Thursday, July 31, 2008

Jeremy Grantham: Meltdown – “I’m officially scared!”

Posted By Prieur du Plessis On July 31, 2008 @ 11:49 am

After having ventured on the bullish side of things a few days ago with Martin Pring’s upbeat scenario for stock markets ([1] Time to be Optimistic), we revert to a significantly more sceptical outlook today.


The bearer of the bad tidings is well-respected money manager Jeremy Grantham who has just published the July edition of his quarterly newsletter entitled “Meltdown! The Global Competence Crisis”. Grantham co-founded Boston-based [2] GMO, an investment house overseeing $126 billion in assets, in 1977.

Reflecting on his comments of a year ago and how events have played out, he says: “I thought things would be bad enough but they turned out to be a lot worse. I thought a year ago we were looking at the ‘first truly global bubble’ in asset prices. The credit crisis looked to be so predictably powerful and unstoppable then that I likened the experience to ‘watching a slow-motion train wreck’, and I predicted that ‘one major bank (broadly defined) will fail within 5 years’, for which I got considerable grief as a doomsayer, as the less optimistic strategists usually do. Well, a year later one bank failure looks positively quaint as a prediction.

“Ironically for a ‘perma bear’, I underestimated in almost every way how badly economic and financial fundamentals would turn out. Events must now be disturbing to everyone, and I for one am officially scared!”

In terms of strategy, Grantham summarizes his view in what he believes should be investors’ motto: “Don’t be brave, run away. Live to fight another day.”

Click [3] here for the full report on Grantham’s reasoning for his bearish stance.

Source: Jeremy Grantham, [4] GMO, July 30, 2008.

Time To Be Optimistc, Says Pring

Posted By Prieur du Plessis

When I first started working in investments in 1984, a standard item on my reading list was Martin Pring’s [1] InterMarket Review, which served an extremely useful function with its prescient analysis. Almost 25 years later, I am still paying close attention to Martin’s views.


Martin has written 14 best-selling books, including his seminal [2] Technical Analysis Explained. He was the winner of the 2007 Traders’ Hall of Fame Award and also the recipient of the 2004 Market Technicians Association Annual Award.

My view is that one should not expect a quick convalescence period for stock markets, short-term rallies aside. Although I am not in the Armageddon camp, I have republished two fairly gloomy interviews in recent weeks, namely those with Louise Yamada ([3] Bearing Up) and James Montier and Albert Edwards ([4] Market Fundamentals are Appalling).

For the sake of balance, and because his arguments certainly deserve more than a cursory glance, I would also like to share with you Martin Pring’s latest report, in which he argues the bullish case for equities. Over to Martin.

“Yes, the financial news gets worse every day. Yes, the average stock is down more than 25% over the past 13 months. Yes, the housing market is still reeling and foreclosure activity is rising. Yes, the price of gas is skyrocketing. And yes, this too will pass, and the economy and stock market will begin a new expansion and sustainable bull market, as all business cycles have.

“Over our several decades of investment management experience, we have witnessed many business cycle recessions and stock market declines. They all have one thing in common. In the midst of the most negative financial news, the stock market begins to move higher in anticipation of the next economic recovery.

“We believe the market has more than discounted all the bad news out there and is putting the finishing touches to the bottoming process for stocks. Yes, a significant advance is set to begin that will take stocks much higher in the year ahead.

“Considering all the negative financial headlines, is it any wonder investor psychology has reached a gloomy extreme? Legendary value investor and philanthropist Sir John Templeton made a career (and fortune) taking advantage of bargains that showed up during recessionary periods and bear markets. His foremost investment discipline was geared to wait patiently for stock prices to ‘reach the point of maximum pessimism’ and then he invested. It is somewhat ironic that this pioneer of value investing, who began his career in the 1930’s, would pass away this month at the age of 95, just when the markets have hit an emotional low point. We know Sir John would be buying stocks during today’s financial turmoil. Investor psychology has reached that pessimistic extreme and conversely sets up the year ahead to be a very profitable one.”

Please click [5] here for Martin’s full report in which he expands on four reasons to support his optimism.

Monday, July 28, 2008

In Volatile Times, Investors Tune in All and Any Predictions

July 28, 2008

The news hit Wall Street trading floors on the morning of July 2: Some analyst at Merrill Lynch was saying the General Motors Corporation might go bankrupt.

Within minutes, the share price of G.M., the landmark corporation that once symbolized America’s industrial might, was plunging to its lowest point since 1954.

What the Merrill analyst actually wrote, in a downbeat report on the troubled automotive giant, was that bankruptcy for G.M. was “not impossible” — an equivocal forecast that could be applied to almost any event, from winning the lottery to the odds of rain a week from Wednesday.

But amid a financial crisis where the unthinkable has seemingly become routine, Wall Street forecasters — and even the markets themselves — are struggling to get a handle on what will happen next. The result has been a flood of brash pronouncements, as the Cassandras of the financial set try to outdo themselves with increasingly outlandish predictions.

“These are volatile times. There’s a lot of moving parts here, and nobody can quite figure out how they all mesh,” said the investment strategist Edward Yardeni. “You’re hearing a lot of catastrophic predictions.”

So far, many of these forecasts, whether computer-crunched numbers or seat-of-the-pants guesstimates, have turned out to be wrong. But investors, struggling to make sense of one of the most severe downturns in a generation, still seem to hang on to Wall Street’s every word. Forecasts that might have been dismissed a year ago are now earning serious attention and moving markets.

Some critics of forecasting say this is a dangerous trend. The events of the last year have lent credence to the case of the heretics who say that Wall Street puts too much faith in its ability to predict the future by looking at the past.

In a best-selling book, “The Black Swan,” Nassim Nicholas Taleb, a former trader, famously blasted economists for exploiting “our desire to be fooled by a simpler representation of the world.”

“I cannot find a single convincing argument that tells me that astrologers won’t do better than economists,” Mr. Taleb said last week by telephone from Lebanon, where he was mountain hiking.

“The problem is the arrogance of these economists,” he said. “They’re making people rely on theories that have not worked, do not work, and are really dangerous.”

Mr. Taleb pointed to the reliance of some investors on financial models, the quantitative wizardry that can churn reams of data in an instant. These were the same models that, in the lead-up to the subprime mortgage meltdown, assumed home prices would never decline on a nationwide basis. They also ran so-called stress tests on complex investments that ended up losing money when the economy went south.

But despite this decidedly mixed track record, forecasters still enjoy a rapt audience, particularly at a moment when so much in the markets depends on the uncertain course of the housing market and the broader economy.

At investment and commercial banks, losses tied to bad mortgage investments, which now exceed $450 billion, are certain to rise further if home prices continue to decline and more people default on their mortgages. Last week, Bill Gross, a prominent bond fund manager, offered another forecast for the final bill: $1 trillion. Some market watchers say the figure could be even higher.

Even the collective wisdom of the marketplace has been wrong time and again. The stock market, that weathervane for corporate profits and the economy, keeps swinging from fear to greed and back. A glance at the major stock indexes over the last year reveals a host of false bottoms and fools’ rallies.

The Dow Jones industrials rallied to an all-time high of 14,164 in October, just weeks before the credit crisis worsened and rumors surfaced about problems at Bear Stearns. From there, the index fell 17 percent, to 11,740 in March, then recovered somewhat in the spring, climbing back above 13,000 in May.

This month, the market sank again, tumbling below 11,000 as concerns about the financial health of the nation’s two largest mortgage finance companies, Fannie Mae and Freddie Mac, gripped markets around the world.

But the forecasts keep coming, many of them with what seems like a remarkable level of precision. Last Tuesday, for example, a well-known finance professor at the Stern School of Business at New York University, Edward Altman, declared that Ford Motor and G.M. had a 46 percent chance of defaulting on their debt sometime in the next five years. Not 47 percent or 45 percent: 46 percent.

Mr. Altman’s conclusion, based on a computer model, received big play in some parts of the financial press.

In fact, Mr. Altman found that, on average, companies with an equivalent bond rating to Ford’s and G.M.’s face a 50-50 chance of default within five years. His estimate was based on the performance of hundreds of companies, very few of which matched the brand recognition or reach of the two automakers.

“It was sensationalized somewhat,” Mr. Altman, in an interview, said of his findings. “The chance of default of that type of company is probably a lot lower.”

He said he intended his findings to be used as “a metric” that would offer investors a useful benchmark for comparison. But he allowed that the 46 percent figure “maybe gives it a little more scientific magic than it deserves.” Shares of Ford and G.M. rose that day, though the perceived risk of the companies’ debt increased.

Ideally, predictions on companies and stocks would be “thoughtful, nontheatrical forecasts that take a look at long-term fundamentals,” said Abby Joseph Cohen, a longtime strategist at Goldman Sachs.

But, Ms. Cohen added, less dramatic forecasts rarely make headlines. “If what is being provided to viewers and readers are these theatrical forecasts, that is what many people will pay attention to because that’s what they have available.”

Another source of investment guidance used to come from research analysts, who try to predict quarterly earnings at companies. But there is a great deal of guesswork involved here, too. Analysts correctly predict earnings only a fifth of the time. Nearly two-thirds of quarterly earnings beat estimates, and the rest come in too low, according to data from Thomson Reuters. Many companies, of course, try to defuse overly optimistic forecasts to manage investors’ expectations and deliver “better-than-expected” results.

This year, Wall Street’s crystal balls have performed even worse than in the past. As earnings season for the second quarter winds down, 67 percent of companies reported earnings higher than what analysts had predicted, and 22 percent reported earnings that were worse. Only 10 percent of companies matched analysts’ expectations.

Poor predictions are nothing new in the financial world: in 1999, a pair of prognosticators — James K. Glassman and Kevin A. Hassett — published a book titled “Dow 36,000”; the blue-chip index closed last week at 11,370.

But investors seeking light in a dark period may just have to stick with no one’s predictions but their own.

“We have gone from an abnormally calm period, and we’ve blown right through normal volatility,” Ms. Cohen said. “We are in an exceptionally volatile period.”

Indeed. G.M. shares have bounced back from those bankruptcy fears. If you put a dollar into G.M. on July 2, you would have $1.19 today, a gain of nearly 20 percent. Who would have predicted that?

Friday, July 25, 2008

Energy Sector Declines

The recent downturn in oil has left the S&P 500 Energy sector down 7.5% year to date. Investors who have built up positions in Energy names throughout oil's runup this year surely have a sour taste in their mouths this month. Since oil peaked on July 11th, the average S&P 1500 Energy stock is down 9.96%, while the S&P 1500 as a whole is up about 2%.


Wednesday, July 23, 2008

John Paulson to invest in financials hit by mortgage write-downs

John Paulson, the hedge fund manager that hit it big last year betting against the mortgage market, has plans to raise a new fund to invest in financial firms currently taking it on the chin from mortgage-related write-downs, according to Bloomberg.

The news service reports that:

Paulson aims to open the fund by December, according to two people with knowledge of the matter. His New York-based Paulson & Co. hasn't set a fund-raising target, said the people, who declined to be identified because the plans aren't complete.
The $33 billion Credit Opportunities Fund managed by Paulson posted sixfold gains in 2007, as positions anticipating slumping mortgage-backed assets produced $3.7 billion in profits, making Paulson the highest-paid hedge fund manager last year. Paulson's fund scored another big win earlier this year when former Federal Reserve President Alan Grenspan joined the New York hedge fund as an adviser. - George White

Monday, July 21, 2008

Asset Class Correlations

Today's Wall Street Journal had an interesting article about asset class correlations. With that in mind, below we highlight (click here for PDF) a correlation matrix of various asset classes including the S&P 500 sectors, oil gold, the dollar, the yen, emerging markets, the 10-year note and the FTSE 100. The first matrix highlights the correlation between the daily percent changes of asset classes since the S&P 500 peaked on October 9th, 2007. Each column (vertical) is color coded from green to red based on highest to lowest correlations.

The second matrix highlights the correlations between the same asset classes, only from a much longer time horizon (1990-present). Then, in the bottom chart, we highlight the difference between the short-term and long-term correlations to see where differences arise. Correlations that have increased since the bear market began in 10/07 are shaded in light green, while correlations that have decreased are shaded in light red. In each column, the biggest increase and decrease in correlation is highlighted in dark green or red. As shown, correlations have generally increased among sectors, while stocks have become less correlated with oil, gold and Treasuries. Correlations between stocks and the yen have increased the most in the short-term compared to their long-term correlations. To view the matrices in PDF form, please click here. It's definitely an interesting data set to analyze and it's better to let the info speak for itself.


A Buy the Loser Rally

lf you didn't own the dregs of the S&P 500 going into the rally that started last Wednesday, chances are you have underperformed over the last few days. We broke the S&P 500 into deciles (50 stocks in each decile) based on stock performance from the 5/19 high to the 7/15 low and calculated the average performance of stocks in each decile since the 7/15 low. The average stock in the S&P 500 has risen 6.44% since then. The 50 stocks that were down the most from 5/19-7/15 are up 26.4%. Conversely, the 50 stocks that held up the best during the recent market decliens are only up an average of 0.99%. Clearly, this has been a buy the losers rally.


Below we highlight the 20 worst performing stocks from the 5/19 top to the 7/15 low. As shown, they are up a whopping 37% since 7/15. Unfortunately, not many people still owned shares in them last week.


Friday, July 18, 2008

Preferreds and Munis

On Monday we posted on the struggling preferred stock market. Since its lows earlier in the week, the S&P Preferred Stock index has rallied sharply off the lows. The decline and snapback rally in preferreds reminds us of the collapse in municipal bonds and their subsequent rally back in February. Below we highlight a chart of PFF (preferred stock ETF) and MUB (muni-bond ETF) since last September. Both are supposed to be relatively stable asset classes, but they have been anything but this year. But hopefully PFF can rally back like MUB did in the month or two following its February bottom.


Thursday, July 17, 2008

Welcome to the “vacuum” market

An antidote to Albert Edwards perhaps?

On Thursday, Tobias Levkovich, US strategist at Citi, brought us the “Invested Bubble.”

The equity markets are stuck in a vacuum. In deep contrast to the stock market bubble of the late 1990s when the market levitated on irrational exuberance that generated a tech bubble, the current hammering of financial stocks beyond some more balanced scope suggests that a vacuum is being created where all the investment air is being sucked out of equities.

Talented investors have been left in the trash heap of markets. In the 1998-99 bubble period, those who considered valuation as a meaningful factor in their investment process found the markets to be considerably out of touch with historical reality. Such intelligence was ridiculed as being old-fashioned and such people were seen to be “simply not getting the power of the Internet.” To some extent, inverse market pressures in the current “vacuum” market are suggesting (incorrectly, in our view) that there is no inherent or intrinsic value in many of the “franchise” financial or consumer names.

Trading trumps investing. The focus on trading for short periods of time has driven many stocks down to attractive investment levels, but investing for 12- 24 months has become almost an anachronism, leaving much value on the table with few takers — a veritable “baby with the bathwater effect.” In this context, the myopic time horizon pendulum has swung too far, but there is no clear catalyst for change.

Financials are needed for the broad market to catch a real bid. It seems difficult to imagine that equity markets will trade higher without participation of the financial names, given the close connection between capital markets and capital market-sensitive stocks. Excessive underperformance argues for some mean reversion, but investors appear to need to feel pain elsewhere in the market to compel a mindset change.

Excessive tech growth capped the bubble; home price stabilization could turn off the vacuum. Overly aggressive tech spending marked the end of the tech bubble. A number of factors such as the collapse in housing starts, trend line home prices and affordability indices argue that the residential market is close to finding some floor, which would be significant for Financials caught in the implications of the housing bust.

Here is Levkovich’s key housing chart, from Haver Analytics. Equity markets in both London and Wall Street were in exuberant mood on Thursday (FTSE 100 up 3 per cent at 3pm BST), but in terms of housing activity maybe we have a little further to go…


Pakistani Investors Attack Stock Exchange

KarachibrokerWhile we rely on government action to stop stocks from going down, investors in Pakistan take to the streets and attack the stock exchange. As shown in the chart below, the Karachi All Share Index has now gone down 15 days in a row, with the biggest declines coming this week. Since June 27th, the index is down 17.07%. As shown in the image at right, Pakistani investors are taking their losses out on the Exchange itself.

Below is an excerpt from a Bloomberg article written today by Farhan Sharif:

Pakistan investors stormed out of the Karachi Stock Exchange, smashed windows and cursed regulators after the benchmark index fell for a 15th day, the worst losing streak in at least 18 years.

``I have lost my life savings in the last 15 days and no one in the government or regulators came to help us,'' said Imran Inayat, 45, a protester and a former banker who retired early and said he lost 300,000 rupees ($4,175) on the market.


Banks do in fact bounce

If you drop them from a great enough height. Chart of the day - the rally in financials seen on Wall Street late Wednesday.


Wednesday, July 16, 2008

China's P/E Down to 20

After peaking just below 50 in January, the P/E ratio (trailing 12-month) of China's Shanghai Composite index is now at 20.95. Since China has long been considered an emerging market with high growth potential, it has historically had a high P/E ratio (average 36). However, a P/E of 20 is not unfamiliar territory for the index. Back in mid '05, the P/E got all the way down to 16.39 just before the historic rise in the index over the next few years.


What's Going On?

Written by Rob Arnott and John West
Wednesday, 16 July 2008 08:16

The current credit shake-up began one year ago, with Bear Stearns revealing large losses incurred in its two subprime-heavy hedge funds. Since that time, RAFI® equity applications have delivered mixed results with generally sound performance overseas—especially relative to the conventional capitalization-weighted value indexes—and shortfalls in the United States. In light of these mixed results, we examine the Fundamental Index® approach in previous difficult credit and liquidity periods and explore some attribution of the recent shortfall in the United States. While recent times have been disappointing for some cases, this exploration suggests the Fundamental Index concept remains as valid as ever. Indeed, in most markets outside of the United States, RAFI has performed admirably in the face of a hurricane-force headwind—that is, growth sharply outpacing value.

Since the credit crunch started, growth stocks have ripped market leadership away from value in a startling fashion all over the world. Figure 1 displays the excess returns of value over growth across five major equity categories. Only emerging markets witnessed value outperformance. Growth dominated by 700-1,200 bps in the remaining asset classes. It was an historic and global run—the past 12 months were the third-worst year of performance (using rolling quarterly observations) for EAFE Value versus EAFE Growth since 1970. Given that these 131 rolling one-year periods cover 38 years, this implies a 40-year storm for international value investors!

Chart: Style Performance June 2007 - June 2008

Amidst this environment, RAFI applications have witnessed a range of excess returns versus their cap-weighted counterparts. As Table 1 shows, the results in the less-efficient markets (emerging markets and non-U.S. small company) added value, while those in the most-efficient markets (developed large—both U.S. and developed ex-U.S.—and U.S. small-mid) trailed their respective benchmarks for the 12 months ending June 30, 2008.

Chart: RAFI vs. Rep. Cap-Weight Indexes

The modest shortfall in U.S. small companies and developed ex-U.S. large companies is well within the projected range of relative performance compared with cap-weighted indexes, particularly given the vast underperformance of value in these domains. In fact, our research suggests that we would expect to incur these types of results once every six or seven years.[1]

The recent underperformance in U.S. large companies, however, is somewhat larger than our research suggests is normal, even given the magnitude of the underperformance by the cap-weighted value indexes. Figure 2 plots the RAFI U.S. large company rolling one-year excess returns. The past 12 months' relative return is pretty far to the left of the distribution, suggesting something on the order of a 1-in-15-years event. Let's explore why.

Chart: Histogram

RAFI In Down Markets

The recent relative underperformance has come during a period of negative returns in the equity market—a time when our research has shown that the Fundamental Index methodology tends to excel. Part of the explanation is that over the past 12 months, low-multiple companies and value sectors have significantly underperformed, which is quite rare in bear markets.

Recall, capitalization weighting places a greater emphasis on the perceived future growth of a company; thus, expected future growers will have a higher allocation. Meanwhile, slower growers, weighted by current economic scale, will have a higher relative weight in the Fundamental Index portfolio. For this reason, on average, the RAFI strategy has an inherent value tilt relative to cap-weighted indexes, exactly mirroring the market's growth bias relative to the broad economy.

In most down economic periods and bear markets, it is well-documented that value outperforms growth, especially in the late stages of a bear market! Liquidity is still available, and financing costs for leveraged borrowers typically stay the same on a nominal basis—spreads rise, but this is typically because government bond yields fall. Likewise, commodity prices tend to drop as slowing aggregate demand leads to reduced raw goods consumption. Thus, the slower growers, capital-intensive and financially leveraged companies often typical of RAFI overweights, can weather these more-conventional storms in relatively good shape. However, higher expected growers that are "priced to perfection" get routinely punished, as the Nifty Fifty of the early 1970s and the Tech Bubble of the late 1990s clearly demonstrate. And so, the reason that the RAFI approach wins, on average, in down markets is that the high-multiple companies get severely punished as the rosy economic outlook that justifies their elevated P/E ratios fails to materialize.

The past 12 months has been an exception to this rule: Low-multiple companies and value sectors underperformed significantly. Many of these firms suffered against the headwinds of rising yield spreads and commodity prices, whereas many of the growth companies have been able to withstand these strong headwinds ... so far.

The Impact Of Rebalancing

A significant contributor to recent FTSE RAFI US 1000 underperformance is that the index was reconstituted in March 2008. In hindsight, second-quarter returns would have been better by 2.3 percentage points (pps) without the rebalance. In fact, the most recent rebalance finally moved the RAFI portfolio to a moderate overweight stance in financials (before the March 2008 rebalance, we were only 1% above the cap weight, despite our inherent value tilt!). We have long advocated that one of the chief benefits of the Fundamental Index approach is the manner in which it contratrades against recent market trends by rebalancing company prices back to fundamentals. In so doing, a Fundamental Index portfolio will contratrade against style fads and crashes, sector fads and crashes, and even individual company fads and crashes.

Just as most practitioners believe that rebalancing our asset allocation is a powerful tool in our investing tool kit, a Fundamental Index portfolio rebalances within our equity holdings. However, rebalancing can sometimes be a shorter-term detractor from portfolio performance when market trends—positive or negative—persist. For example, rebalancing away from technology and other high-flying growth stocks—especially those with negligible sales and no profits—in the late 1990s left relative gains on the table for a period of time. Rebalancing did pay off, however, once gravity finally took over and the emerging growth shares crashed back to Earth.

On the opposite end, rebalancing into stocks (or asset classes) that continue to underperform will also cause short-term disappointment. This is exactly what occurred with the FTSE RAFI US 1000 and other valuation-indifferent indexes in March 2008. As an example, the FTSE RAFI US 1000 held 18.8% in financials prior to the March rebalance and 25.2% subsequently. Given that financials declined 18.3% from the end of March through June 30, this cost us over 100 bps in returns versus a portfolio that bypassed reconstitution. Similarly, rebalancing away from energy cost nearly 50 bps during the quarter. In our minds, this is more of a rebalancing timeliness issue than an indictment of the Fundamental Index strategy. Indeed, it's hard to find an investment professional who doesn't advocate rebalancing as a fundamental (pardon the pun) investment activity.

Changes At The Top

With all the movement in the market, it is fascinating to note the changes in the top 10 companies—both in terms of names and weights. As Table 2 shows, there is a compression in the fundamental size measures as of June 30, 2008. Note also that the overlap on these two lists is now down to only six companies (it was eight at March 2007 rebalance), and financials occupy zero spots in the S&P top 10 (indeed not a single one of the top 15!) at this stage. Citigroup, JPMorgan Chase, Wal-Mart and Verizon are all huge, but the market doesn't think their future prospects deserve a top 10 ranking. Reciprocally, the market believes that Procter & Gamble, Johnson & Johnson, IBM and Apple will all be a more important part of our future economy than the four out-of-favor names, even though none of these four ranks in the top 10 based on the current scale of their enterprises. Even if the market is right about most of these, it still means that the RAFI strategy can add value in the one or two whose prospects are underestimated and the corresponding one or two on the list whose prospects are overstated.

Table: Weights for top 10 Cos., June 30, 2008

Will some financials fall much further? Probably. Could the sector, collectively, fall more? Of course. Does it make sense that none of them—not one—ranks in the top 15 by market cap? We're not so sure about that! This rout in the financial services sector—the largest sector of the U.S. economy—bears all the trappings of an "anti-bubble," a runaway speculative avoidance of anything in the sector. We think this is a terrific opportunity to shift from the "active bets" of capitalization weighting to the economic bets of the Fundamental Index concept!

Lessons From The Past

It is worth noting that the past 12 months is atypical—but not without historical precedent. Let's review a few facts related to 1990—a similar environment to the past 12 months.

In 1990, the S&P 500 suffered a 3.1% decline, with the FTSE RAFI US 1000 posting an 8.9% loss, a deficit similar to the past 12 months. Additional comparisons between the two years are presented in Table 3.

Table: Then & Now: 1990 vs. 12 Mos. Ending 6/30/08

Several trends from 1990 are worth noting as they relate to today:

  • Not surprisingly, financials suffered badly in 1990, as bad loans and deleveraging impacted bank balance sheets. In 1990, financials trailed the S&P 500 by 17.7 pps as compared with a similar deficit of 29 pps in the trailing 12 months ended June 30, 2008. Both periods saw financials finish dead last among the major economic sectors.
  • As they have in the past year, commodities rallied strongly in 1990 with the Goldman Sachs Commodity Index surging 29.1% after Saddam Hussein and Iraq invaded Kuwait, causing a significant spike in oil prices. However, this run-up in raw inputs paled in comparison to the 76% rise in the GSCI over the past 12 months.
  • Credit was a major issue in 1990, as conditions rapidly deteriorated on the heels of the American savings & loan crisis. High-yield (corporate bonds rated below investment grade) spreads above government bonds spiked by 510 bps in 1990, indicating rising risk aversion on the part of lenders. Similarly, we have witnessed high-yield spreads jump from 440 bps from June 2007 through June 2008.
  • Growth trounced value by roughly 800 bps as measured by the Russell 1000 Growth versus the Russell 1000 Value in 1990. Over the latest 12 months, growth outperformed value by nearly 1,300 bps.

Perhaps most important to investors and for the historically inclined, after the poor performance of 1990, the FTSE RAFI US 1000 Index went on to produce a five-year annualized return of 19.2% versus 16.6% for the S&P 500—an excess return of 2.6% pps per annum—bettering the 2.1% experienced over our originally tested 1962-2004 time horizon.[2] As seen in Table 4, this also doubled the incremental return of value during this period. Of course, it wasn't a linear ride each and every year above the S&P 500. Growth again surged in 1991, actually outpacing value by 1,600 bps—its third-best year ever since the inception of the Russell indices, exceeded only by the bubble-induced 1998 and 1999. Despite this massive growth headwind, the Fundamental Index portfolio finished relatively flat in 1991, but then went on to produce reasonable excess returns in the ensuing four years.

Chart: FTSE RAFI Performance Five Years Post 1990


Mark Twain once quipped, "History doesn't repeat itself, but it does rhyme." We don't expect history to repeat exactly, but we do believe the Fundamental Index approach will weather the storm of 2007-2008 much as it has in the past. The return drag from capitalization weighting—overweighting overpriced securities and underweighting underpriced securities—is a structural long-term return inhibitor. Over shorter intervals, any Fundamental Index application may underperform by placing proportionately more in underperforming stocks than its cap-weighted counterpart. The same can be said for equal weighting or, for that matter, any other price-indifferent strategy. After all, the goal of price-indifferent indexing is to randomize portfolio weights to approximately allocate half of our money to overvalued shares and half to the undervalued.

We know that capitalization weighting will structurally place more in securities whose stocks are priced above fair value and less in those that are priced below fair value. Why? Because the weights relative to fair value are not random; they are linked to price and the errors embedded within that price! For this reason, Fundamental Index supporters—if they had existed in December 1990—would have been confident about the future prospects of the RAFI methodology, just as we are today.

1. Both RAFI Global ex-U.S. and RAFI U.S. Small Company have approximate historical, backtested excess returns of 3.4% with tracking errors of 4% through 2007. This covers 1979 for RAFI U.S. Small Company and 1984 for RAFI Global ex-US.

2. Arnott, Robert D., Jason Hsu, and Philip Moore. 2005. "Fundamental Indexation." Financial Analysts Journal, vol. 61, no. 2. (March/April): 83-99.

© Research Affiliates®, LLC 2008. The material contained in this newsletter is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any securities transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Neither Robert D. Arnott nor Research Affiliates and its related entities warrants the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this newsletter is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this newsletter should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

ROBERT ARNOTT, Chairman and Founder of Research Affiliates, LLC.

JOHN WEST, CFA, Associate Director, Marketing & Affiliate Relations of Research Affiliates, LLC

A Buy Signal?

If you are looking for a (thin-reed) buy signal, consider that short seller David Tice (Prudent Bear Fund and Behind the Numbers) has announced the sale of his firm to Federated Investors today.

Tuesday, July 15, 2008

S&P 500 Dividend Yield Highest Since June 1995

Below we provide charts of the historical dividend yield of the S&P 500. The S&P 500 is currently yielding the most it has since June 1995 at 2.49%. After declining for about 20 years from the early 80s to the late 90s, the dividend yield has been on a steady rise this decade.



US Bank Default Risk Rises; European Bank Default Risk Falls

As global financial stocks have fallen significantly over the last week, you would think default risk has risen as well. However, while default risk has risen significantly for US banks and brokers, it has actually fallen for the European firms. Below we highlight a table of the percent change in equities and default risk over the last week for 15 global financial firms. As shown, Lehman's default risk has risen the most, followed by Wachovia, Washington Mutual, Merrill Lynch and Morgan Stanley. On the other hand, it has fallen 18.68% for Deutsche Bank, 16.85% for Credit Suisse, 13% for UBS, 10% for HSBC, and 3.5% for Barclays. At least things are calming down somewhere.



Monday, July 14, 2008

Gross Likes Dollar More Than Euro for 1st Time on EU

By Gavin Finch

July 14 (Bloomberg) -- For three years euro bulls used the prospect of higher interest rates in Europe to justify the currency's 32 percent rally against the dollar. No more.

A growing number of the world's biggest investors say a slowdown in the region's economy may be more severe than in the U.S., forcing the European Central Bank to reverse this month's rate increase. By January, the euro will be lower against the dollar, yen and even the pound, according to the median estimate of strategists surveyed by Bloomberg. Bill Gross, manager of the world's biggest bond fund, turned bearish on the euro for the first time since the currency's inception in 1999.

``We might have hit a point where the euro doesn't have a lot to stand on,'' said Emanuele Ravano, co-head of European strategy in London for Gross's Pacific Investment Management Co., which runs the $129 billion Pimco Total Return Fund. ``The euro is ultimately very overvalued. It could be quite a bit lower at some point in time over the next couple of years.''

The euro fell as much as 1.7 percent to $1.5611 in the week following President Jean-Claude Trichet's comments on July 3 that he had ``no bias'' on further changes in borrowing costs after boosting the main refinancing rate to 4.25 percent from 4 percent. Before Trichet spoke the currency traded near a record high on speculation the ECB would signal more than one rate increase was needed to tame inflation. It fell 0.5 percent to $1.5857 as of noon in London today, from $1.5938 on July 11.

Hedge Funds Flee

As the odds that the ECB will lift rates dwindled, hedge funds sold the 15-nation common currency, according to Zurich- based UBS AG, the world's second-biggest currency trader behind Deutsche Bank AG in Frankfurt. New York-based Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, said it's ``increasingly confident'' the euro will fall.

``Capital flows look less supportive for the euro and, with the ECB out of the way, the interest-rate policy would also seem to support our view,'' Stephen Hull, a strategist for Lehman in London, wrote in a research note July 11.

The euro is 30 percent overvalued versus the dollar, based on purchasing power parity, according to Newport Beach, California-based Pimco. That's more than any other currency among the Group of 10 richest nations. Purchasing power parity accounts for differences in the exchange rates of national currencies.

``When a currency gets between 25 percent and 30 percent overvalued it tends'' to revert to the mean, said Ravano. The euro may drop to $1.535 from $1.5938 last week, he said.

Burger Test

The Economist's Big Mac Index, which compares prices for the McDonald's Corp. product globally, shows the hamburger is 22 percent more expensive in Europe than in the U.S.

``We're not far off the capitulation point for the euro,'' said Mitul Kotecha, head of foreign-exchange research in London at Calyon, the investment-banking unit of Credit Agricole SA, France's second-biggest bank. The euro will fall to $1.52 by the end of the third quarter and to $1.45 by April 2009, he said.

The European single currency's gain since December 2005 was spurred by eight increases in the ECB's key refinancing rate.

French President Nicolas Sarkozy complained that the currency's strength was harming the competitiveness of European exporters and risked damaging economic growth. Exports from Germany, Europe's largest economy, declined 3.2 percent in May, the most in almost four years, the Federal Statistics Office in Wiesbaden said July 9.

Gross domestic product in the 15 nations sharing the euro will slow to 1.4 percent in 2009, from 1.7 percent this year, according to the median forecast of 29 economists in a Bloomberg survey. The U.S. economy will grow 1.8 percent next year, from 1.5 percent this year, according to the median of 78 estimates.

`Sharp Slowing'

There are ``concrete signs of a sharp slowing of euro-zone growth,'' Robert Sinche, head of global currency strategy at Bank of America Corp. in New York, wrote in a note dated July 11. Investors should sell the euro against the dollar, he said.

It may be too soon to bet against the euro because the U.S. economy is also slowing, according to Derek Halpenny, head of currency research in London at Bank of Tokyo-Mitsubishi UFJ Ltd., a unit of Japan's largest bank by market value. The euro will rise to $1.62 by the end of the third quarter, before falling back to $1.58 in the final three months of the year, he said.

``We're bullish on the euro,'' Halpenny said. ``The real story over the next three months is going to be the obvious and continued downturn in the U.S. economy compared to Europe.''

The ECB will cut the key rate a quarter-percentage point to 4 percent by the end of June 2009, according to the median of 30 economists in a Bloomberg survey. The Federal Reserve has lowered its target rate for overnight loans seven times since September to 2 percent.

`Incredibly Bearish'

``The rally in the euro is over and we're now incredibly bearish on the currency given the outlook for Europe's economy,'' said Hans-Guenter Redeker, the London-based global head of currency strategy at BNP Paribas SA, the most accurate foreign-exchange forecaster in a 2007 Bloomberg survey.

The euro will slide to $1.50 by the end of the third quarter and $1.45 by year-end, he said. Redeker is more bearish than most strategists. The common European currency will weaken 5.4 percent to $1.50 by year-end, and slip to $1.45 by mid-2009, according to the median of 37 analysts surveyed by Bloomberg.

``At current levels the euro is an awfully expensive currency,'' said Stephen Jen, chief currency strategist at Morgan Stanley in London and a former Fed economist. ``We see fair value for the currency at around $1.30.''

To contact the reporter on this story: Gavin Finch in London at

Last Updated: July 14, 2008 07:06 EDT

Recession-Plagued Nation Demands New Bubble To Invest In

The Onion

WASHINGTON—A panel of top business leaders testified before Congress about the worsening recession Monday, demanding the government provide Americans with a new irresponsible and largely illusory economic bubble in which to invest.

"What America needs right now is not more talk and long-term strategy, but a concrete way to create more imaginary wealth in the very immediate future," said Thomas Jenkins, CFO of the Boston-area Jenkins Financial Group, a bubble-based investment firm. "We are in a crisis, and that crisis demands an unviable short-term solution."

Enlarge Image Recession Expert

A prominent finance expert asks Congress to help Americans rebuild their ficticious dreams.

The current economic woes, brought on by the collapse of the so-called "housing bubble," are considered the worst to hit investors since the equally untenable dot-com bubble burst in 2001. According to investment experts, now that the option of making millions of dollars in a short time with imaginary profits from bad real-estate deals has disappeared, the need for another spontaneous make-believe source of wealth has never been more urgent.

"Perhaps the new bubble could have something to do with watching movies on cell phones," said investment banker Greg Carlisle of the New York firm Carlisle, Shaloe & Graves. "Or, say, medicine, or shipping. Or clouds. The manner of bubble isn't important—just as long as it creates a hugely overvalued market based on nothing more than whimsical fantasy and saddled with the potential for a long-term accrual of debts that will never be paid back, thereby unleashing a ripple effect that will take nearly a decade to correct."

Enlarge Image The Next Bubble?

"The U.S. economy cannot survive on sound investments alone," Carlisle added.

Congress is currently considering an emergency economic-stimulus measure, tentatively called the Bubble Act, which would order the Federal Reserve to† begin encouraging massive private investment in some fantastical financial scheme in order to get the nation's false economy back on track.

Current bubbles being considered include the handheld electronics bubble, the undersea-mining-rights bubble, and the decorative office-plant bubble. Additional options include speculative trading in fairy dust—which lobbyists point out has the advantage of being an entirely imaginary commodity to begin with—and a bubble based around a hypothetical, to-be-determined product called "widgets."

The most support thus far has gone toward the so-called paper bubble. In this appealing scenario, various privately issued pieces of paper, backed by government tax incentives but entirely worthless, would temporarily be given grossly inflated artificial values and sold to unsuspecting stockholders by greedy and unscrupulous entrepreneurs.

"Little pieces of paper are the next big thing," speculator Joanna Nadir, of Falls Church, VA said. "Just keep telling yourself that. If enough people can be talked into thinking it's legitimate, it will become temporarily true."

Demand for a new investment bubble began months ago, when the subprime mortgage bubble burst and left the business world without a suitable source of pretend income. But as more and more time has passed with no substitute bubble forthcoming, investors have begun to fear that the worst-case scenario—an outcome known among economists as "real-world repercussions"—may be inevitable.

"Every American family deserves a false sense of security," said Chris Reppto, a risk analyst for Citigroup in New York. "Once we have a bubble to provide a fragile foundation, we can begin building pyramid scheme on top of pyramid scheme, and before we know it, the financial situation will return to normal."

Despite the overwhelming support for a new bubble among investors, some in Washington are critical of the idea, calling continued reliance on bubble-based economics a mistake. Regardless of the outcome of this week's congressional hearings, however, one thing will remain certain: The calls for a new bubble are only going to get louder.

"America needs another bubble," said Chicago investor Bob Taiken. "At this point, bubbles are the only thing keeping us afloat."

Preferred Stocks Get Crushed

Preferred stock owners, especially financial preferreds, have seen share values evaporate over the last couple of weeks. Below we highlight the S&P Preferred Stock index going back to late 2003, along with a chart of its 50-day moving average spread. These shares are thought to be less volatile and less risky than common stocks, but with the index currently trading nearly 20% below its 50-day moving average, they have been anything but that.



Thursday, July 10, 2008

The New Bankers

Besides the 74% premium of the proposed deal, this morning's announcement of Dow Chemical's (DOW) buyout of Rohm and Haas (ROH) for $78 per share in cash had another noteworthy aspect to it concerning the funding of the deal. In the third paragraph of the press release, DOW says:

Financing for the acquisition includes an equity investment by Berkshire Hathaway and the Kuwait Investment Authority in the form of convertible preferred securities for $3 billion and $1 billion respectively. Debt financing has been committed by Citi, Merrill Lynch and Morgan Stanley who acted as financial advisors on the transaction.

Since when have the government of Kuwait and Berkshire Hathaway become bankers for M&A deals? While this is the first transaction we have seen where the Kuwait Investment Authority has helped finance a major merger, it is the second deal in recent months where Berkshire Hathaway has been involved. With the brokerage firms so strapped for cash, we wonder at what point companies in need of financing will bypass them altogether.

Tuesday, July 08, 2008

Toxic CDOs Given Up for Dead Coming to Life With Pension Funds

By Jody Shenn

July 8 (Bloomberg) -- CDOs are back.

Collateralized debt obligations that helped drive banks to $400 billion of writedowns and credit losses are finding buyers under a different name: Re-Remics.

Goldman Sachs Group Inc., JPMorgan Chase & Co. and at least six other firms are repackaging unwanted mortgage bonds as sales of CDOs composed of asset-backed securities fall to less than $1 billion this year from $227 billion in 2007 because of the global credit crunch. Re-Remics contain parts that are structured to guard against higher losses on underlying loans than most CDOs, allowing holders to sell or retain other sections at lower prices that can translate to potential yields of more than 20 percent.

``It's just the reincarnation of the CDO,'' said Paul Colonna, who manages more than $100 billion as chief investment officer for fixed income at GE Asset Management in Stamford, Connecticut. ``The mechanics are the same, but you're getting in at a much different level of valuation.''

GE Asset Management has considered buying the debt, Colonna said. The General Electric Co. unit may also have Re-Remics made out of bonds it owns if disposing of the riskier pieces boosts the securities' overall value.

Re-Remic stands for ``resecuritizations of real estate mortgage investment conduits,'' the formal name of mortgage bonds. Sales of the securities may help revive the market for new home-loan debt, according to Bernard Maas, an analyst in New York at credit-rating firm DBRS Ltd.

`Look to Restart'

``The hope is that by moving illiquid bonds to interested parties, the structured-finance community can look to restart,'' he said.

More than $9.3 billion of Re-Remics were created in the first five months of 2008, almost triple a year ago, according to Inside MBS & ABS. The debt represented 47 percent of mortgage bonds issued in the period, excluding those guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae.

A record $25 billion of Re-Remics were formed in 2007, the newsletter said. Sales in 2008 may exceed that, according to Sharon Greenberg, a Barclays Capital analyst in New York.

Unlike most CDOS, Re-Remics don't own debt or credit-default swaps based on the lowest-ranking subprime mortgage-bond classes. They are composed of AAA rated bonds backed by so-called Alt-A mortgages, issued to borrowers with higher credit scores who don't prove their incomes, seek higher debt ratios or buy investment properties.

Few Bonds

While CDOs are backed by more than a hundred bonds, Re- Remics typically combine fewer than a dozen, allowing holders to more easily analyze the debt.

Holders of mortgage bonds use Re-Remics to separate better- quality from riskier debt. That increases the chance the higher- ranked debt will retain its AAA rating, enhancing its value enough to boost the total worth of the mortgage pool, said Doug Dachille, chief executive officer of New York-based First Principles Capital Management LLC, which oversees $7 billion in fixed-income investments.

Lower-ranked pieces of the Re-Remics would be the first to record losses from defaults on the underlying mortgages, once lower-ranking bonds from the initial deals are wiped out, Dachille said.

A bond trading at 40 cents on the dollar could be split into a piece worth 80 cents and another piece that could then be sold cheaply enough to offer returns as high as 20 percent, Dachille said. Banks advised by First Principles bought lower-yielding senior pieces and some are also considering buying the bonds for their pension funds, he said. The firm is also starting a fund for pension clients that would invest in the debt, Dachille said.

`Credit Support'

``A lot of the stuff they wouldn't buy without the additional credit support,'' he said. ``They're happy with the 7.5 percent return. They just wanted greater certainty that they're going to get that 7.5 percent return.''

Transamerica Life Insurance Co., a unit of the Hague-based Aegon NV, is among holders of Re-Remics created this year by Lehman Brothers Holdings Inc., according to data compiled by Bloomberg. Reliance Standard Life Insurance Co., a unit of Wilmington, Delaware-based Delphi Financial Group Inc., owns a Re-Remic created by Countrywide Financial Corp., the data show. Cindy Nodorft, an Aegon spokeswoman, declined to comment. Bernard Kilkelly, a spokesman at Delphi, didn't return a message.

``It's one of the few cases where re-securitization actually increases, rather than destroys, value,'' said Scott Simon, head of mortgage-backed bonds at Pacific Investment Management Co. He wouldn't disclose whether the Newport Beach, California-based firm, the world's largest fixed-income manager, has bought the debt or used Re-Remics to repackage debt held by its funds.

$370 Billion

Commercial banks and savings-and-loans held more than $370 billion of non-agency mortgage bonds on March 31, according to Federal Deposit Insurance Corp. data. Much of that can only be sold at fire-sale prices after record subprime-mortgage defaults and home-price declines sparked losses on the underlying loans.

``This is an attempt to shake things up,'' said Scott Kirby, who manages about $20 billion of structured-finance securities at Ameriprise Financial Inc.'s RiverSource Investments LLC in Minneapolis. ``There's a lot of paper floating around that's having difficulty finding a home.''

CDOs, once the fastest-growing part of the debt markets, tumbled to zero cents on the dollar and credit ratings on some AAA pieces were cut to junk levels.

Goldman Sachs, based in New York, had about $15 billion of residential-mortgage securities on its books as of May 30, Chief Financial Officer David Viniar said on a conference call last month. New York-based JPMorgan's investment bank had $12.8 billion of prime and Alt-A securities as of March 31, according to an investor presentation in April. Lehman had $15 billion of home-loan assets as of May 30, CFO Ian Lowitt said on a conference call last month.

Restructuring Needed

``There are ample bonds that would fit the description of needing restructuring,'' Greenberg, the Barclays analyst, said.

Banks can increase the total credit quality of their assets by selling off lower-rated pieces and keeping the better part, Matthew Jozoff, an analyst at JPMorgan said. Avoiding downgrades also would prevent the banks from having to hold more capital to protect against losses on the debt.

Goldman spokesman Michael Duvally, JPMorgan spokeswoman Tasha Pelio and Lehman spokesman Mark Lane declined to comment.

Riskier Re-Remic mortgage securities are ``natural fit'' for hedge funds, according to a June 27 report by JPMorgan's Jozoff and John Sim. The debt offers higher potential yields at a time when it's difficult to borrow to boost returns, they wrote.

Re-Remics have repackaged so-called non-agency mortgage securities, which lack explicit or implied government guarantees, for at least 15 years. Re-securitizations of agency mortgage bonds date to the mid-1980s under First Boston's Laurence Fink, now chief executive officer of BlackRock Inc., and Lewis Ranieri of Salomon Brothers, now chairman of Ranieri & Co., Franklin Bank Corp. and Root Markets Inc.

Today's Re-Remics are ``an opportunity for dealers to find liquidity and to move bonds out of their inventory,'' said DBRS's Maas.

To contact the reporter on this story: Jody Shenn in New York at

FoHF investors face (more) tax issues

Disguise In the bland, but less than convincing, disguise of Rev. Rul. 2008-39, the Internal Revenue Service has issued a fatwa targeting fund of hedge funds and their investors.

Sort-of translated from the original bureau-beancountingese, the ruling prohibits funds of hedge funds from claiming management and incentive fees on Schedule E, along with other partnership income or losses. Instead, the fees must be reported on Schedule A, where they are subject to two per cent and three per cent hurdles; some taxpayers will consequently lose all or some of the benefit of the deductions, depending on their income level and total deductions.

It’s not clear just how widely the ruling’s impact will be felt. Arthur Bell, principal of the eponymous accounting firm, said that his firm had encouraged clients to report in this manner all along, “as there is no support for the upper tier FoHF’s fees reporting otherwise,” and the IRS had telegraphed the ruling.

“If the IRS audits a fund and requires a change, the investor partners will have to file amended returns for one or more years. Some funds, and their investors, will be upset,” Bell said.

***ALERT: Incredibly boring and arcane document***

Rev. Rul. 2008-39
Section 702(b).—Character of Items Constituting Distributive Share
Internal Revenue Service

Interesting Yale Confidence Indicators

The Yale School of Management has a number of stock market confidence indices that question US investors. Recently, two of the confidence indices have been showing some interesting trends.

The first chart below highlights historical results for Yale's One-Year Confidence Index. The index surveys both institutional and individual investors for their confidence that the market will be up in the next year. As shown, market confidence from individual investors has ticked lower and lower since 2004 and is currently just over 70%. Institutional confidence peaked in mid-2006 and then fell significantly later that year. In recent months, however, institutional confidence has picked up and a big divergence has been created between institutional and individual investors. Hopefully the weak individual confidence and higher institutional confidence means a rally is coming soon.


Another index that the Yale School of Management conducts is Crash Confidence. This survey asks institutional and individual investors for their confidence that there will not be a market crash in the next six months. In the most recently monthly survey (June), confidence that there won't be a crash from individuals fell to its lowest level in the survey's history. The prior low occurred in November 2002.


Monday, July 07, 2008

Insight: Traversing wild market swings

By Mohamed El-ErianMon Jul 7, 10:25 AM ET

A year ago, I argued in the FT that we were "exiting a world in which the difference among individual investors' performance was essentially a function of the degree of their exposure to the most illiquid and leveraged asset classes, and entering a world where more sophisticated risk management capabilities will increasingly be the main differentiator."

In a subsequent column, written in the midst of the sharp recovery from the mid-March market lows, I suggested "it is still too early for investors and policymakers to unfasten their seatbelts. Instead, they should prepare for renewed volatility."

How about today? Does the latest sell-off in global markets provide an opportunity for investors or is it another leg down in a secular bear market for all risk assets?

Today's markets are particularly tricky as they provide the duality of both great opportunity and enormous risk. And in contrast to recent years, investors will not be able to appeal to a few macro themes; be they bullish ("the great moderation" and "goldilocks") or bearish ("debt exhaustion" and the collapse of structured finance). Instead of the phase of highly correlated market moves, up and then down, we will witness the gradual assertion of fundamental differentiation between market segments and for instruments in the capital structures.

To illustrate, let us start with the unpleasant side of the duality. Successful risk management must reflect the fact that markets are now in the grip of three distinct but reinforcing forces that will play out over a number of quarters.

First, look for further balance sheet contractions in the financial sector that will continue to suck oxygen out of, and undermine risk appetite in credit and equity markets. This is part of a long-term process of de-risking that is currently driven by markets but will soon have a more important regulatory dimension.

Second, markets are yet to adequately price the morphing of the credit crunch into a full-scale US economic disruption. Prepare for even stronger headwinds fuelled by declining real income and eroding household wealth.

Third, there are no easy policy solutions. Instead, policy makers face an extremely difficult situation in which any action, no matter how well-intentioned, entails unstable feedback loops and impose distortions elsewhere. Collateral damage cannot be avoided, yet its exact characterisation is uncertain given the extent of still-hidden vulnerabilities in both the real economy and the financial sector.

This volatile cocktail also speaks to the other side of the duality: the existence of big opportunities. The toxic mix is causing markets to throw the baby out with the bath water. There is now a littering of high quality assets whose prices are divorced from their underlying quality. Rather than reflect fundamentals that will eventually assert themselves, these valuations have fallen victim to the seemingly endless disruption in the financing of highly leveraged owners that have no choice but to continually dispose of assets in a disorderly fashion.

So much for the summary characterisation of today's highly dualistic investment outlook; how about the implications for investment strategies? Interestingly, they differ significantly depending on where your investible capital stands with respect to some key structural attributes - an insight that also speaks to why we are likely to see more market volatility.

The answer lies in a phased, multi-quarter approach by investors that benefit from the following structural attributes: a high degree of capital permanency that steers clear of the need to finance sudden withdrawals; a willingness to take long-term views that can be sustained through wild market swings; and a process that accommodates opportunities that, in some cases, do not fit well into traditional classifications of asset classes.

If you possess these structural attributes, today's markets offer opportunities that are high up in the capital structure and that, in a few years, will be looked at as having constituted incredible bargains. If you don't, you are well advised to stay on the sidelines, focused on the probability that these same markets will also be treacherous for at least the remainder of this year.

The writer, co-CEO and co-CIO of Pimco, is author of "When Markets Collide: Investment Strategies for the Age of Global Economic Change."

The latest term in the accountant's lexicon..."NAV Divergence"

We recently spoke with a senior manager working for the New York office of one of the Big 4 accounting firms. He casually mentioned what appears to be the latest addition to the accountant's lexicon: NAV Divergence.

Under this concept, a hedge fund prepares its NAV under one set of accounting (or more accurately valuation) standards. This is used to cut the "trading NAV", which will be the price used for subscriptions, redemptions and, of course, the payment of the manager's management and incentive fees.

The slight snag is that this "trading NAV" won't be the same as the NAV reported in the financial statements, prepared under US GAAP.

There is actually a long standing precedent for this practice: hedge funds reporting under International Financial Reporting Standards (IFRS) are required to price long securities at the bid and short securities at the ask, to reflect the prices the fund would actually receive in a sale (or equally pay to cover a short.) Some hedge funds disagree with this policy (despite the fact that it seems to be a very appropriate valuation method), and disclose in their offering documents that they will price securities at the mid or at the last sale.

In these circumstances, the financial statements are prepared under IFRS, but a footnote disclosure identifies the difference between the financial statement NAV and the trading NAV.

It now seems that this concept has crossed the Atlantic and may quickly become an issue for US hedge fund investors - or more widely investors in hedge funds which report under US GAAP.

How could this arise? Under the new FAS 157 accounting standard, hedge funds must value their assets at fair value, being the exit price in a situation other than a forced or distressed sale. What happens, however, if a hedge fund disagrees with FAS 157 and determines, for example, that it would be inappropriate to calculate the "fair value" of illiquid side pocket investments and hence decides to hold them at cost for "trading NAV" purposes.

As another example, what happens if a hedge fund holds a large block of a thinly traded small or micro cap stock and wants to take a blockage discount? This is explicitly disallowed by FAS 157: perhaps the hedge fund, however, could specify in its offering materials that it can make use of blockage discounts and hence calculates the 'trading NAV" on that basis.

To us, this seems to be a double edged sword. In some instances, GAAP may well be wrong - the example of blockage discounts is an excellent example. There is a very good argument that a fund should take some discount from open market prices when it holds many days (or months) of trading volume in what is nonetheless an exchange traded equity. The problem, however, is how to calculate that discount: how can investors compare one fund which takes a 5% discount to another which takes a 25% discount in pretty much similar situations. NAV Divergence allows individual funds essentially to set their own accounting policies, each of which must be analyzed and then monitored by investors.

The side pocket example also gives rise to problems. It may make sense for the underlying fund not to value its side pockets - but what about a fund of fund that holds a position in that manager? The fund of funds must record its investments at fair value if it is to calculate an accurate NAV for its own investors: holding valuable side pocket investments at cost will understate the fund of fund's own NAV. We can see all kinds of thorny issues here.

The biggest problem, though, comes when GAAP may well be right, but the hedge fund nonetheless wishes to use an alternate method of valuation. In recent times, plenty of funds may have disagreed with broker quotes or other pricing information available for toxic CDO, CBO and other structured paper. What happens if the fund is able to disregard this information and use its own "fair valuation" model for purposes of the trading NAV?

At the moment, one of the biggest protections against enduring misvaluation of complex securities is that, at least once a year, the fund must provide pricing evidence sufficient to convince the auditors that the financial statements are presented in accordance with GAAP and are, within the range of materiality, true and fair. (This is not to say, mind you, that we are in any way convinced that the auditors have any specific expertise in pricing: the average 23 year old sent out by the Big 4 to audit multi strategy funds is not exactly an expert in pricing complex securities.)

This issue aside, "NAV Divergence" seems to us to be a very slippery slope. If auditors allow different NAV's for side pockets and blockage discounts, the same logic could very well allow funds to use "alternate" valuation methods for hard to value securities. Under this process, a fund could concoct, with impunity, its own pricing policy entirely separate from the GAAP process which underpins the financial statements.

We are not saying that GAAP is always right. However, investors have a right for a level playing field and GAAP, at the moment at least, is the best option we have.

It goes without saying that investors should not accept funds who use NAV Divergence to revalue their books at prices higher than that permitted under GAAP. It also goes without saying that the auditors should not sign off on accounts prepared on this basis as it makes a mockery of the entire audit process.

Let's hope both the investor and auditor community can head this one off at the pass.

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.