I haven’t said much about what I’ve been doing personally here of late. In sum, the general theme is that I’ve been scaling out of positions the entire summer, and am now 100% cash. Had I not sold anything, I would be up more on the year than I am at present – but that’s pretty much par for the course in a rally that has been as sharp and persistent as this one.

There’s still a strong undercurrent of disbelief at this rally, so in that sense not much has changed since March, when the world was bearish and nothing but pain existed for equity holders. The difference now (besides much higher prices) is that there’s a growing contingent with a belief that the recovery is at hand, or their more speculative counterparts who don’t believe in a recovery but are afraid of missing a higher move.

A growing number of financial stocks that are essentially worthless have seen their option values multiply several-fold; the well-documented list includes Fannie Mae (FNM), Freddie Mac (FRE), AIG, Citigroup (C), and Lehman (LEHMQ.PK), and August trading volume has been heavily concentrated in those names. I’m not discounting the option value of a stock; real-world outcomes are probabilistic and stock prices should reflect that. But it does speak to speculation returning to the market, and that’s a sign of caution in a time of great uncertainty – and make no mistake, the short-term bandages are only hiding long-term problems.

Good investing is not about having a myopic focus on maximizing returns, it’s also about managing risk. Winning is important, but so is not losing. With the feedback loop of the last six months, market conditions are such that it’s very easy to forget that losing is a distinct possibility in an era of debt deflation. Although inflation has been the headline worry of Fed watchers, I’m not convinced; the intermediate concern (2-5 years) that seems underestimated is deflation. Central banks are small in comparison to global capital flows, and although we might try to stimulate like crazy, it will be difficult to offset trillions of dollars in irresponsible lending being rationalized.

In light of this, I’m looking at convertible securities that offer yields of 6% or more (about 500 bps over 2-year Treasuries) in industries that will have above-average profitability in the case of an economic recovery. My assumption is that the yield alone will offer an attractive return, and with most at a discount to par, the total return potential approaches double-digits over a two-year time frame. If I’m wrong about the immediacy of a market recovery, the convertible option offers a hedge on rising stock prices – in sum, a better balance of risk and reward than either a straight stock or bond allocation.

A final closing note: I’m going to change up my policy about writing, since I often spend dozens of hours studying something only to determine it is a dead end. So, in the future, I’ll comment on those, instead of just the scarce opportunities I end up acting on.

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This isn’t going to be a typical book review, because my thoughts on the book can be summed up in a concise manner, and I think the real story is much more relevant in regards to current events.

Goldman Sachs: The Culture of Success is written by a former Vice-President at the company, detailing the path taken to the firm’s 1999 IPO. It’s a fairly involved historical work that covers major events and people that made Goldman what it was at the time it went public (the book was published in early 2000, so no vampire squid references). My two complaints:

That said, Goldman Sachs (GS) makes for a good story, albeit one that is not overly colorful – chalk it up to Goldman’s insistence on teamwork, but there are few real characters; the typical biography is a dignified portrayal of top management.

With Goldman’s success, there’s a temptation to view this as a case study in how to great a global financial services company, or manage an organization. I think that’s misleading for two reasons. First, there’s certainly an element of change to surviving as a Wall Street partnership through a tumultuous century-plus. Second, there’s no identifiable hard-and-fast rule beyond “be long-term greedy,” and management’s judgment at various times led the firm to move aggressively into and quickly away from the same business, like asset management.

One theme that runs through the book is the changing culture at Goldman Sachs, and how it became more short-term greedy at times; normally this led to a period of bad results down the line. A central issue: can Goldman (or any investment bank) compete with its clients through proprietary risk-taking, and still play the proper role in serving their clients? Goldman’s actions have indicated they believe it’s possible, or at least beneficial to them to do both. Compounding that issue is the capital structure of the firm, which was a partnership (with unlimited personal liability for members) before the IPO removed that onus.

When Goldman was a partnership, there was significant downside to prop trading and other risky activities – namely, a large failure could bankrupt the individual partners at Goldman. Under the current structure, that isn’t the case, as the classic equity call option exists. Did the reformulation of Wall Street into a corporate world, as opposed to a partnership world, come with the creation of systemic risk? I don’t have any hard evidence, but I can’t imagine that the risks being taken in the middle of this decade would have occurred had personal liability still existed.

Roger Ehrenberg wants to make the compensation of traders more equity-like, which he says is the real story behind Andrew Hall’s potential $100 million payday from Citigroup (C). The partnerships of old risked their own capital to serve customers; the modern quasi-hedge fund risks the capital of others to primarily benefit employees. As unlikely as it might sound, looking back in time to smaller, more focused financial companies based on the partnership model offers a starting point for reframing the debate about Wall Street reach and compensation.

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