into the investments he’s recommending; and someone who can explain to me in a few sentences, in language easily understood by earthlings, his philosophy of investing.

Despite everything, I’m not overly pessimistic. I’m long on America, as my friends on Wall Street might say. I believe that equities will grow in value. I expect the Dow to return to 9,000, or 10,000, if not sooner, then later. And when it does, if I’m not already out, I might just get out. I’m not enjoying this particular ride.

I no longer expect to get rich. It makes me happy to realize this. It also makes it easier to give more money to charity. In retrospect, I can’t imagine what led all of us to believe that we could regularly expect double-digit annual returns on our money, for doing no work. Maybe this attitude will cause me to miss the next great run-up. No matter. I’ll take 3 or 4 percent gains a year, or 1 or 2, if necessary. I’ll keep more cash on hand. I’ll keep a two-week supply of meals-ready-to-eat, bottled water, and lanterns in my basement. If things get bad, I’ll take my family and drive west, to find Cody Lundin. And if the bottom truly falls out, I’ll find a Mormon and ask him, politely, if he’ll share.