Saturday, October 23, 2010

Party Like It's 1974

One seer says stocks will have short-term rallies as bonds succumb to a major bear market. But long-term investors, beware.

MEMORIES OF THE 1970S AREN'T PLEASANT for the most part. Watergate. Defeat in Vietnam. Leisure suits. Granny dresses. Disco. And most importantly, the emergence of stagflation, with inflation and unemployment soaring in what seemed then to be the Dickensian worst of times.
What's forgotten is that the second half of that benighted decade wasn't bad for equity investors. After the devastating bear market of 1973-74, stocks actually scored decent rallies through the rest of the decade. And that was in the face of a collapsing bond market bought on by the soaring inflation and the collapse of the dollar.
Notwithstanding the current focus on deflation, CLSA strategist Russell Napier, thinks markets will experience something more like the inflationary 'Seventies. Bonds are face a major bear market while equities should see major rallies—even if the ultimate lows in real, inflation-adjusted terms still lie ahead.
For equity investors, valuations have gotten so depressed that they all but guarantee strong returns, he says. Dividend yields are the highest relative to government bond yields since 1955, according to Napier. Since 1958, when stocks began to yield less than bonds, high stock yields relative to bonds consistently have meant strong equity returns.
Moreover, he adds, the relative valuations of stocks versus bonds suggest markets are discounting a decline of more than 60% in corporate profits. Absent such an eventuality in a double-dip recession, stocks are priced for a too pessimistic future, Napier contends.
Indeed, in a research report entitled "It's not the economy, stupid," equities ought to do substantially better than what's implied by gross domestic product or employment data. Valuations count more, and they're so depressed that anything short of a new downturn implies vastly better returns from stocks that bonds.
Of course, just the opposite has been true in 2010. For instance, the S&P 500 SPDR exchange-traded fund (SPY) has returned 6.21% since the beginning of the year, according to fund-tracker Morningstar, which is less than one-third what the longest-duration Treasury ETF, the Pimco 25+ Year Zero Coupon U.S. Treasury Fund (ZROZ) scored so far in 2010, 19.34%.
In other words, this year the correct decision has been to buy bonds for capital gains and stocks for income. That has been a profound reversal of fortune.
And it is one that favors stocks over bonds, Napier contends. The deflationary outcome discounted by the markets is made less likely by a number of factors. Money and credit no longer are contracting. Corporate cash is likely to be mobilized for expansion or acquisitions instead of bolstering balance sheets.
Bonds, Napier further contends, are about to enter a bear market "that will last a generation." With yields starting at such a low level, with the 10-year Treasury around 2.50%, any substantial rise in yields will result in price declines and negative total returns.
But the early stages of a bond bear market aren't a barrier to equity returns, as the record of the late 1970s showed. Indeed, Napier doesn't see stocks being threatened until the benchmark 10-year Treasury reaches 5%.
Even so, he points out that the real, inflation-adjusted low in stocks wasn't reached until 1982. Which should give investors pause. Indeed, Napier contends that valuations aren't down far enough to give investors confidence to buy and hold stocks for the long term.
To be sure, stocks are cheap relative to bonds. For fixed-income portfolios, there are more basis points in yield on the upside than downside.
Whether investors will act on this is another question. Corporate pension funds have moved heavily into bonds, for instance.
Cheap stocks also can remain cheap for a long time. Bonds and bond funds face significant losses if yields rise. So what's the answer? Napier's research suggests fixed-income investors should shift a portion to stocks, and vice versa.

Wednesday, October 20, 2010

Kass: Equities Edge Toward a Top

Doug Kass

10/19/10 - 02:00 PM EDT
This blog post originally appeared on RealMoney Silver on Oct. 19 at 9:13 a.m. EDT.
I find myself back to taking the (market) road less traveled once again as investors' unjustified blind faith in the success of QE 2 has increased the U.S. stock market's degree of risk relative to the reward.

Let me start by emphasizing that the precision of stock market forecasts in a market dominated by algorithms, momentum players and even mob psychology is an increasingly difficult exercise, but I will try nonetheless.
In early July 2010, when the S&P 500 was plummeting and closing in on the 1,000 level, I suggested that the scale had tipped to the bullish side and that equities were in the process of making the lows for the year.
Since then, buoyed by the notion that the prospects for an open-ended QE 2, which would be aimed at lowering real interest rates, raising inflation rates and have a strategy that might even be targeted at the S&P 500 in order to elevate the U.S. stock market, equities have leapt forward for weeks in a routine and consistent fashion.

In light of what I expect to be a disappointing economic impact from QE 2 -- I call it quantitative wheezing -- and the negative consequences of that strategy ("screwflation") on the majority of Americans, I now believe that equities are in the process of putting in the highs for the year.

After spending like drunken sailors during the Bush administration, Republican legislators have acknowledged that it will block even the most sensible stimulus programs, and the Democratic administration and its legislators have lost the will to fight their adversaries. As a result, the responsibility for turning around the domestic economy now lies squarely on the shoulders of the Fed.

The implementation of QE 2 during the first week of November is now a virtual certainty. The general belief in its efficacy has vaulted stock markets around the world considerably higher.

The markets believe that unusual, definitive and targeted monetary solutions will solve deep-rooted problems that, in the past, were put on the shoulders of fiscal policy (e.g., a tepid jobs market).

On Wall Street, we too easily extrapolate trends. Whether it's company earnings or industry statistics or economic recoveries, policies and rescue packages, investors want to believe in the more or most favorable outcomes. So, we are told by David Tepper, Wall Street strategists and most long-biased investors that if the liquidity infusion from the first round of quantitative easing worked in the U.S., it has to work in QE 2.
Throughout the market's rally over the past six weeks, I was reminded something Milton Friedman's once expressed, which I have taken the liberty of paraphrasing below to emphasize my concerns with regard to the efficacy of QE 2: If you put the Federal Reserve in charge of the Sahara Desert, in five years, there would be a shortage of sand.

We have embarked on a slippery slope of policy, and, from my perch, there is too much confidence regarding a favorable outcome.

Is it really a good idea to put our investment trust in the successful policy of the Federal Reserve in its ability to fine tune inflation and stimulate growth? After all, in the past the Federal Reserve couldn't find their way home and failed to identify the stock market bubble in the late 1990s, the housing bubble in 2003-07 and the recent credit bubble.

In a recent interview with Fortune Magazine's Carol Loomis, Warren Buffett said that he "can't imagine anybody having bonds in their portfolio." (I continue to believe that short bonds is the trade of the decade.) At the same time, Fed Chairman Ben Bernanke is hellbent on buying U.S. bonds ad infinitum. As my buddy/friend/pal, Jeff Matthews, recently wrote, Who do you have more confidence in making your investment decisions -- Berkshire Hathaway's (BRK.A) Warren Buffett or the Federal Reserve's Ben Bernanke?
Most market participants are fixated with the potential for QE 2 to boost asset prices and generate organic economic growth, however, without a subsequent rise in aggregate demand and productivity, the program will ultimately be deemed a failure as prices readjust over time to reflect the real underlying fundamentals. Mr. Bernanke is making the same blunder that we made with the past bubbles busts -- if we can create paper profits and convince consumers that they should spend those paper profits, then we'll be on our way to economic prosperity. The problems arise when asset prices readjust lower to meet their true fundamentals. It's Ponzi finance and nothing more. -- "Northern Trust: QE 1 Failed, Why Will QE 2 Work?" from Pragmatic Capitalism
As I have written previously, I don't believe QE 2 will meaningfully move the needle of domestic economic growth and will only have a limited impact on:
  • the jobs market, which is plagued by structural unemployment;
  • housing, which that is haunted by a large shadow inventory of unsold homes and in which mortgage credit will likely be further reduced by the moratorium on foreclosures; and
  • confidence, which is still mired in uncertainty regarding regulatory and tax policy (and that is undermined by high unemployment).
Conditions are far different for QE 2 than QE 1. Interest rates have already fallen to very low levels, and the benefits have already been felt on mortgage rates and in refinancing. Also, unlike QE 1, when the world's central banks were all-in, differing policies now dominate the global landscape.

Meanwhile, our fiscal imbalances multiply, our currency craters (as a worldwide rush to currency devaluation is offsetting some of the normal trade deficit benefit), and the bulls rationalize these concerns by suggesting that the consequences "are beyond our investment time frame."

Importantly, there are a number of other possible adverse consequences from the inefficient allocation of resources that is the outgrowth of the next tranche of monetary stimulation.
While the immediate response to the likelihood of QE 2 has been to buoy asset prices, the domestic economy is stalling at around 1.5% to 2.0% GDP growth, and little improvement in the jobs market has been seen. This hesitancy makes the anemic slope of the current recovery vulnerable to the unforeseen (e.g., trade wars, policy errors, etc.) and could place the generally assumed self-sustaining economic cycle at risk. As well, the long tail of the last cycle's abusive use of credit looms large, as demonstrated by mortgage-gate.
My bottom line is that QE 2 will have only a modest effect on the broad economy. Our largest corporations will fare better as interest rates drop and will profitably extend their debt maturities in a cheap and hospitable bond market, but, as commodities rise, some troubling consequences could emerge.
We are not on a road to the stagflation of the 1970s, but we may very well be on the road to screwflation.
Screwflation, like its first cousin stagflation, is an expression of a period of slow and uneven economic growth, but, its potential inflationary consequences have an outsized impact on a specific group. The emergence of screwflation hurts just the group that you want to protect -- namely, the middle class, a segment of the population that has already spent a decade experiencing an erosion in disposable income and a painful period (at least over the past several years) of lower stock and home prices. Importantly, quantitative easing is designed to lower real interest rates and, at the same time, raise inflation. A lower interest rate policy hurts the savings classes -- both the middle class and the elderly. And inflation in the costs of food, energy and everything else consumed (without a concomitant increase in salaries) will screw the average American who doesn't benefit from QE 2.
In summary, somebody holds the key to a self-sustaining domestic economy, but I doubt that it is a monetary maven, as some of the potential side effects of quantitative easing might be worse than the medicine. And the confidence and animal spirits that the markets have expressed since early September might just be blind faith.
The domestic economy remains in a contained recession, and, while containment efforts will continue with QE 2, the efficacy of these efforts will likely disappoint and wane.
I continue to see the risks to 2011 corporate profit and U.S. and worldwide economic growth rates to the downside. It remains likely that secular and nontraditional headwinds will produce an extended period of inconsistent and uneven growth in the years ahead, which will be difficult for both corporate managers and investment managers to navigate. Arguably, given the sharp rise in equities, the downside risks might be growing ever greater, especially if I am correct that QE 2 will be a dud.
The key to remedying today's low P/E multiples would be to apply the same amount of attention, brain power and solutions spent on short-term policy (which invariably makes things worse) on the underlying structural problems that our country faces.
But, patience, more than policy, is something that investors, politicians and others have precious little of these days.

Those ETF shorts

Blackrock, the world’s largest asset manager — with $3,450bn under management according to figures released on Wednesday — puts out a regular quarterly review of the ETF industry.
And as usual, it presents some interesting factoids on all matters exchange-traded fund — be they product, currency or commodity. Blackrock itself, of course, is a leading player in the ETF market through its ownership of iShares and currently — according to its own report — has some $534.6bn in ETF assets under management.

Amongst other things there are some good statistics on just how shorted ETFs are, which is interesting given some of the debate that’s focused on the matter recently.
We stress the ETF industry maintains that the creation/redemption mechanisms built into the structures — designed to keep the funds tracking their underlying benchmarks — would prevent any possible shorting-related implosion.

Nevertheless, it is interesting to what degree these products are now being used in this manner, since it reflects just how actively and dynamically they are being traded.
As Blackrock’s Deborah Fuhr, author of the report, notes:
Short interest in United States listed ETFs have reached the highest ever during 2010.
• Based on data through September 2010 the average number of ETF shares short during 2010 YTD reached an all time high of 1,735 Mn shares, with an average of 1,653 Mn in 2009 and 1,693 Mn in 2008. The September 2010 short interest level for United Stateslisted ETFs was 11.1% of shares outstanding or 1,811 Mn shares, up 4.4% from 1,735 Mn in December 2009. Investors are using ETFs for long/short and hedging strategies.
All of which means, if you happen to be long ETFs, you can now make quite a healthy return from just lending them out — in many cases making up for the management/expense fees incurred by owning them.
As Fuhr explains:
For investors who own ETF shares, the lending revenue that can be earned on ETFs, may at times, and for some ETFs, more than cover the annual Total Expense Ratio (TER). Short interest is often considered an indication of the level of scepticism in the market.
Of course, short interest should be considered in view of outstanding shares — and here the latest figures suggest a more muted trend in historic terms. For example, in September, some 11.2 per cent of all US ETF shares were currently out on loan, which compares to an average of 12.4 per cent in 2009, 17 per cent in 2008 and 16.1 per cent in 2007.

Of course, some ETFs do remain more shorted than others. A number even have more stock out on loan than outstanding shares.

Here, for example, is the latest chart from Blackrock showing the top 20 US ETFs based on short interest — with those ratios over 100 per cent relative to outstanding shares highlighted by us:

According to Fuhr, though, it shouldn’t signal anything alarming if an ETF does have more than 100 per cent of its shares out on loan. The situation, she says, is simply the result of the same shares simply being lent onwards and onwards.

If you actually went to redeem the shares, you would have to own them first, she stresses.
Meanwhile, if the process of acquiring them generated a squeeze, authorised participants would be triggered into action — rebalancing the market as they came in.

Of course, we’re not sure how that fits with the picture of regular and consecutive ETF settlement fails, as depicted in Threshold Security data from the NYSE Arca exchange. The numbers here may simply be too small to count.

Meanwhile, as an aside, the report also notes that in September 2010 US ETF turnover made up 25.9 per cent of total BlackRock equity revenue, with the average daily trading volume year-to-date up by some 15.5 per cent to $52.9bn.
Full ETF market report in the usual place.

Wednesday, October 13, 2010

Notes From the Value Investing Congress: Burbank, Ainslie, Parames, & Singhi

We're pleased to present notes from the Value Investing Congress taking place today and tomorrow. Today's notes include presentations from John Burbank (Passport Capital), Lee Ainslie (Maverick Capital), Francisco Parames (Bestinver Asset Management), and Amitabh Singhi (Surefin Investments).

Below is a quick summary of today's ideas.

John Burbank ~ Passport Capital

Burbank's presentation focused on the 'math of democracy.' His talk started off quite grim as he believes the US government's current level of spending is unsustainable. Burbank feels the US is changing and must now be viewed as an emerging market. This is along the lines of what Burbank presented at the Ira Sohn West Conference recently as well. Over the longer-term, he believes we're headed either in the direction of Argentina or Germany.

The most jolting claim in Burbank's presentation was the notion that classic bottom-up stockpicking is dead. This is intriguing of course because the majority of attendees at the VIC employ such a strategy. Burbank approaches things a bit differently, utilizing a top-down approach and actually feels that the next two years in the market could be more tranquil than currently anticipated.

In terms of portfolio allocation, Burbank likes being long countries with high political/economic freedom. He likes a group he refers to as the "new CASSH" referring to Canada, Australia, Singapore, Switzerland, and Hong Kong. Conversely, he likes being short developed countries with large debt.

In terms of specific positions, Burbank mentioned Passport's largest position as Riversdale Mining (ASX: RIV). He believes gold is a 'must have' investment, but preferably via the physical asset and *not* through the exchange traded fund, GLD. David Einhorn of Greenlight Capital has also in the past mentioned that owning physical gold is cheaper than GLD (due to expenses). Passport Capital currently has an 8% position in physical gold as it is a much cheaper way to play the metal.

Burbank is quite fond of hard assets/commodities and wants to buy assets that China needs. Specifically, he likes potash for that very reason and has big stakes in Mosaic (MOS) and CF Industries (CF). Additionally, he has a position in Potash (POT), the company subject to takeover bids from BHP Billiton. Recently, Dan Loeb's hedge fund Third Point disclosed a new stake in POT. Burbank also has a major investment in coking coal in Mozambique. The fund manager also said he is long steel and short copper.

In terms of other positions, Passport also owns big blue-chips with yield including Exxon Mobil (XOM), Kraft (KFT), Dr. Pepper (DPS), and Microsoft (MSFT). Lastly, the hedge fund manager mentioned that individuals who understand capital allocation need to boost their contributions to political candidates. Passport Capital's portfolio is detailed in our newsletter, Hedge Fund Wisdom.

Lee Ainslie ~ Maverick Capital

Ainslie's presentation focused on the 'case for technology.' The Maverick Capital founder noted that the investment landscape is very different now than it was two years ago. The hedge fund manager says this is a tough market for stock pickers and that we're seeing the highest correlation among large-caps since the 1930's.

Back in 2009, low quality and small-cap stocks (higher beta) rallied furiously and led the market rebound. Interestingly enough, these low quality names have also led the market thus far in 2010 and that fundamentals haven't played an important role.

According to him, the most attractive opportunities currently reside in high quality, large-cap, lower beta stocks. In essence, he's targeting companies with solid balance sheets and high return on equity. Currently, Ainslie believes technology stocks are the cheapest they've been in 20 years. He cites their high free-cashflow yields and points out that 'growth' tech is beating out 'value' tech.

He believes the weak US dollar is helpful to technology companies. Ainslie also points out the large amount of cash on their balance sheets and opines that this cash should be deployed via acquisitions, share buybacks or dividends to benefit shareholders. Maverick's fondness for technology is an investment theme of theirs we've tracked since the first quarter of this year.

In terms of specific names, Ainslie emphasized Commscope (CTV) as a good hold through 2012. This is one of the five major tech stocks in his portfolio. The others include Marvell Technology Group (MRVL), Intel (INTC), Microsoft (MSFT), and Dell (DELL). Maverick Capital is currently 17% net long technology, their highest exposure ever.

Lastly, shifting to the heated topic of for-profit education, Ainslie was positive on the sector. But then again, we already knew that considering his sizable long of Apollo Group (APOL) disclosed in Maverick's portfolio.

Amitabh Singhi ~ Surefin Investments

Singhi has returned 29.8% annualized since inception in mid-2001. He focuses on India with his investments often buys 'cigar butts' and plays special situations. His current portfolio is comprised of 12 positions (most of which have single digit P/E ratios as he typically doesn't like to pay for growth). At the Congress, he spouted off numerous ideas.

Firstly, he mentioned Larsen & Toubro as an infrastructure play in India. This company trades as LTOUF on the pink sheets and as BOM:500510 in India. Secondly, he likes Housing Development Finance Corp as a play on housing upgrades (traded as BOM: 500010 in India). The interesting thing about some of Singhi's picks is that they are stocks trading near highs and some would argue that valuation is stretched here. Singhi does not own Larsen & Toubro because it trades at a very high multiple, 40x earnings. He is recommending superbly run and very well known companies, though.

Singhi's main idea today was Balkrishna Industries Limited (traded in India as BOM:502355), a tire maker known as BKT. The company trades at a P/E of just 7, but Q1 in FY '11 was slow. His last idea was Agrimax.

Francisco Garcia Parames ~ Bestinver Asset Management

Parames is Spain's largest money manager at $6 billion under management. He is a follower of the Austrian School of Economics. From an investment standpoint, he typically looks for good businesses with strong management trading at a solid price. Currently, he feels the Europe is still a less efficient market than the US. Obviously as a value investor, this could be seen as a welcome development as it can present opportunities. But what's interesting here is that while Parames is based in Spain, he doesn't have a single cent invested in his country.

In his talk, Parames said that, "patience is our biggest competitive advantage." He likes to buy family owned companies, something that is much more common in Europe (80% of his investments fit this criteria). In general, Bestinver focuses on strong businesses with high free cash flow yield.

At the Congress, he said that he likes BMW Preferred Shares (LSE: 0KF2.L) which currently trade at 3.1x 2012 free cash flow per share. He thinks the preferreds have over 200% upside and he owns 11 million shares (they are thinly traded at around 60,000 shares daily). Parames notes BMW's 7% margins and that this can be improved to 8-10% via better manufacturing operations.

He also mentioned CIR SpA (BIT: CIR), through Sorgenia Group, a multi-utility operator in Italy. Also, Parames mentioned Ferrovial which trades on the pink sheets as FRRVY and in Europe as ETR:UFG. He believes shares are worth around 17 euros (the company currently trades around 7 euros per share).

Kass: Risk to the Downside Grows

Kass: Risk to the Downside Grows

Doug Kass

10/11/10 - 02:00 PM EDT
Investors and traders are cheering for more bad economic news so, as the logic goes, the Fed must monetize more assets, even though the strategy has been innocuous. This is like Detroit Lions fans cheering for losses so they can get another high draft pick, even though they have been getting high draft picks for years, and it has had no beneficial effect for the team. -- Bill King, The King Report
As we begin the final quarter of 2010, let's start by reviewing how both the bulls and the bears have erred in their strategic visions for this year:
  • The bulls have underestimated the ability of the U.S. economy to sustain growth without an extreme Fed makeover and did not foresee the continued contraction in P/E multiples. Current low levels of manufacturing capacity utilization rates and an elevated unemployment rate were not in the Bulls' playbook a year, six months or even three months ago.
  • The bears have underestimated the extent to which investors would go along with the Fed's ride and were willing to believe that the government can stimulate growth allowing the cycle to become self sustaining.
I have questioned the ultimate efficacy of further quantitative-easing measures. While the first round of quantitative easing produced "shock and awe" two years ago, QE 2 will likely produce "shucks and aww."
Most market participants are fixated with the potential for QE 2 to boost asset prices and generate organic economic growth, however, without a subsequent rise in aggregate demand and productivity, the program will ultimately be deemed a failure as prices readjust over time to reflect the real underlying fundamentals. Mr. Bernanke is making the same blunder that we made with the past bubbles busts -- if we can create paper profits and convince consumers that they should spend those paper profits, then we'll be on our way to economic prosperity. The problems arise when asset prices readjust lower to meet their true fundamentals. It's Ponzi finance and nothing more. As I have previously explained, the goal of QE is to increase aggregate demand by creating a fictitious wealth effect and by increasing bank loans. The market appears to think that QE 1 was some sort of success, but as I have argued, QE 1 was only successful because it altered bank balance sheets and alleviated the credit strains. After all, this was Ben Bernanke's goal at the time -- to alleviate the credit pressures. What QE 1 did not do (and what we need now) is increase lending supported by a boost in real aggregate demand. QE does not add net new financial assets to the private sector and is not inherently inflationary, though Mr. Bernanke appears to be convinced otherwise. Unfortunately, QE 1 failed to succeed in contributing substantially to the economic recovery as Northern Trust recently showed.
-- "Northern Trust: QE 1 Failed, Why Will QE 2 Work?" from Pragmatic Capitalism
QE 2 (quantitative wheezing?) will not meaningfully move the needle of domestic economic growth and will only have a limited impact on:
  • the jobs market, which is plagued by structural unemployment;
  • housing, which that is haunted by a large shadow inventory of unsold homes and in which mortgage credit will likely be further reduced by the moratorium on foreclosures; and
  • confidence, which is still mired in uncertainty regarding regulatory and tax policy (and that is undermined by high unemployment).
Meanwhile, our fiscal imbalances multiply, and our currency craters (and a worldwide rush to currency devaluation offsets some of the normal trade deficit benefit). There are a number of other possible adverse consequences from the inefficient allocation of resources that is the outgrowth of the next tranche of monetary stimulation.
The Federal Reserve seems determined to make mistakes. First, it started rumors that it would resume Treasury bond purchases, with the amount as high as $1 trillion. It seems all but certain this will happen once the midterm election passes. Then, the press reported rumors about plans to raise the inflation target to 4% or higher from 2%. This is a major change from the Fed's quick rejection of a higher target when the International Monetary Fund suggested it a few months ago. Anyone can make a mistake, but wise people don't repeat the same one. Increasing inflation to reduce unemployment initiated the Great Inflation of the 1960s and 1970s. Milton Friedman pointed out in 1968 why any gain in employment would be temporary: It would last only so long as people underestimated the rate of inflation. Friedman's analysis is now a standard teaching of economics. Surely, Fed economists understand this.
Adding another trillion dollars to the bank reserves by buying bonds will not relax a constraint that is holding back spending. There is no shortage of liquidity in the economy -- banks already hold more than $1 trillion of reserves in excess of their legal requirements, and business balance sheets show an unprecedented amount of cash and near-cash assets. True, increasing bank reserves means mortgage rates will decline, at least temporarily; they already have in anticipation of the bond purchases. But neither the Fed nor the public should expect much stimulus as a result.
The most important restriction on investment today is not tight monetary policy but uncertainty about administration policy. Businesses cannot know what their taxes, health care, energy and regulatory costs will be, so they cannot know what return to expect on any new investment. They wait, hoping for a better day and an end to anti-business pronouncements from the White House. President Obama could do more for the economy by declaring a three-year moratorium on new taxes and new regulation.
-- Allan Meltzer, The Fed Compounds Its Mistakes, Wall Street Journal (op-ed)
The U.S. economic recovery remains fragile and is still characterized by excess industrial capacity and a surplus of labor. If we were in a sound and non-jeopardized economy, the Fed would not be having a QE 2 discussion nor would the administration be seeking extreme fiscal solutions. In my view we are in a contained recession, and while containment efforts continue, the efficacy of these efforts now appears to be waning. While the immediate response to the likelihood of QE 2 has been to buoy asset prices, the domestic economy is stalling at around 1.5% to 2.0% GDP growth, and little improvement in the jobs market has been made. This hesitancy makes the slope of the recovery vulnerable to the unforeseen -- trade wars, policy errors and/or numerous tail risks from the last credit cycle (e.g., mortgage-gate).

To be balanced, I recognize that there are a number of factors that will insulate stocks from a meaningful drop. Among the positive considerations is that most discounted dividend models indicate value in equities (as interest rates are anchored at zero). Large corporations are flush with cash, are operating at record profit margins and face an inexpensive and hospitable bond market, which is supporting good dividend growth and robust buyback activity. Allocations into equities by institutional and retail investors remain muted. And, with mortgage rates plummeting, the consumer's debt service and balance sheet has improved more rapidly than anticipated.

Nevertheless, as I have written previously, I continue to see the risks to 2011 corporate profit and U.S. and worldwide economic growth rates to the downside. It remains likely that secular and nontraditional headwinds will produce an extended period of inconsistent and uneven growth in the years ahead -- difficult for both corporate managers and investment managers to navigate. Arguably, given the sharp rise in equities, the downside risk might be growing ever greater and may soon lie at the highest level than at any time over the last 12 months, especially if I am correct that QE 2 will be a dud.

Saturday, October 09, 2010

LTCM Survivor Meriwether Launches Global Macro Hedge Fund

Two-time hedge fund loser John Meriwether has launched two new hedge funds, hoping that the third time turns out better.
A founder of the legendary and infamous Long-Term Capital Management, which collapsed in 1998, requiring a government bailout, Meriwether has unveiled his JM Advisors Management's global macro strategy.

Asness Encounters `Grim Reaper' Before Quant Fund Rebounds From 50% Loss

Clifford Asness, who runs AQR Capital Management LLC, one of the world’s biggest hedge funds, says fellow fund managers gouge their clients by charging exorbitant fees for just tracking the markets. He also takes a dim view of the administration of President Barack Obama, calling his economic team “Cossacks on a shtetl,” a reference to the Russian cavalrymen who sacked Jewish villages in Eastern Europe in the 19th century.
The hedge fund manager -- who is both a University of Chicago Ph.D. and a Marvel comic book collector -- is well known for his impolitic outbursts, Bloomberg Markets magazine reports in its November issue.
“What kind of coward doesn’t share his views?” asks Asness, 43, as he paces his office overlooking Long Island Sound in Greenwich, Connecticut. “I believe strongly that the world is going on the wrong course.”
Asness went the wrong way three years ago. From the start of 2007 through year-end 2008, AQR’s flagship Absolute Return fund fell more than 50 percent -- the kind of drawdown that’s often a death warrant for a fund. Firmwide assets tumbled to $17.2 billion in March 2009 from a peak of $39.1 billion in September 2007, according to AQR investors.
“I heard the Valkyries circling,” quips Asness, who says he identifies with action heroes like Captain America and Spider- Man. “I saw the grim reaper at my door.”
Smart Recovery
AQR survived. It did so by launching a campaign of diplomacy with its clients and offering a host of new funds and strategies. Asness’s funds have recovered smartly. Though the Absolute Return fund’s assets were down to $1.6 billion as of Aug. 31 from a peak of $4 billion, the fund rose 38 percent in 2009 and more than 10 percent through mid-September of this year, investors say.
As a quantitative investment firm, AQR uses algorithms and computerized models to trade stocks, bonds, currencies and commodities. Many quant funds got hit hard in 2007 and then again in the 2008 market crash.
“AQR has to fight against this current that’s going against them,” says Daniel Celeghin, a partner at Casey, Quirk & Associates LLC, a consulting firm in Darien, Connecticut. “They are one of the few quant firms that have managed to come back.”
AQR’s $1 billion Delta fund, opened in late 2008, returned 19.3 percent in 2009, an investor says -- beating Hedge Fund Research Inc.’s Fund of Funds Composite Index, which returned 11.5 percent. The fund was up 3.9 percent in 2010 through August versus a 0.3 percent loss for the HFRI index.
Asset Allocation
One version of AQR Global Risk Premium, a $3.9 billion asset allocation fund -- meaning it divides its investments across myriad markets -- surged 21.2 percent in 2009 and was up 17.2 percent this year through August, according to investors.
AQR has also been building a family of mutual funds for retail investors since 2008, with total assets in September of $2.3 billion. Three of them focus on momentum investing -- exploiting the tendency of securities to continue in their most recent trajectories. One invests in futures, and another bets on various kinds of arbitrage. Two trade foreign stocks. The latest, an asset allocation fund based on the Global Risk Premium fund’s strategy, rolled out October 1.
The firm markets the funds, which use quantitative models, through financial advisers.
Year to date through August, AQR has added $5.8 billion to its assets, which totaled $26.8 billion by the end of that month, according to investors. “It’s extraordinary to have had that kind of drawdown and then see them pull in their belts and come back so strongly,” says Tom Healey, founder of private investment firm Healey Development LLC, which invests with AQR.
Suffering Investors
Still, longtime investors in AQR suffered. The devastation of 2007 and 2008 gave the Absolute Return fund a negative record from its 1998 inception to its nadir in the market crash, according to a former employee. AQR declined to provide any fund returns for this article.
In early August 2007, AQR and some other quants found their programs had directed them into many of the same losing stock positions -- briefly costing them billions as markets short- circuited. Most funds quickly bounced back, only to plunge again in 2008 when stock, bond and commodity prices collapsed.
Research firm Lipper Inc., which tracks quant funds, says their number fell to 240 in July from 374 at the end of 2005. From the start of 2005 through June 2010, investment firms actively trading U.S. equities using quantitative strategies had a cumulative return of minus 1.15 percent.
Those using fundamental techniques -- traditional stock picking based on companies’ prospects and share prices -- had a cumulative return of 9.51 percent, according to EVestment Alliance LLC, an Atlanta-based research firm.
Four-Day Rout
The August 2007 quant rout unfolded over four days, probably after one or more firms tried to close out some of their positions, according toAndrew Lo, director of Massachusetts Institute of Technology’s Laboratory for Financial Engineering, who has studied the quant crash.
On Aug. 6, there was a rush to the exits. Stocks popular with quants collapsed as they sold, while those they were betting against soared as managers scrambled to cover short positions. On Aug. 10, markets rebounded. AQR Absolute Return, which had a peak-to-trough loss of 13 percent in August, finished the month down only 3.4 percent because it stuck with its positions.
The calamity of 2008 was far more wide ranging and enduring. The collapse of mortgage-related assets brought down the stock, bond and commodity markets globally. Absolute Return fell about 40 percent, according to investors. Now, Asness is working overtime to win back investors and make sure his algorithms perform.
Low Fees
One reason some of AQR’s funds attract investors is their low fees. The Delta fund offers investors an arrangement in which they pay a 1 percent management fee plus 10 percent of any profits it earns, versus the 2 percent and 20 percent typical of hedge funds. The fee rises or falls depending on how closely the fund tracks its benchmark.
AQR mutual funds charge as little as 0.49 percent, on a par with some of those offered by low-cost Vanguard Group Inc. Vanguard founderJohn Bogle says he’s impressed.
“He’s proved his point that he can do it at a reasonable cost,” says Bogle, who’s a fan of AQR research. “If I were a betting person, I’d bet he gives competitive returns.”
Asness’s low fees, positive performance and powers of persuasion have reassured investors.
Alaska Endorsement
“His ability to communicate in front of trustees is phenomenal,” says Jeff Scott, chief investment officer of the $36 billion Alaska Permanent Fund Corp., which invested $500 million with AQR in January, now spread among Absolute Return, Delta and Global Risk Premium. “These are people who are trying to solve our problems and not just raise money.”
On an August morning, Asness walks to his sun-dappled office windowsill and picks up a Captain America action figure. The hedge-fund mogul owns a panoply of action heroes, from the Hulk to the Silver Surfer, and the comic books that spawned them.
“I like to think of it as a much, much more affordable version of a money manager collecting art,” he says.
Though the wisecracks never stop, Asness is at the same time a demanding boss, two former employees say. One recalls being questioned about profit-loss updates on Thanksgiving.
And Asness admits to a temper: He’s knocked his ViewSonic computer monitor to the floor on three occasions, though it never broke.
“Either they’re building good computer screens or my punch isn’t what it used to be,” he says.
Grad School Ambiance
Asness calls the decor at AQR -- with its wood-paneled walls and spare furnishings -- “Goldman Sachs circa 1997.” In tone, however, the research process hums more like a finance graduate school.
“We try and run it like an applied academic seminar,” Asness says. “If you can get savage capitalists to rationally act like a team, then you have a beautiful thing.”
AQR’s trading is mostly automated, so there is little of the shouting and tumult that characterize some hedge funds. Partners, traders and analysts sit on a trading floor in a dozen rows, with some senior researchers taking the windowed offices. Academics are invited to give talks on subjects ranging from behavioral finance to accounting rules.
A Plethora of Funds
AQR manages some 65 funds of various stripes, and often tailors core strategies to meet client needs -- using more or less leverage, for example. The firm has adapted its models to trade in everything from the Polish zloty to Japanese bonds, to oil, gold and wheat. Asness says the myriad strategies and markets provide the extra safety that comes with spreading one’s bets.
Example: AQR uses its models to run traditional long-only funds, seeking to beat a benchmark by a few percentage points while limiting risk.
“We really believe in diversification of all kinds,” Asness says, adding that it especially helped during the meat grinder of 2008. “It did make it a lot easier to stay the course.”
Even as he works to outsmart volatile markets, Asness continues offering opinions on everything from Broadway musicals to overhauling U.S. health care. Asness performs across all media, writing opinion pieces for newspapers and magazines, talking on television shows and at conferences and contributing to websites.
“It’s almost like he can’t help himself,” says Theodore Aronson of Philadelphia quant firm Aronson + Johnson + Ortiz. “He’s afraid of no one and is not capable of telling a lie. It’s not the usual pablum.”
E-Mail Blasts
Asness sounds off most frequently in e-mail blasts to a personal network of friends, family and investors. One sarcastic example, from March, concerned a U.S. Senate move to create a federal office to predict financial crises.
“This is definitely going to work,” he wrote. “No more bubbles. These geniuses will get it right. Promise. And all for a government salary.”
Asness admits to a superhero complex. His favorite Marvel comic book character is Captain America, who gains strength with the help of a secret serum and whose shield can be used as an indestructible weapon. Asness has an image of the shield tattooed on his left arm.
“His super-villains are intellectual dishonesty and ignorance,” says Jonathan Beinner, a managing director at Goldman Sachs Group Inc. and a former classmate of Asness. “When someone offers an opinion that Cliff feels is incorrect or dishonest, whether it be related to investments, politics or pizza, he feels it is his duty to stand up, even if it’s not in his best interest.”
‘Frigging Idiots’
In August, Asness was complaining about Obama’s health- care law, which he calls socialized medicine, the increased powers Congress gave financial regulators and the tendency of commentators to blame banks alone for the crisis.
“Everyone dropped the ball on this; the public acted like frigging idiots,” he says. “There were sins of individuals, sins of banks, sins of government.”
Asness’s views are not always predictable. He has praised Tea Party activists, blogging in March, “Your aggressive stand for freedom and small government has inspired the country.” At the same time, he endorses the American Civil Liberties Union’s campaigns to guard civil liberties.
With AQR in comeback mode, Asness is in good humor as he bites into a piece of spicy tuna roll sushi one August afternoon at AQR’s offices. Around a conference room table are two of the three other founding AQR partners. David Kabiller, 47, a former Northwestern University tennis champion, heads client relations and favors Tom Ford blazers.
School Pals
John Liew, 43, is a former Asness classmate at the University of Chicago Graduate School of Business, where they both earned Ph.D.s in finance. He heads AQR’s global asset allocation team.
The fourth founding partner, Robert Krail, also a University of Chicago alum, is on medical leave.
AQR was buttressed by some key decisions during 2007 and 2008, Asness says. For example, the firm didn’t panic and pull the plug on its models. “We believed in the models,” Asness says. While that punished AQR in the sell-off, it left the firm positioned for the rebound beginning in March 2009.
“It’s riding a statistical beast,” he says. “Having a lodestone to come back to helps.”
AQR has tried to keep its investors loyal by keeping them well informed of its strategies for battling the market turmoil.
“Clients want to hear from us,” Kabiller says. “People have a negative view of a black box.”
No New Restrictions
The firm didn’t impose new restrictions on investor redemptions, as many funds did.
The firm did make some changes. Now, a big stock sell-off will automatically trigger systems that reduce leverage at various thresholds, cut back on risk and raise cash.
Like many quant firms, AQR is grounded in the efficient market hypothesis, or EMH, promulgated by professor Eugene Fama of the University of Chicago, who was Asness’s Ph.D. thesis adviser. Fama, 71, and his adherents say that the stock market is effective at digesting the available information about an asset and setting the right price for it.
EMH lost a lot of its luster in the sell-off, when the Standard & Poor’s 500 Index fell 57 percent in 18 months. “From a macro perspective, the market has been woefully lacking in trying to figure out what the valuation of an asset should be,” says Justin Fox, author of “The Myth of the Rational Market” (HarperBusiness, 2009).
“People had an idea that the market was effective at sussing things out. That’s been discredited.”
Not Perfectly Efficient
Asness doesn’t believe any market is perfectly efficient.
“We aren’t believers in the extreme form of the efficient market hypothesis and shouldn’t have to defend it,” Asness says. “EMH says ‘prices reflect all information,’ and I think the tech crash and the real-estate bubble culminating in 2008 were real blows to that idea.”
AQR’s business, in fact, is to find inefficiencies in the markets and profit from them. AQR researchers examine variables that over time generate higher returns, or premiums. Fama and Kenneth French, who now teaches at Dartmouth College, in 1992 published research showing that stocks with high book values relative to their prices outperformed those with low book values. The difference between the two is known as the value premium. The book value of a company is its net worth.
The same research found that small-capitalization stocks outperformed large caps.
Value Premium
Quants such as those at AQR have found ways to apply the value premium to different markets and asset classes, like currencies and bonds -- or even whole countries. Asness and colleagues might add up the market valuation of stocks in France and Germany, compare them with the earnings or book values of the listed companies and conclude that one of the countries’ stocks are undervalued.
Another variable that generates a premium is momentum -- the tendency of a stock’s price to continue upward if it is rising and downward if it’s falling. Asness, in his 1994 Ph.D. dissertation, was among the first to show the existence of a premium tied to momentum, Fama says.
The value and momentum premiums drive more than half of AQR’s returns, Asness says. Another model AQR uses asserts that the stocks of companies that are reducing their share count tend to outperform those of companies increasing it.
“We think they all make money more often than not,” Asness says.
Lawyer’s Son
Born in the borough of Queens, New York, Asness may have inherited his entrepreneurial streak from his mother, Carol, who ran a medical education firm. His father, Barry, was an assistant district attorney in Manhattan. Asness’s younger brother Bradley would follow in their father’s footsteps; he took up law and is now general counsel at AQR.
“He’s 6 foot 2, has all his blond hair, and I am bitter,” Asness deadpans.
Cliff Asness is 5 foot 10 inches (1.8 meters) tall and weighs 200 pounds (90 kilograms). He is bald with a graying beard.
Asness wasn’t an academic star at Herricks High School in New Hyde Park, New York.
“I had a mediocre record in high school,” Asness says. “I was desperately trying to get girls interested in geeks.”
His destiny, according to the 1984 yearbook: “Rich.”
Summa Cum Laude
Asness earned two B.S. degrees at the University of Pennsylvania, one from the Wharton School and the other from what is now the School of Engineering and Applied Science, graduating summa cum laude.
“I believed in diversification even then,” he says.
The future hedge fund mogul made his presence felt on campus.
“He was the king of the geeks,” says Beinner, a dorm mate in Asness’s freshman year who’s now chief investment officer of Goldman Sachs Asset Management’s fixed-income unit. “Cliff just had a following. People were always asking him questions when he was hanging around the computer lab.”
Lo, then a Wharton School professor, hired Asness as an assistant. Lo eventually started his own quant firm, AlphaSimplex Group, now part of the French bank Natixis.
“He would run regression analyses for me,” says Lo, referring to the process used to find relationships between variables for the purpose of predicting future values. “Given his background in computer programming and finance, he was perfect.”
Chicago Bound
Lo wrote Asness a recommendation to the University of Chicago Graduate School of Business, now the Booth School of Business, and soon he was off to America’s citadel of free- market thinking.
Asness became one of Fama’s favorites.
“Cliff was among the smartest students to pass through,” Fama says. In 1990, Asness became the efficient-markets guru’s teaching assistant, putting him on track for an academic career.
“I thought he had the potential to make an excellent professor,” Fama says.
A summer job at Goldman Sachs, engineered with help from Beinner, sent Asness in a different direction. In 1992, he signed on for a one-year research job. In 1993 and 1994, the Ph.D. candidate found himself struggling to complete a 150-page thesis while logging 80-hour weeks for Goldman. In 1994, the investment bank hired him to build a quant research department.
$1 Million Classroom
Although they’re friends, Fama says he remains irked that Asness didn’t pursue an academic career.
“We invested a lot of time and effort in Cliff,” he says. Asness donated $1 million to name a classroom after Fama. “He should name another,” Fama says.
At Goldman, Asness recruited future AQR partners Liew and Krail, two former classmates from the University of Chicago who worked at Trout Trading Co. In addition to building trading models, the Quantitative Research Group crunched numbers and drew charts to help guide the bank’s traditional stock pickers and other managers. Asness also started what was then a small hedge fund for Goldman called Global Alpha -- which would grow to $11 billion in assets by 2007.
Under Asness, Global Alpha scored gains of 111 percent in 1996 and 42 percent in 1997. He grew frustrated with his other duties.
“We thought it was crazy that they wouldn’t let us focus on investing alone,” Asness says.
Two Sets of Twins
Asness, Liew, Krail and Kabiller, who had worked in Goldman’s pension services group, decamped to start AQR in 1998. In 1999, Asness married Laurel Fraser, a former Christie’s International salesperson, who before they dated had been his executive assistant at Goldman. They are parents of two sets of twins, born 18 months apart.
AQR started with $1 billion, Asness says. It began trading in August 1998 -- when the bubble in Internet and other technology stocks was in full bloom. AQR followed its models, betting against expensive stocks and buying cheap ones. That meant Absolute Return hemorrhaged money until the market turned against tech in March 2000.
“We began with $1 billion and through hard work and acumen turned that into $400 million,” Asness jokes.
The founders toured the world, trying to persuade investors that the tide would turn. In 2000, Asness penned a paper called “Bubble Logic,” in which he picked apart the arguments supporting sky-high technology stock valuations.
“When fallacies rule the land, somebody has to point out the naked emperor,” he wrote.
Market Turn
In March 2000, the market turned and Absolute Return began making money. The fund finished 2000 up 16.7 percent, investors say. The Nasdaq Composite Index lost 77.9 percent of its value between March 2000 and October 2002. From there, AQR flourished, with assets rising to $12 billion in 2004, when the firm moved to Greenwich.
A key lesson of 1998 to 2000 was replayed less than 10 years later.
“No strategy is so good that it can’t have a bad year or more,” Asness says. “You’ve got to guess at worst cases: No model will tell you that. My rule of thumb is double the worst that you have ever seen.”
The firm has also redoubled its effort to develop new strategies for boosting returns and improve existing ones. John Cochrane, the AQR Capital Management Professor of Finance at the University of Chicago, says many quants just mine past data and extrapolate returns.
‘Really Analytical’
“AQR is really analytical,” he says. “They put a lot of academic research to work -- and they create a lot of academic research.”
The Delta fund is one result. Drawing on years of analysis, the fund is based on the notion that some of the investing techniques used by hedge funds, such as merger and convertible bond arbitrage, aren’t as sophisticated as they’re cracked up to be.
Merger arb hedge funds typically buy the stock of acquisition targets and sell short that of acquirers. Convertible arbitrage often involves buying a convertible bond and shorting the corresponding stock, locking in the yield.
AQR’s research showed that with the right formulas programmed in, the buying and selling of stocks and bonds for merger and convertible bond arbitrage could be automated. And that’s what the Delta fund is: a kind of systematic hedge fund using multiple strategies.
“It’s sexy in a wonkish sort of way,” Asness says.
Balancing Risk
The Global Risk Premium fund is another example. Research showed that pension funds that use traditional, balanced asset allocation formulas -- say, 60 percent stocks and 40 percent bonds -- are actually unbalanced in terms of risk. That’s because stocks, which are much more volatile, may account for 85 to 90 percent of such a portfolio’s risk.
The Risk Premium fund puts money to work in a variety of asset classes -- stocks, bonds, commodities and others -- to spread risk more evenly. The amount of volatility a pension investor wants in order to get to a desired return is adjusted with leverage.
Asness and colleagues say they’re tweaking formulas at the fortified Absolute Return fund so that it can return to its former prominence in the firm.
“AQR believes in preserving capital by managing risk,” says the Alaska Permanent Fund’s Scott, who’s targeting returns of 5 percentage points above inflation going forward. “The returns are working, but the bigger picture is working too. What we found with Cliff is, he rolls up his sleeves and teaches us.”
Post-Crash Blues
Around the developed world, expectations for future investment returns have withered following the financial crisis and the drawn-out recession. Asness realizes that AQR won’t soon return to the fat margins of pre-crash days.
“The whole industry is less lucrative than it used to be,” he says.
How will AQR define its own success in an era of tempered hopes? More assets? Higher profits? Asness -- father of four, self-declared family man -- gives an answer he knows will get him in trouble at home.
“Two words,” he says, pausing for effect with a smile. “Trophy wife.”
There goes the bigmouth again.

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.