Monday, March 30, 2009

Of bonds and stocks and the Weimar Republic

You’d have to be living under a bailout-sized rock not to be aware of the current debate surrounding equities vs corporate bonds.

HSBC has now thrown its hat in the ring, in a 24-page research note entitled “The triumph of the pessimists”, which looks at the behaviour of corporate bonds and equities over the past 140 years or so. Here’s the summary.

Lots of studies have looked at government bond and equity valuations, few at the relationship between corporate debt and equities. We’ve filled the gap, going back to the middle of the 19th century.

The results don’t look pretty for equities, which are likely to suffer a multi-year downgrading compared with corporate debt
Historically, there have been three multi-decade periods. Relative prices in the first two were very different to those in the third. Before the beginning of the last century, yields on corporate equity were sometimes lower than those on corporate debt and sometimes higher. Over the following 50 years — from about 1907 until 1951 — they were almost always higher, sometimes a great deal higher. But for the 50 years starting in the early 1950s, dividend yields on equities fell sharply relative to yields on corporate bonds. By 2000, the peak of the cult of the equity, the relative yield of equities compared with government and corporate bonds had reached its lowest level ever.In fact, the only significant period in which dividend yields weren’t higher than corporate bond yields was in the early 1930s (chart, using railway bond yields as a proxy for corporates, below), when dividend yields collapsed and corporate bond yields surged because of the cascade of Depression-related defaults, according to HSBC. Investors’ enthusiasm for equities was dulled, and, in a parallel with our current financial crisis, their appetite for corporate debt sharpened. Even as the economy improved and profits rose, investors attached an increasingly low valuation to dividend payments, resulting in increased dividend yields.
Fearing another depression, then, investors demanded more of their returns upfront. That’s why dividend yields went up and corporate spreads went down. Although stocks went up and down, the shift continued until 1950, by which time the trailing PE for the S&P had fallen to 6x, its dividend yield had reached 7.5%, yields on Baa bonds had fallen to 3.2% and spreads to less than 80bps. In the early 1930s, Baa yields reached 11% and spreads touched 725bps.

That was the cheapest that equities have ever been against corporate bonds. Over the next 50 years, not all at once and with big, sometimes huge setbacks, valuations of stocks compared with corporate bonds moved from their cheapest ever to their most expensive. Which … is the situation in which we find ourselves now.

HSBC - Dividend yields vs corporate bond yields

Which leads us to today, when, according to HSBC, we’re facing two scenarios for corporate bonds and equities. Over the past 18 months, the implosion of the global financial system has led to huge risk aversion and acute deflationary concerns, both of which have driven government bond yields lower still. Now, it could be that quantitative easing by central banks will lead to a pick up in inflationary concerns and worries about how governments will repay the huge numbers of bonds that they have issued and will continue to issue. That’s certainly not an argument that one should dismiss out of hand. That wouldn’t augur well for government bonds in the long term.

Alternatively, the situation we’re in now might echo the 1930s, when risk appetite was shot to pieces and, regardless of whether inflation fell through the floor or picked up somewhat, government-bond yields fell and then fell further. For their part, having spiked up hugely, corporate spreads declined for the rest of the decade. But as we saw earlier, if investors lapped up bonds, particularly corporate bonds, they shunned equities; earnings yields and dividend yields rose dramatically. In that environment, investors, in other words, were expressing a strong preference for safety and income over risk and capital gains.

Although we strongly suspect that the present world looks more like the second of these scenarios than the first, we really don’t know for sure. Perhaps it doesn’t much matter, as long as governments don’t unleash another huge inflation. For what is certainly true is that central bankers have now told us explicitly that they will not allow government bond yields to rise for the foreseeable future. Their aim is simple: to make risk-free assets so unattractive that investors wade into riskier markets, thus restoring confidence to the financial system and the economy as a whole. For now, it’s clear, equity markets have taken the hint, but corporate credit markets haven’t. That situation will, we think, be reversed.
This is a sentiment echoed in The Aleph Blog and Crossing Wall Street. The spread between corporate bonds and equities is getting big - corporates were sitting out of the recent rally. They are, as per HSBC’s research title, the pessimists.

However, as HSBC also notes, this is essentially a deflationary vs inflationary debate. In a deflationary environment, as in the Great Depression, corporate bonds, with their stable returns, make sense. In an inflationary environment those fixed returns are eroded. Equities, with their ability to raise prices in tandem with inflation (or as close as they can get) could be more attractive.

A slightly random example here - but the German stock market of the 1920s increased by a staggering amount as inflation shot through the roof. We’re far from hyper-inflation, but throwbacks to that era, like the below 1921 clipping from the New York Times, should give us pause for thought.

NYT - The German stock market, 1921

Chart of the Week: TIPS Breaking Out

While there were many important stories that broke this week, the one which found me briefly holding my breath was the failed auction of £1.75 billion in U.K. government 40-year bonds on Wednesday followed by the weak demand for $34 billion of 5-year U.S. Treasury notes later in the day. While Thursday’s successful auction of $24 billion of 7-year U.S. Treasury notes has temporarily put the government debt auction issue on the back burner, the interest rate plot is clearly thickening – and the debate on deflation vs. inflation is starting to heat up.

One excellent way to protect against inflation is through the use of Treasury Inflation-Protected Securities, more commonly known as TIPS. As I noted last September in Treasury Inflation -Protected Securities and Inflationary Expectations, TIPS utilize the CPI as an inflationary benchmark and TIPS coupon payments and the underlying principal are automatically adjusted to account for inflation.

All of this brings us to the chart of the week below, which shows a ratio of the iShares Barclays TIPS Bond Fund ETF (TIP) to the 10-Year U.S. Treasury Note. This ratio has seen several jolts in the last six or so months, but since mid-December, investors have shown a strong preference for TIPS over the standard Treasuries. In fact, as concern about inflation has elevated during the course of the last week or so, TIP, with an average maturity of approximately nine years, has moved up impressively while Treasuries with comparable maturities have fallen. The ratio is now approaching its pre-Lehman levels, so that further moves could help to gauge whether inflationary or deflationary fears are dominating the thinking of investors.

Exclusive: AIG Was Responsible For The Banks' January & February Profitability

Zero Hedge is rarely speechless, but after receiving this email from a correlation desk trader, we simply had to hold a moment of silence for the phenomenal scam that continues unabated in the financial markets, and now has the full oversight and blessing of the U.S. government, which in turns keeps on duping U.S. taxpayers into believing everything is good.

I present the insider perspective of trader Lou (who wishes to remain anonymous) in its entirety:

"AIG-FP accumulated thousands of trades over the years, all essentially consisted of selling default protection. This was done via a number of structures with really only one criteria - rated at least AA- (if it fit these criteria all OK - as far as I could tell credit assessment was completely outsourced to the rating agencies).

Main products they took on were always levered credit risk, credit-linked notes (collateral and CDS both had to be at least AA-, no joint probability stuff) and AAA or super senior portfolio swaps. Portfolio swaps were either corporate synthetic CDO or asset backed, effectively sub-prime wraps (as per news stories regarding GS and DB).

Credit linked notes are done through single-name CDS desks and a cash desk (for the note collateral) and the portfolio swaps are done through the correlation desk. These trades were done is almost every jurisdiction - wherever AIG had an office they had IB salespeople covering them.

Correlation desks just back their risk out via the single names desks - the correlation desk manages the delta/gamma according to their correlation model. So correlation desks carry model risk but very little market risk.

I was mostly involved in the corporate synthetic CDO side.

During Jan/Feb AIG would call up and just ask for complete unwind prices from the credit desk in the relevant jurisdiction. These were not single deal unwinds as are typically more price transparent - these were whole portfolio unwinds. The size of these unwinds were enormous, the quotes I have heard were "we have never done as big or as profitable trades - ever".

As these trades are unwound, the correlation desk needs to unwind the single name risk through the single name desks - effectively the AIG-FP unwinds caused massive single name protection buying. This caused single name credit to massively underperform equities - run a chart from say last September to current of say S&P 500 and Itraxx - credit has underperformed massively. This is largely due to AIG-FP unwinds.

I can only guess/extrapolate what sort of PnL this put into the major global banks (both correlation and single names desks) during this period. Allowing for significant reserve release and trade PnL, I think for the big correlation players this could have easily been US$1-2bn per bank in this period."

For those to whom this is merely a lot of mumbo-jumbo, let me explain in layman's terms:
AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam.

In simple terms think of it as an auto dealer, which knows that U.S. taxpayers will provide for an infinite amount of money to fund its ongoing sales of horrendous vehicles (think Pontiac Azteks): the company decides to sell all the cars currently in contract, to lessors at far below the amortized market value, thereby generating huge profits for these lessors, as these turn around and sell the cars at a major profit, funded exclusively by U.S. taxpayers (readers should feel free to provide more gripping allegories).

What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were a) one-time in nature due to wholesale unwinds of AIG portfolios, b) entirely at the expense of AIG, and thus taxpayers, c) executed with Tim Geithner's (and thus the administration's) full knowledge and intent, d) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.

For banks to proclaim their profitability in January and February is about as close to criminal hypocrisy as is possible. And again, the taxpayers fund this "one time profit", which causes a market rally, thus allowing the banks to promptly turn around and start selling more expensive equity (soon coming to a prospectus near you), also funded by taxpayers' money flows into the market. If the administration is truly aware of all these events (and if Zero Hedge knows about it, it is safe to say Tim Geithner also got the memo), then the potential fallout would be staggering once this information makes the light of day.

And the conspiracy thickens.

Thanks to an intrepid reader who pointed this out, a month ago ISDA published an amended close out protocol. This protocol would allow non-market close outs, i.e. CDS trade crosses that were not alligned with market bid/offers.
The purpose of the Protocol is to permit parties to agree upfront that in the event of a counterparty default, they will use Close-Out Amount valuation methodology to value trades. Close-Out Amount valuation, which was introduced in the 2002 ISDA Master Agreement, differs from the Market Quotation approach in that it allows participants more flexibility in valuation where market quotations may be difficult to obtain.
Of course ISDA made it seems that it was doing a favor to industry participants, very likely dictating under the gun:

Industry participants observed the significant benefits of the Close-Out Amount approach following the default of Lehman Brothers. In launching the Close-Out Amount Protocol, ISDA is facilitating amendment of existing 1992 ISDA Master Agreements by replacing Market Quotation and, if elected, Loss with the Close-Out Amount approach.

"This is yet another example of ISDA helping the industry to coalesce around more efficient and effective practices, while maintaining flexibility," said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. "The Protocol permits parties to value trades in the way that is most appropriate, which greatly enhances smooth functioning of the market in testing circumstances."

And, lo and behold, on the list of adhering parties, AIG takes front and center stage (together with several other parties that probably deserve the microscope treatment).

So - in simple terms, ISDA, which is the only effective supervisor of the Over The Counter CDS market, is giving its blessing for trades to occur (cross) below where there is a realistic market bid, or higher than the offer. In traditional equity markets this is a highly illegal practice. ISDA is allowing retrospective arbitrary trades to have occurred at whatever price any two parties agree on, so long as the very vague necessary and sufficient condition of "market quotations may be difficult to obtain" is met. As anyone who follows CDS trading knows, this can be extrapolated to virtually any specific single-name, index or structured product easily. In essence ISDA gave its blessing for below the radar fund transfers of questionable legality. The curious timing of this decision and the alleged abuse of CDS transaction marks by and among AIG and the big banks, is striking to say the least.

This wholesale manipulation of markets, investors and taxpayers has gone on long enough.

A Few Notes on The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets

In their 2009 book, The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets, Mebane Faber and Eric Richardson "profile the top endowments and then examine how an investor can hope to replicate their returns while avoiding bear markets. The focus [is] on practical applications that an investor can implement immediately to take control of their investment portfolio." Mebane Faber "is the portfolio manager at Cambria Investment Management where he manages equity and global tactical asset allocation portfolios" and a co-founder of AlphaClone, an investing research web site. Eric Richardson is Chairman and founder of Cambria Investment Management. The book has a complementary web site that links to source materials. The principal messages of the book are:

Chapters 1-3: The top-performing university endowments (Yale and Harvard) are worthy of emulation by individual investors. These endowments have excelled through active management of portfolios diversified per Modern Portfolio Theory across a wide variety of asset classes (U.S. stocks, foreign stocks, bonds, cash, real assets, private equity and hedge funds), with disciplined rebalancing toward "Policy Portfolio" weightings that tilt toward equity-like assets. Active management means selecting the best assets within class either directly or indirectly by selecting the best asset managers.

Chapter 4-6: Individual investors can on their own easily emulate parts of the endowment portfolios with a simple Policy Portfolio comprised of low-cost exchange traded funds (ETF) designed to mimic the returns of relevant asset classes, rebalanced annually. This easy emulation does not include: (1) private equity and hedge funds; and, (2) active selection of specific assets within class. Disciplined rebalancing toward Policy Portfolio weightings is important to performance.

Chapter 7 -8: Individual investors can easily enhance this simple endowment emulation, as follows:

Exploit the return momentum effect for each ETF asset class proxy in the Policy Portfolio by allocated policy-dictated funds to the ETF (to cash) when the ETF is above (below) its simple 200-day moving average.

Amplify the momentum effect by rotating all funds monthly to the one, two or three ETF asset class proxies with the highest returns over the past three, six and 12 months (average of the three).

Extend the diversification of the Policy Portfolio by further segmenting asset classes as enabled by available ETFs, allow shorting of asset classes (per the momentum rule) and/or exclude bonds.

If borrowing costs are low, apply leverage.

Actively select specific assets to populate asset classes based on the holdings of top fund managers (such as Bershire Hathaway, Greenlight Capital and Blue Ridge Capital) as reported in quarterly 13F reports to the Securities and Exchange Commission.

The following chart, constructed from data in Table 7.10 in the book, compares the annualized returns for the Harvard and Yale endowments and for three enhancements of the simple endowment emulation over the period June 1985 through June 2008. The variability ranges for each are one standard deviation of annual returns. The chart also shows the worst-year return. Results indicate that the emulation models are competitive with the endowments. However, results for the three enhanced emulation models are "gross returns, so management fees, taxes and commissions would eat into returns a bit."

Note that, over large parts of the period of this analysis, simple and cheap asset class proxies (such as ETFs) were not available to investors. Also, trading frictions in "the old days" (pre-decimalization, pre-discount broker, olden days mutual funds) were higher than now. Costs of constructing and maintaining the three enhanced emulation models during these subperiods may have eaten into emulation returns more than "a bit." Small accounts may not have been practically able to achieve the desired level of diversification.

Two other considerations may affect future performance of the enhanced emulation models:

With asset class diversification, rebalancing and timing greatly simplified through proliferation of ETFs, the adaptive marketplace might permanently degrade the models by disrupting old long-run correlations and timing premiums. (The extreme stress test would be the "if everyone does this" case.)

Much of the logic in the book (like Modern Portfolio Theory) assumes the normality, or at least statistical tractability, of financial market returns via mean, standard deviation and Sharpe ratio metrics. Actual return distributions may in fact be too wild to rely on these metrics, with the stress tests considered in the book (such as "Worst Year" during June 1985-June 2008) not "wild" enough to realize a breakdown.

In summary, The Ivy Portfolio offers investors a well-reasoned, well-documented, easily understood and easily implemented approach to long-term, self-directed portfolio management based on disciplined asset class diversification enhanced by momentum. While investors should expect to underperform the modeled level of returns, the approach has considerable support from formal research.

For reviews of a few other books and information web sites (as well as tests of some trading strategies), see Blog Synthesis: Reviews of Books and Web Sites. See especially our blog entries of 10/23/08, 2/27/07 and 2/15/07 for related approaches.

Thursday, March 26, 2009

WSJ: Have We Seen the Last of the Bear Raids?

So is that it? Is the downturn over? After bouncing off of 6500, or more than half its peak value, and with Citigroup briefly breaking $1, the Dow Jones Industrial Average has rallied back more than 1200 points. So, is it safe to go back in the water? Best to figure out what went wrong first -- what I like to call a bear-raid extraordinaire.

The Dow clearly got a boost from Treasury Secretary Tim Geithner's new and improved plan, announced on Monday, to rid our banks of those nasty toxic assets. The idea is to form a "Public-Private Investment Fund" to buy up $500 billion to $1 trillion worth of bad assets -- mostly mortgage backed securities (MBSs) and collateralized debt obligations (CDOs).

While it's true that private interests can conceptually help establish the right market price for these assets, the reality is Mr. Geithner's public-private scheme won't work. Why? Because the pricing paradox remains -- private parties won't overpay, yet banks believe these assets are extremely undervalued by the market. As Edward Yingling, president of the American Bankers Association, said recently on CNBC, "You have to go into the securities, examine the securities, examine the cash flow. I've seen it done, and the market is so far below what they're really worth."

The Treasury can't just keep throwing money at the problem, but needs instead to figure out what's really been going on -- the aforementioned bear-raid extraordinaire that's crushed Citigroup and Bank of America and General Electric, among others. Only then can Mr. Geithner craft a real plan to fight back.

In a typical bear raid, traders short a target stock -- i.e., borrow shares and then sell them, hoping to cover or replace them at a cheaper price. Once short, traders then spread bad news, amplify it, even make it up if they have to, to get a stock to drop so they can cover their short.

Bear raid image This bear raid was different. Wall Street is short-term financed, mostly through overnight and repurchasing agreements, which was fine when banks were just doing IPOs and trading stocks. But as they began to own things for their own account (MBSs, CDOs) there emerged a huge mismatch between the duration of their holdings (10- and 30-year mortgages and the derivatives based on them) and their overnight funding. When this happens a bear can ride in, undercut a bank's short-term funding, and force it to sell a long-term holding.

Since these derivatives were so weird, if you wanted to count them as part of your reserves, regulators demanded that you buy insurance against the derivatives defaulting. And everyone did. The "default insurance" was in the form of credit default swaps (CDSs), often from AIG's now infamous Financial Products unit. Never mind that AIG never bothered reserving for potential payouts or ever had to put up collateral because of its own AAA rating. The whole exercise was stupid, akin to buying insurance from the captain of the Titanic, who put the premiums in the ship's safe and collected a tidy bonus for his efforts.

Because these derivatives were part of the banks' reserve calculations, if you could knock down their value, mark-to-market accounting would force the banks to take more write-offs and scramble for capital to replace it. Remember that Citigroup went so far as to set up off-balance-sheet vehicles to own this stuff. So Wall Street got stuck holding the hot potato making them vulnerable to a bear raid.

You can't just manipulate a $62 trillion market for derivatives. So what did the bears do? They looked and found an asymmetry to exploit in those same credit default swaps. If you bid up the price of swaps, because markets are all linked, the higher likelihood (or at least the perception based on swap prices) of derivative defaults would cause the value of these CDO derivatives to drop, thus triggering banks and financial companies to write off losses and their stocks to plummet.

General Electric CEO Jeff Immelt famously complained that "by spending 25 million bucks in a handful of transactions in an unregulated market" traders in credit default swaps could tank major companies. "I just don't think we should treat credit default swaps as like the Delphic Oracle of any kind," he continued. "It's the most easily manipulated and broadly manipulated market that there is."

Complain all you want, it worked. In early March, Citigroup hit $1 and Bank of America dropped to $3 and GE bottomed at $6.66 from $36 not much more than a year ago. Same for Lloyds Banking Group in the U.K. dropping from 400 to 40. Citi CEO Vikram Pandit recently announced that the bank was profitable in January and February. (How couldn't they be? With short-term rates close to zero, any loan could be profitable). Never mind they still had squished CDOs, it was enough to get some of the pressure off, for now.

Oddly, with the new Treasury plan, these same bear raiders are still incentivized to manipulate the price of swaps to depress toxic derivative prices, especially so with the government's help to get hedge funds to turn around and buy them. Perversely, they may get rewarded for their own shenanigans.

This week's Treasury announcement of private buyers isn't going to magically change the depressed prices of these toxic derivatives. The Treasury needs to fight fire with fire. If I were Mr. Geithner, I'd pull off a bull run -- i.e., pile into the CDS market and sell as many swaps as I could, the opposite of a bear raid. If the bears are buying, I'd be selling, using the same asymmetry against them. Sensing the deep pockets of Uncle Sam, the bears will back off. Worst case, the Fed is on the hook for defaults, which they are anyway!

With the pressure of default assumptions easing, prices of CDOs should rise, which not only gives breathing room to banks, but may actually get these derivatives to a price where banks would be willing to sell them, replacing toxic assets in their reserves with cash or short term Treasurys, which ought to stimulate lending.

So are hedge funds villains? Not especially. The bear raid probably saved us five to 10 years' of bank earning disappointments as they worked off these bad loans. Those that mismatched duration set themselves up to be clawed. Under cover of a Treasury bull run, banks should raise whatever capital they can and dump as many bad loans before the bear raiders come back. Let the bears find others to feast on, like autos, cellular, cable and California.

Wednesday, March 25, 2009

Bull market?

Time to buy? Yes it's always time to invest in good hedge funds. Over 3,000 absolute return funds made money in the last 12 months but few long only equity funds did. The fact is that the FUTURE prospects for the REAL hedge fund industry are outstanding. Every investor I know intends to INCREASE or maintain allocations to absolute return. The redemption of unsophisticated money creates more room for sophisticated investors who understand that smaller AUMs lead to bigger alphas. Low quality funds that shut down will simply be replaced by better new ones. So while my all alpha, zero beta portfolio was up in 2008, I'll be leaving those yen in good hedge fund strategies.

Hedge funds outperform equity benchmarks on a risk-adjusted basis over ALL time horizons. So far in 2009 most hedge funds that I follow are up while unhedged long only has lost over -10% after a disastrous -40% in 2008. Despite being negative last year, even the index of "all" hedge funds delivered 22% of alpha when compared to long only. But absolute returns are the raison d'etre and why anyone would invest in an AVERAGE hedge fund is incomprehensible to me. It's almost as weird as wasting time and money in an "average" stock. With the right evaluation techniques investors can do a LOT better than "alternative beta".

The Pareto principle rules - 80% of alpha is generated by 20% of managers. There is nothing unexpected about recent "aggregate" numbers and good hedge funds continue to deliver EXACTLY what they promised - uncorrelated absolute returns with capital preservation. Portable alpha redistributes from the unskilled to the skilled. 2 out of 3 of hedge funds shut down in 1970 but the following 40 years saw LOTS of industry expansion AND investor acceptance. No business sector grows in a straight line. Good hedge funds HAVE generated the performance that investors require. Not long from now hedge funds will be FRONT AND CENTER in most portfolios. Did the implosion slow internet growth? For every Netscape, Etoys and Excite along comes a Google, Twitter and Facebook. Creative destruction drives the hedge fund world too.

I suppose stock markets might eventually get back to where they once were. But even if I get hold of a Financial Times from March 2029 showing the Dow, Nikkei, Dax and FTSE all above 100,000, I STILL won't be betting on long only. Under that scenario I KNOW good hedge funds will return more. And if those benchmarks turn out to be LOWER than today, hedge funds will also have outperformed. The demand for GENUINE sources of absolute return is growing but that unrequitted love affair with stocks has jilted many investors. The long only crowd say risk appetite will return but I'll be staying in the safe haven of hedge funds. Skilled long/short security selection and many different strategies offers a smoother ride whatever the future holds. UNHEDGED funds are not for investors like me so I'll avoid the stock market rollercoaster.

Why should bull markets or bear markets affect the capital growth of a TRULY diversified portfolio? Traditional asset allocation has not met the expectations of many investors. The ONLY hedge for a long is a short. As the last decade has shown, if you own lots of stocks, bonds, real estate, private equity and commodities you are NOT sufficiently diversified. Long only assets are correlated particularly in bear markets. A robust portfolio requires substantial allocations to those skill-based strategies that do NOT depend on rising asset classes or a strong economy for success.

Anyone who regularly meets with hedge fund managers and bothers to look CLOSELY at the data quickly concludes that the more cautious an investor's risk tolerance, the more of their portfolio they need in quality hedge funds. I have the notion that the sole purpose of fund managers is to make money for their clients over USEFUL time frames without deep drawdowns. 50% losses are FAR beyond the acceptable level of risk with +100% needed to just get back to breakeven. I simply examine the FACTS and the empirical evidence clearly PROVES the lower risk and higher performance of good hedge funds. Diversification with lots of completely different strategies is of course critical to optimal portfolio construction for the long term.

Not investing in any stock because of Bernie Ebbers would be dumb so why are some uninformed "experts" arguing for avoiding quality absolute return strategies because of some fraudulent stockbroker called Bernie Madoff? That would be almost as stupid as those avoiding honest funds of funds that actually do due diligence because of Bernie Cornfeld. One of the best hedge fund managers in history was Bernie Baruch; if only governments had access to his sagacity today as President Roosevelt did during the 1930s depression. It is not helpful to rely solely on economists to "advise" on the economy.

The stigma of high sigma renders unhedged equity funds unsuitable for those who seek reliable performance at low volatility. The blandiloquence of the index fund afficionados with their "cheap" fees but expensive losses has not helped investors this decade. The fact that equities could underperform bonds over long periods refutes such theories. Stocks constitute an opportunity set of securities to buy and short sell. There is no mythic equity risk premium. History is bunk but investment skill does exist. Beta isn't dead, it was never alive BUT alpha is thriving, as usual. For alpha generation, you need a better data set and better ways of extracting information from that data set. Hedge funds are NOT an asset class; they are skilled strategies applied within and between asset classes.

Redemptions? Sure some cash is being transitioned and manager mixes should always be upgraded. You have to redeem from the underperformers before you can reinvest in the better hedge funds. It is also great news for the new money that will be coming in. The removal of the beta repackagers, that pretended to be "hedge funds" but got blown away by the market meltdown, improves the quality of the industry. Isn't that how capitalism is supposed to work? Doesn't the cull of the bottom quartiles IMPROVE the strength of the industry? Some are redeeming for liquidity reasons due to bigger losses in public and private equity. When money is taken from excellent hedge funds for ATM purposes, it creates more space for long term investors' money.

Investors care about performance, not asset gathering accolades, so why is reduced AUM a "bad" thing given that is it likely to lead to INCREASED performance? Smaller size hedge funds and a better manager universe means HIGHER returns and less crowded trades. There are MORE arbitrages, dislocations, anomalies and mispricings around for those with the ability to find them than ever before. As we saw with previous "death of hedge fund" predictions in the 1980s and 1990s, shaking out the losers is good for the absolute return industry and even better for investors.

Public scrutiny of "secretive", "unregulated" hedge funds is fine as long as it also brings public availability. Rarely have the FORWARD-LOOKING alpha opportunities been brighter and who can afford to take the damaging risk of beta again? The turmoil has eliminated funds with poor risk management processes while the departure of hot money has expanded the capacity available for investors that understand the long term diversification VALUE of good hedge funds. The shakeout is POSITIVE for those seeking alpha.

The more unsophisticated money that departs simply creates more room for people that appreciate the VALUE, SAFETY and RISK REDUCTION properties of good hedge funds. Alpha-centric portfolios requires skilled security selection and risk management. Since skill is rare and performance dispersion wide, strategy analysis, manager evaluation and portfolio optimization adds more alpha. No-one claims investing in hedge funds is easy. Choosing index funds is easier but "passive" returns have been very damaging.

Aggregate returns when the hedge fund industry was smaller in size were larger. Robust strategies have capacity and implementation constraints so a lower AUM is likely POSITIVE for performance. Changes in the financial market? Sure but the best managers adapt to ANY conditions. Variant perception and negative sentiment creates opportunities for those who do the hard work and analytical heavy lifting to identify the value through the hysteria and non-expert commentary. Following the crowd often results in wealth destruction. As last year showed, the zero sum alpha game means lots of managers to be wrong. The animal spirit nature of the markets inevitably results in some alpha winners but more beta losers. If "everyone" is making money then something is wrong.

Time is worth more than money so I shall not be waiting around for stock markets to recover when so many talented managers are at or near their high water marks NOW. With better solutions available, why endure the deadly drawdowns, vicious volatility and ridiculous risk of the stock market? Life is short and liabilities grow so who has decades available to await the alleged upward drift of the index? Reliable long term returns require attention to short term risk. In the worst bear markets there are always rising stocks and there are plenty of short sell candidates during bull markets. Long only index based investing guarantees too much money flows to bad stocks. Tracking a benchmark means the same HIGH risk as the benchmark is taken. Equity capital should flow to good companies; not ones that "have to be bought" because they are big and someone else actively decided to include them in their "passive" index.

By replacing market risk with quality manager risk, investors get reliable growth with capital preservation irrespective of underlying market direction. If they diversify, do their homework and are advised properly, investors DO get compensated for taking good hedge fund manager risk but they have NOT been paid for taking stock market risk for far TOO long. Individual investors need absolute returns in reasonable time frames. Whether you have $1,000 or $1 trillion to put to work, a substantial allocation to skill-based, risk managed absolute return strategies is ESSENTIAL. Investors need performance whatever the economic situation. In fact they need it even more in tough economic times.

The very rare hedge fund that loses -100% receives saturated global media coverage but there have not been many articles on the hedge funds that MADE +100% in 2008. Some believe that by holding on long enough, traditional portfolios will be fine. Economists rarely let the FACTS get in the way of their assumptions. The long only crowd claim that by staying in for the "long haul", UNHEDGED funds are all your portfolio needs. Conversely anyone who looks closely at PROPER hedge funds quickly sees their overwhelming superiority and safety. The critics know very little about hedge funds and have usually never invested in one themselves but still think their opinions are valid. The world changed; the mantra of buy and hold was over last century.

No place to hide? Actually there have been plenty of places to hide during the market turbulence. For managed futures CTAs, options traders and short biased strategies, 2008 was a superb year. Cash isn't king when it yields zero. Traditional asset allocation simply hasn't worked very well; skill based security selection with strategies that DIVERSIFY are what work. If an investor wants RELIABLE growth at limited risk in ANY scenario, a well constructed portfolio of quality hedge funds running DIFFERENT strategies is the way to achieve it.

Stay the course? But what course is the economy on in the long term? How should one invest given that we do not know market conditions in the future? Why the stoic indifference to portfolio pain when proven antidotes are available? The answer is with the absolute return managers that have the talent and incentives to make money irrespective of market direction. Modern portfolio theory doesn't need a tweak; it needs an extreme makeover. Any manager that loses -50% TWICE in a decade does not seem to merit a place in a risk averse portfolio. Bull market? It's always a bull market for investing in good hedge funds.

Monday, March 23, 2009

Inside the world's biggest hedge fund

Bridgewater founder Ray Dalio's intense focus on principles helps him make money in good times and bad. Now he's bracing for some very tough times indeed.

(Fortune Magazine) -- Is the current downturn merely a severe slump, or are we facing a second coming of the Great Depression? That's the question everyone is asking these days. But Ray Dalio, founder of Bridgewater Associates and manager of what is now the world's biggest hedge fund, has been preparing to answer it for eight years.

In 2001 he had his investment team build a "depression gauge" into the firm's computer system, line by line in the code, to adjust the portfolio's strategy and risk profile if the economy ever entered a massive deleveraging period - the kind of multiyear process that ricocheted through the world economy in the 1930s and that has eviscerated markets periodically through the ages.

On Sept. 30 of last year, just a couple of weeks after the failure of Lehman Brothers, Dalio logged into his system and saw that the computer had flipped the switch. Bridgewater's black box is now operating on high alert.

Yet even as he is preparing his clients to hunker down for something different and more challenging than a typical recession, Dalio still expects his fund to thrive. Because his approach doesn't depend on the direction of any particular market, he explains matter-of-factly, there is no reason that he shouldn't continue to find as many good investment opportunities as he always has. Considering what he sees coming, that's a pretty bold statement.

In normal times we might be writing about Ray Dalio, 59, simply because he's one of the world's most successful investors. Since starting Bridgewater Associates out of an extra bedroom in his Upper East Side Manhattan apartment in 1975, Dalio (pronounced Dally-o) has built the firm into a powerhouse managing some $80 billion. With a personal fortune estimated at more than $4 billion, he ranks as one of the wealthiest residents even in money-soaked Greenwich, Conn.

More impressively, for the past 18 years his flagship hedge fund, Pure Alpha, which now holds more than $38 billion, has averaged an annual return of 15% before fees - gliding through the Asian flu of the 1990s, the dotcom implosion, the terrorist attacks of Sept. 11, 2001, and the current worldwide financial crisis without ever suffering an annual loss greater than 2%. Last year, when 70% of hedge funds lost money and the average fund fell 18%, Pure Alpha generated a gross return of 14%.

But these are not normal times. And what makes Dalio compelling is not just his track record but the way he goes about making money, and the rigorous analysis he applies to understanding markets, organizations, the economy, and life.

Does Dalio think of himself as one of the world's great investors? "No," he says, shaking his head, visibly agitated. "First of all, I don't know what the definition is of 'one of the great investors.' It's a totally irrelevant question. I have the fear of messing up. And that fear drives me to ask, 'Well, could this thing happen? Could that thing happen? If it happened in Japan, how do I know it won't happen to me?'"

Dalio describes himself as a "hyperrealist," in the sense that he is driven to understand the processes that govern the way the world really works, without bringing subjective value judgments into the equation. "I think the thing that makes him different is an intolerance for the inadequate answer," says Bob Prince, 50, Bridgewater's co-chief investment officer, who's been with the firm since 1986. "He'll just keep peeling back layer after layer to get at the essential truth."

In every activity in his life - from managing his firm to stalking a wart hog on a bow-hunting trip - Dalio believes in applying a carefully thought-out process to get the results he wants. That's especially true in making investment decisions. "I'm very big on having clarified principles," he says. "I don't believe in being reactive. You can't do that in the markets effectively. I can't. I need perspective. I need a game plan." To develop one, he stress-tests strategies through computer simulation across time and around the world to make sure that they're "timeless and universal." It's all about cautious - and highly educated - wagering on probabilities.

During the long boom, many hedge fund managers earned billions on big leveraged bets that stocks would rise; later, a handful made fortunes by anticipating the bust. That not Dalio's style. (In fact, he hates being called a hedge fund manager.) For one thing, he doesn't magnify his bets with a lot of borrowed money - his leverage ratio is about 4 to 1, far less than other investors have used.

Like fellow quant-minded managers D.E. Shaw or Jim Simons of Renaissance Technologies, Dalio translates his insights into algorithms and then has a powerful computer system scour dozens of markets around the world looking for mispriced assets and other opportunities. Rather than focusing only on stocks and searching for Peter Lynch's proverbial "10-bagger," Dalio and his computers concentrate heavily on the currency and fixed-income markets, grinding out consistent singles, doubles, and occasional triples. That approach, as we've seen, can be very rewarding.

Understanding the 'D-process'

Bridgewater's main office is an unobtrusive, three-story stone and glass building that sits on 22 acres of heavily wooded land in Westport, Conn., some 20 miles up the coast from Greenwich. The firm has added space in three other buildings around the area as the explosive growth in its assets under management - averaging more than 40% annually for the past 10 years - has necessitated a similar investment in new employees and technological capacity. Since 2000 its headcount has grown from just under 100 to about 800, with more than 100 people in its client services division alone.

Unlike a typical hedge fund, Bridgewater does not manage money for wealthy individuals. Rather, it works only with large institutions like pension funds and sovereign wealth funds. Right now the firm has 270 clients, about half in the U.S. and half overseas. Like a standard hedge fund, it charges a management fee of 2% of assets and 20% of profits.

But its relationship with its investors consists of much more than taking a cut of their money. Bridgewater's army of analysts provides clients with a stream of research. "I love their daily economic report," says Loews Corp. CEO Jim Tisch. "For me it's a must-read." And the analysts are always on call to perform custom jobs or offer a portfolio critique - even of allocations to other hedge funds. "I view them more as a partner than a vendor," says John Lane, the director of Eastman Kodak's $7.5 billion pension portfolio, which has had money with the firm since the late 1980s. "We don't make a major change here in strategy without calling Bridgewater to get their view."

The money-management industry has been battered by scandal and failures lately, but Lane has complete confidence in Bridgewater. "Of all the investment firms we work with," he says, "they're the most trusted." Asked head-on about the trust issue, Dalio points out that outside custodians hold customers' money and that his institutional clients aggressively audit Bridgewater's operations.

Dalio, a sturdy six-footer who favors open-collar cotton shirts and corduroys when he's not meeting with clients, works out of an unostentatious office brimming with photos of his wife and four children and has a view of the Saugatuck River, which flows through the property. The rustic feel of his surroundings pleases him. A member of the board of the National Fish and Wildlife Foundation, he's an avid fisherman and bow hunter who has gone after everything from Cape buffaloes to wild boars. He says that his attraction to outdoor activities - he also enjoys snowboarding - is primarily a manifestation of his appreciation for the beauty and sophistication of nature. By comparison, he says, "anything that man sees or does is overly simplistic."

To maintain his mental energy and creativity, Dalio meditates about five times a week for 20 minutes, a practice he says he adopted when "the Beatles started doing it in 1968." He is also a rabid music fan with omnivorous tastes. He keeps a box at the opera in New York City, makes an annual trek to New Orleans for Jazzfest, regularly goes salsa dancing with his wife, and has a passion for the blues.

Like many billionaire money managers, Dalio has his own charitable foundation. For the past three years, he's funded newspaper and radio ads supporting a campaign called "Let's Redefine Christmas," which challenged people to give donations to charities as gifts instead of indulging in the holiday ritual of conspicuous consumption.

Although Dalio says he is not a particularly big reader, these days his desk is piled high with some 20-odd books on economic debacles, such as "Essays on the Great Depression" by Ben Bernanke and "The Great Crash of 1929" by John Kenneth Galbraith. Inside each are Post-it notes and hand-scribbled thoughts in the margins. He also keeps close at hand a binder he's put together with detailed, 100-page timelines of the four major deleveraging episodes of the past century - the hyperinflation of the Weimar Republic in the 1920s, the worldwide crash during the Great Depression in the 1930s, the Latin American debt crisis of the 1980s, and Japan's lost decade of the 1990s. He says the timelines provide "a virtual experience of what it would be like to trade through each scenario."

Out of those four historical examples, Dalio says that our current situation most closely resembles the Great Depression because of the global breadth of the problems. But he doesn't like to use the term "depression." He thinks it's too scary, evoking as it does images of hobos and Hoovervilles, and distracts people from focusing on the mechanics of what is going on. He prefers to use a term he coined: "D-process."

Most people, says Dalio, think that a depression is simply a really, really bad recession. But in reality, the two are distinct, naturally occurring events. A recession is a contraction in real GDP brought on by a central bank tightening monetary policy, usually to control inflation, and ends when the central bank eases. But a D-process occurs when an economy has an unsustainably high debt burden and monetary policy ceases to be effective, usually because interest rates are close to zero, and the central bank has no way to stimulate the economy. To compensate, the value of debt must be written down (risking deflation) or the central bank must print money (a trigger of inflation), or some combination of both.

In recent years the level of debt as a percentage of GDP in the U.S. has skyrocketed past previous highs last seen in the early 1930s. And the Federal Reserve's benchmark rate is now hovering just above zero. To Dalio, therefore, it's clear that a D-process is under way. "It seems very likely that stocks will get materially cheaper," he says. "We have to go through an important debt restructuring process, and a lot of assets are going to be for sale, huge numbers of assets. And there's going to be a shortage of buyers."

Even investors in most hedge funds won't be immune. According to research by Bridgewater, the hedge fund industry in aggregate is 75% correlated to the S&P 500, an issue on which Dalio has been sounding an alarm for a couple of years now. "Too many people have a systematic bias toward positive economic growth," he says. "I think that what we're going to probably have is an economy that's going to get worse, with most people positioned for it to be better." By the end of the D-process, he expects that the reverse may well be the case.

Alpha returns

Dalio grew up in suburban Long Island, N.Y., the only child of a jazz musician and a homemaker. Unlike his father, who played clarinet, piccolo, flute, and sax, Dalio never had the patience to learn an instrument. As a boy in the early 1960s, he caddied at a nearby golf course. The stock market was booming at the time and, at age 12, Dalio heard enough hot tips that he decided he wanted to get in on the action, so he went to see his father's broker. When his first purchase, Northeast Airlines, took off, he was hooked.

After attending Long Island University, he got an MBA at Harvard, spent a year as the director of commodities trading at brokerage Dominick & Dominick, and ended up working under Sandy Weill at CBWL Hayden Stone, where his job was to help businesses hedge their market risks using futures. After a year he struck out on his own as a consultant, helping companies hedge interest rate and currency risk. On the side, he invested his own money and began to accumulate trading "decision rules" - at first jotted down on notebooks, later stored on computers - that could be back-tested to see whether they worked in different eras and markets. In the mid-1980s, he parlayed his reputation for quality research into a chance to manage $5 million of fixed-income money for the World Bank, and produced spectacular returns. He launched his hedge fund portfolio in 1990 with money from Loews Corp. and Kodak.

It's no accident that Bridgewater's flagship fund is called Pure Alpha. The name reflects Dalio's commitment to an approach to investing - "portable alpha," or the separation of so-called alpha and beta - that was innovative when he started but is commonplace today in the wonkier corridors of Wall Street. "Ray Dalio recognized that the traditional model of portfolio construction was too constrained," says Angelo Calvello, a former executive at State Street Global Advisers and Man Investments and the author of a number of publications on portable alpha. "He really changed the way that people thought about investing and allocating risk."

In investing terms, beta is the passive return that a portfolio might get from the ups and downs of a benchmark such as the S&P 500 stock index. Alpha is the measure of a manager's return, with the same risk, in excess of the beta. For his own fund, Dalio devised an "alpha overlay" approach that allowed him to allocate a certain amount of capital to replicate an investor's chosen benchmark and then roam free among other asset classes looking for the best possible "alpha streams," or return opportunities. It was the perfect way to employ the trading formulas he had been accumulating over the years.

Then, Dalio says without irony, he discovered the holy grail of investing, "by which I mean that if you find this thing you will be rich and successful in investing." This grail is not, unfortunately, a talisman that a regular person might stumble on, but a formula: 15 or more uncorrelated return streams, either betas or alphas. According to Dalio, such a portfolio reduces risk by 80%.

The tricky part, of course, is finding a large number of reliable, uncorrelated, moneymaking sources of alpha in the first place. (If it were easy, everyone would do it). And it requires venturing far beyond the bounds of equities. Today, Bridgewater's computers scan the world for opportunities in roughly 100 different categories, ranging from directional bets on the price of industrial metals to relative bets on pairs of emerging market countries' interest rates. Having the fund so widely diversified reduces the risk of a major blowup - and it limits the impact that Pure Alpha can have on any one market.

Bridgewater's confidence in the Pure Alpha system is so great that a couple of years ago Dalio did something rare on Wall Street - turn away money. By the end of 2005, Dalio and his team felt that they were reaching the limits of their investment capacity. They decided it was time to stop taking new accounts and focus exclusively on their best strategy. Much of the money they were managing was segregated into portfolios for, say, global bond exposure using a more traditional approach, rather than Pure Alpha. So they gave their clients the opportunity to either transfer their money to Pure Alpha or withdraw it, if the portable alpha approach didn't fit their institutional mandate.

In the end Bridgewater did lose a few clients but created room to add more money from its existing ones. These days, in addition to the $38.6 billion in the Pure Alpha fund, Bridgewater has $17.9 billion in a portfolio called All-Weather, which Dalio originally created for his family trust. All-Weather is a "passive" fund designed to provide a long-term return comparable to that of a 60/40 mix of stocks and bonds, but with less risk (last year it was down 20%). For investors willing to take more risk, there is also a Pure Alpha II fund that makes the exact same bets as the flagship but with half again as much volatility.

'Either a cult... or the happiest place on earth'

A couple of years ago, Dalio surveyed his rapidly growing firm and decided that he needed to codify his value system so that there would be a model for working and managing the Bridgewater way. So he sat down to write an outline of his principles. The result is an extraordinary 62-page document that every employee is required to study. (Sample tidbit: "At Bridgewater people have to value getting at the truth so badly that they are willing to humiliate themselves to get it.")

"If you took five organizational psychologists, locked them in a room, and told them to create the perfect blueprint for a corporate culture, this is about what they would come up with," says Bob Eichinger, a retired consultant who has spent five decades working with companies on how to manage talent and now works part-time for Bridgewater. "He's trying to design a culture in which people with talent have the freedom to perform."

The result of that design feels pretty radical compared with the typical corporate environment. In keeping with his identity as a hyperrealist, Dalio is committed to total transparency. So, for instance, every meeting is taped and kept on file. Blunt and frequent feedback is required, including "drill-down" sessions that probe into why employees failed at tasks. Managers aren't allowed to evaluate an employee's performance unless he or she is present. Because Dalio believes mistakes are valuable learning tools, every time something goes wrong employees are required to file a memo in the so-called Issues Log. And because Dalio is passionate about the meritocracy of ideas, subordinates are encouraged to argue with their superiors - and the superiors are required to encourage it. "We hate egos," he says.

If young employees - and loads of recent Ivy League grads with 99th-percentile SAT scores roam the halls - need a reminder of the potential opportunity afforded by that meritocracy, they need look no further than Greg Jensen, 34, the head of research and the third voice, along with Dalio and Prince, in the firm's weekly investment strategy meetings. Jensen started at Bridgewater as an intern directly out of Dartmouth and rose quickly through the ranks. "I love that your contribution here gets evaluated on a logical, principled basis rather than through the prism of a power base," he says.

Not surprisingly, the intense culture is not for everybody. "It's either a cult with mind control or the happiest place on earth, depending on whether you buy into it," says one former employee. Even some happy current employees say that there was an initial adjustment period and admitted that aggressively candid feedback wasn't always fun. But several spoke of how empowering such an open approach can be, and a few even offered testimonials for how embracing a policy of radical clarity had improved their personal lives.

More to the point, perhaps, is the fact that Dalio's system gives him the results he's looking for. He says he is perfectly comfortable having his assertions challenged at all times. In fact, he craves it. "I draw my conclusions," he says, "and I say, 'Please shoot holes in this. Tell me where I'm wrong.' People tend to think that my success, or whatever you want to call it, has been because I'm a really good decision-maker. I think it is actually because I'm less confident in making decisions. So in other words, I never know anything really. Everything is a probability."

And that's what keeps him alert to ever-changing conditions. "If I had to make lots of long-term bets, my track record would be much worse than it is," he says. "The beauty of my position is that I have the ability to change my mind tomorrow.

Thursday, March 19, 2009

Sector % Change Since the 3/9 Close

Below we highlight sector performance during the current rally that started last Tuesday. As shown, the Financial sector is up a whopping 50% since the close on March 9th! The S&P 500 as a whole is up 17.4%, and Telecom, Materials, Industrials, and Consumer Discretionary are all outperforming. Consumer Staples, Health Care, Energy, Utilities, and Technology are underperforming the S&P 500.


Wednesday, March 18, 2009

$1 Trillion

For more personal finance visualizations see:

Tuesday, March 17, 2009

Commodity Snapshot

Below we provide a table and chart of the recent performance of ten major commodities. As shown, copper is up the most year to date at 23.66%. Copper is followed by silver, platinum, and oil on the upside. At the start of the year, we pointed out that gold had been significanlty outperforming silver, and that a long silver/short gold strategy may be a good play. That trade has worked out well so far this year. A similar trend has been happening with oil and natural gas lately, where oil has been rallying and natural gas has continued its decline. From their peaks last year, gold is still the commodity that has held up the best.



Below we highlight our trading range charts of the ten commodities shown above. The green shading represents two standard deviations above and below the commodity's 50-day moving average. As shown, oil has moved to the top of its trading range in recent days, while natural gas remains oversold. Precious metals have pulled back from overbought levels over the last week, while copper remains at the top end of its range.






10-Year Treasury Year Approaching 3%

Interest Ratstable US long-term interest rates continue to drift higher, and at a current level of 2.96%, the yield on the Ten-Year US Treasury is once again nearing 3%. If US yields continue to rise, Canada and Japan will be the only two countries highlighted with long-term interest rates of less than three percent.

Below we provide charts of the ten-year yield for six major industrialized regions. As shown, while yields have been drifting higher for everyone but the UK and Euro region, the rise in US interest rates has been the sharpest.

Interest Rats1

Interest Rats2

Rogers turns his sights on the US and many other things

Not content with savaging the battered British economy and its floundering pound, investment guru Jim Rogers has now turned his sites on the US, its ailing banks and most of all, AIG (while his attack on the UK drew some acid responses, it’s a fairly safe bet to bash the American Insatiable Group).

In an interview with Bloomberg TV, aired Tuesday, Rogers says the US risks sending the world into a depression as its bailouts of failed companies rob healthy businesses of capital, and urges Washing to let AIG - which notched up the biggest Q4 loss in corporate history - go bankrupt:

“The US is taking assets from competent people and giving them to incompetent people,” said Rogers, chairman of Singapore-based Rogers Holdings and author of books including Investment Biker and Adventure Capitalist. “That’s bad economics”.

In other cheery remarks, there were lots of dire warnings but not many solutions in Rogers’ predictions that the US is repeating the mistakes made by Japan in the 1990s and risks creating “zombie banks” by rescuing failed financial services companies that should have been allowed to go under.

His most useful point is possibly that we should all be buying farms and agricultural producers.

And in a characteristically counter-intuitive tack, Rogers warns that oil prices (now floundering around $47 a barrel after last year’s highs of more than $147), may rise to record levels due to waning reserves and a lack of major field discoveries: “Reserves of oil are going down all over the world…The price of oil has to go much, much higher. I don’t know if the oil price will go up to record level in three years or five years. I don’t know when but I know it is.”

Finally, the spectre of inflation also disturbs Rogers - although he owns gold and silver, he adds, calls to return to the gold standard are “not going to solve our problems”:

“People should be prepared for inflation as governments worldwide are printing money to prop up economies at a time when commodities supply is under pressure…We’re going to have serious, serious inflation down the road… I wish I knew when.”

Thanks, Jim.

And here are Rogers’ other main points, courtesy of FirstAdopter:
- This is a bear market rally that can last days, weeks, even months
- He is worried about government debt market. In a few months, they have quintupled government debt
- Massive short squeeze on the U.S. dollar from forced liquidation. It’s an artificial rally
- He owns the yen and the dollar, not sure where to put the money. Maybe real assets
- The only asset class that has fundamentals improving are raw materials and commodities
- He owns some gold, but thinks there is more money to be made in agriculture and silver. IMF is trying to sell their gold, which may hurt it for a while
- Central bank is trying to keep interest rates down, but eventually it will backfire and rate will go through the roof
- If you write-off everything in sight, sure you can show a profit [talking about C, BAC, and JPM saying they are profitable in January and February 2009]
- He is short JPMorgan and covered his Citigroup. He thinks they have gigantic derivatives and off balance sheet exposure, also large credit card division which will be bad
- No position in insurance companies
- Best economic sector in the world next 10-20 years is agriculture and farming. Low inventories and tons of shortages

Paulson goes for gold

That’s John not Hank, of course. And the scourge of the banking industry has just made a big bet on the yellow metal.

This statement was released by Anglo American on Tuesday afternoon. (emphasis ours)
Anglo American announces the sale of its remaining 11.3% shareholding (39,911,282 shares) in AngloGold Ashanti Limited to investment funds managed by Paulson & Co Inc for $32.00 per share in cash, generating proceeds of $1.28 billion. The proceeds will be used for general corporate purposes. Consistent with Anglo American’s stated intention to dispose of this non-core holding, Anglo American no longer owns any shares in AngloGold Ashanti.

Here’s AngloGold’s chief executive Mark Cutifani on Paulson’s investment. (emphasis ours).
“Following Anglo American’s final selldown I’d like to welcome Paulson & Co. as one of AngloGold Ashanti’s largest shareholders. As the world deals with the global economic crisis the value of gold, as the only true “hard currency”, is coming to the fore as evidenced by the investment choices of some of the world’s most seasoned investors,’’ AngloGold Ashanti Ltd. Chief Executive Officer Mark Cutifani said. “We’re extremely pleased that someone with John Paulson’s track record and reputation has chosen AngloGold Ashanti as one of his investments through which to increase his exposure to the gold market. The Anglo American share overhang, with its depressing effect on our share price, has now gone and I’m excited about the opportunities that lie ahead for us.’’

Two Hedge Funds Among Recipients Of AIG’s Bailout Bucks

Two hedge funds can be counted among the recipients of American International Group's government-subsidized payouts.

Thus far the public outrage over the $93 billion that AIG is paying to its counterparties has focused on payments to Goldman Sachs, Deutsche Bank, Barclays, and other big banks, but two hedge funds have received $400 million of taxpayer money.

Citadel Investment Group and Paloma Securities—a branch of Conn.-Based Paloma Partners—were paid $200 million each of taxpayer dollars between Sept. 18 and Dec. 31, according to the list of securities lending counterparties released on Sunday by AIG.

According to the insurance giant, the payments were contractual obligations of AIG under its securities lending agreements.

AIG recorded a stunning fourth quarter loss of $61.7 billion—the largest corporate loss in U.S. history. On Sunday, in addition to the list of counterparties, the firm also announced that it would be paying millions of dollars (some media reports claim up to $1 billion) in bonuses to retain its top employees. The firm said that these payments were also contractual agreements, and that in the future the insurance giant would try to rein in employee compensation.

Monday, March 16, 2009

Leveraged ETF Performance

Below we highlight the year to date performance of the many leveraged and inverse ETFs available to US investors. But first we want to highlight the 3x ETFs to show their year to date performance versus the indices they follow. Remember, these ETFs are meant to track the DAILY performance of the underlying indices, but many investors unfortunately hold them as long-term investments, where the performance can be way off. As shown below, the 3x long large cap ETF (BGU) is down 41.55% year to date while the index it tracks is down 13.99%. This is right inline with where performance should be. However, the 3x inverse large cap ETF (BGZ) is up just 26.78%. Investors hoping for 3x have only gotten 2x in this case. The same holds true for the 3x inverse small cap (TZA), which is up 41.57% versus the underlying index's decline of 20%.

Where performance gets really bad is in the 3x inverse financial ETF (FAZ). While the underlying financial sector is down 28.15% year to date, the 3x inverse ETF is up just 0.34%! Investors who wanted to bet big against the financials this year using FAZ have been correct in their prediction but haven't made a dime on it (well maybe a dime).


Below we highlight the 25 best and worst performing leveraged and inverse ETFs year to date.

Kass: It Ain't Heavy, It's a Bottom

Doug Kass

03/16/09 - 09:31 AM EDT

Today's column is ambitious and some might think reckless in its objective of introducing an optimistic market forecast and the logic behind my S&P 500 -- and SPDRs (SPY Quote - Cramer on SPY - Stock Picks) -- price targets.

My view of a meaningful upside stock market trajectory in the months ahead is clearly a variant view, but I am familiar with that terrain as I have consistently expressed a negative (if not dire) baseline assumption for credit, the world's economies and stock markets for much of the past three years.

To add to my relatively bold and audacious expectations and presentation, I will attempt to be precision-like in exhibiting a chart that most closely represents that promising market outlook over the next several months.

Nearly two weeks ago, I suggested that a 2009 market bottom had been put in, and last week I surmised that, in the fullness of time, a generational market low might have been put in for the U.S. stock market.

At inflection points gauging the market's technical bearings is often useful as is a history lesson, so let's travel that route.

A deep oversold, worsening sentiment and positive internal divergences almost always provide the foundation to stock market recovery.

The move from the October lows to the March lows indicated growing fear and gave way to rising cash positions and the loss of hope, but the market's internals were improving. November's DJIA low of 7,552 was nearly 11% below the October low of 8,451 and the March low of 6,547 was 22.5% under October's low. While each new low was more frightening than the prior one, however, there were improving technical and sentiment signals -- for example NYSE volume at the October low expanded to 2.85 billion shares; at the November low, volume dropped to 2.23 billion shares; and at the March low, volume was only 1.56 billion shares. As well, new lows traced decreasing levels: At the October low, there were 2,900 new lows; at the November low, there were 1,515 lows; and at the March low, there were only 855 new lows on the NYSE.

From a sentiment standpoint, the March low marked an unprecedented number of bears, according to the AAII Survey. (I have recently addressed one of the only debatable sentiment indicators -- namely, a stubbornly low put/call ratio -- as increasingly inconsequential, owing to record low net long positions for hedge funds and more limited individual investor exposure, which negates the need for put protection.)

Last week (and right on cue!), we witnessed conspicuous breakouts and strengthening momentum off of Monday's bottom. The combination of Tuesday's 12:1 ratio of advancing stocks over declining stocks coupled with that day's 27:1 up-to-down volume ratio has not occurred in almost 65 years. The 9% three-day rally and rising volume on two 90% up days was very encouraging. I was also inspired by the improving conditions of my watch list, particularly the strength of financial stocks and the ability of many stocks (e.g. General Electric (GE Quote - Cramer on GE - Stock Picks)) to advance in the face of bad news. (In the case of GE, there was a Fitch downgrade late in the week.)

Most strong rallies don't let investors back in easily and get overbought quickly. I expect the current one to be sharp initially and to continue without much of a retest over the next week, creating a short-term overbought by month's end.

So, how now, Dow Jones?

"History doesn't repeat itself; at best, it sometimes rhymes."

-- Mark Twain

As a template, I expect the 2008-2009 stock market price pattern to most resemble the 1937-1939 period. The technical parallel mirrors a similar fundamental backdrop.

Let's first examine 1937-1939 S&P chart.

Dow in the 1930s & '40s vs. Nasdaq Now
Very similar patterns


The 1937-1938 period holds a number of similarities to the current period:

1. The stock market decline followed a four- to five-year rally, after a three-year decline of greater than 80%, which is similar to the Nasdaq experience.

2. Worldwide industrial production collapsed in 1937.

3. Commodities crashed in 1937.

4. The markets spent five years consolidating the declines.

5. Massive government spending pulled the U.S. out of The Great Depression. (Back then, it was preparing for WWII; this time, it will be government stimulus/infrastructure.)

The 50% drop over a five month period in 1937-1938 holds a similarity to the market's recent drop in that neither had a high-volume selling climax. The market's 1938-1939 recovery, perhaps like 2009's, had four legs and lasted about seven months.

Leg one of the 1938-1939 rally was brief and intense; it lasted only about 12 trading days, and the indices rose by 19%. Leg two was an approximate 60-day consolidation that corrected half of the initial gain. Leg three was about a six-week rise of 30%. Leg four consisted of another two-month consolidation and retracement followed by a 22% six-week rally, serving to mark a multiyear high in the averages.

I expect a similar pattern (as in the late 1930s) to be traced ahead in 2009.

An audacious forecast: In the months ahead, the fear of being in will be replaced by the fear of being out.

Here is a chart of my expectation for the SPDRs in the months ahead.

SPDR Trust (SPY) -- Expectations


A poorly positioned hedge fund community, with an historically low net long exposure and rankled by negative investment returns and the fear of continued redemptions, should provide the initial thrust to the S&P's 50-day moving average of about 810. It is important to recognize that, historically, strong rallies that have durability (like in 1937-1938) but, as previously written, typically don't let investors in during the first advancing leg. With such a clear burst of momentum, the fear of being out could drive the S&P 500 as much as 15 to 40 points above the 50-day moving average, paralleling the 20% third-quarter 1938 move and producing a short-term top and a temporarily overbought market.

The spring should be characterized by a backing and filling as the sharp gains are digested, similar to the the September-October 1938 interval. Sloppy second-quarter warnings will weigh on the market during the April-May period, but the markets could move sideways, bending but not breaking. Signs of market skepticism, sequential economic growth and evidence of a bottoming in the residential real estate and automobile markets (after a sustained period of under-production) could contain the market's downside, providing a range-bound market with a firm bid on dips. As well, the results from the bank stress tests and the release of a more coherent and detailed bank rescue package could provide further support to equities.

By June, economic traction should begin to take hold from the accumulated fiscal and monetary stimulation coupled with the large drop in energy prices. While it will be too early to demonstrate a broad economic recovery, evidence of stabilization will be clearly manifested in improving retail sales, and stocks will take off for their final advancing phase. With fixed income under increasing pressure, large asset allocation programs at some of the largest and late-to-the party pension plans (out of bonds and into stocks) could trigger an explosive rally in the middle to late summer. This move by July or August could close the October 2008 gap in the SPDRs at around $107.

Sunday, March 15, 2009

What will recovery look like?

When good news comes, what should we expect to see?

The graph below plots the quarterly percentage change (at an annual rate) for real GDP and some of its key components since 1947. Calculated Risk has noted that the typical recession pattern is for nonresidential fixed investment to begin its decline after residential fixed investment and consumption, and not begin its recovery until after housing and consumption have begun their recovery.

Quarterly percent change (at an annual rate) of real GDP, 1947:Q2 to 2008:Q4, and three of its components. Data source: BEA Table 1.1.3. Shaded areas denote NBER recession dates.

This pattern emerges more clearly when you look at the average behavior of each component over the course of the earlier historical recessions.

Average cumulative change in 100 times the natural log of real GDP or its respective component beginning from the business cycle peak for the 10 recessions between 1947 and 2001. Horizontal axis denotes quarters after the peak.

Here's the severe 1981-82 recession in isolation:

Cumulative change in 100 times the natural log of real GDP or its respective component beginning in 1981:Q3. Horizontal axis denotes quarters after 1981:Q3.

And here's what we're seeing so far this time. True to form, nonresidential fixed investment had been holding up reasonably well during the early part of the downturn, but has now started to decline significantly. That process has enough momentum that it is hard to see nonresidential fixed investment picking back up before we see some recovery from consumption spending.

Cumulative change in 100 times the natural log of real GDP or its respective component beginning in 2007:Q4. Horizontal axis denotes quarters after 2007:Q4.

And how reasonable a prospect is that? Plunging output and employment are big negatives for consumption spending, as is the huge drop in stock market and real estate wealth. The home equity that remains has become harder to extract, and a general contraction in household debt relative to GDP seems unavoidable. These latter factors presumably have played an important role in the surge in private saving as a percentage of disposable personal income.

Personal saving as a percentage of disposable personal income, 1959:M1 to 2009:M1. Data source: BEA Table 2.6

But a couple of other factors are likely also contributing to these higher saving rates where the near-term dynamics could favor an increase in consumption spending. The first is the fact that gas prices are about $2/gallon lower than they were last spring, which has freed $280 billion for consumers to save or spend on other things.

US average retail gasoline price. Source:

Pessimism itself is another potentially changeable factor that is making a separate contribution to what we see going on. When sentiment turns around, spending will pick up, and I don't see why we'd rule out the possibility of some improvement in sentiment. The preliminary March reading of the Reuters/Michigan index of consumer sentiment was at least slightly up rather than down.

Reuters/Michigan index of consumer sentiment. Data source: FRED and MarketWatch.

With all eyes on consumers, it's interesting that the average value for retail sales in January and February was 1.8% above the dismal number for December.

Source: FRED.

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.