Wednesday, January 25, 2012

in siouxland

One of the hottest assets — and hottest topics — is farmland.  Here’s the price of land in Sioux County, Iowa, as reported annually by Iowa State.  In the area, land has sold for several thousand dollars an acre more than the last data point above, and at a recent auction not far away, an auctioneer cajoled the crowd of buyers, reminding them that “it won’t be back on the market for 40 or 50 years.”  A newspaper account said simply, “Investors have determined that land is a safe bet.”
I did a cautionary posting last spring and prices have rocketed higher since then.  But “it doesn’t pencil,” as they say, unless prices keep going up.  Where have we seen that before?
Also above are corn and soybean prices — that’s what’s grown in Sioux County — indexed for easy comparison.  Of course, that’s only part of the equation.  Crop yields have been getting better and as the acres per farmer has increased dramatically, there have been economies of scale.  On the other side, input prices have been rising and those gargantuan tractors and combines aren’t cheap.  How all of those factors fit together will determine the value of the land in the long run.
Two broad investment forces have also spurned interest in dirt:  Very low interest rates and punk returns elsewhere.  We’ll see how long those trends last and what happens to farmland when they reverse.
Iowa is in the Chicago Federal Reserve District.  If you are interested in more information on farmland, you should check out its last AgLetter or a special publication, “Rising Farmland Values: Causes and Cautions.”  (Chart:  Bloomberg terminal.)

The story of two risk indices

The latest reading from the Credit Suisse Risk Appetite Index shows that we are now out of the "panic mode".  In fact the index is back to the pre-crisis (of 2011) levels.

CS Risk Appetite Index (Source: Credit Suisse)

One way to check the validity of being back to July-2011 levels of risk appetite is to compare the CS index to another indicator. Let's take a look at the Fisher-Gartman Risk Index, developed to allow investors to participate in the "risk on" trade.

Fisher-Gartman Risk Index (Source: Dow Jones)

This index has not recovered nearly as much as the CS one. According to Fisher-Gartman we are at the highs of the Nov-2011 levels. How can one explain such a difference in risk indicators?

We know that the CS index is calculated from bond and equity prices including emerging markets.  On the other hand the Fisher-Gartman index has a substantial commodity and currency exposure.

Fisher-Gartman Risk Index Components (source: Dow Jones) - click on chart to expand

This next chart compares the CRB Commodity Index with the S&P500.  Equities have outperformed commodities by over 10% since the beginning of last year.

CRB Commodity Index vs the S&P500 (Bloomberg)

Similarly one could compare a basket of currencies as represented by the Deutsche Bank US Dollar Short Futures Index with the equity index.  The equity outperformance vs. currencies isn't as pronounced as it is for commodities,  but it is still close to 5% over the same period.

 Deutsche Bank US Dollar Short Futures Index vs. S&P500 (Bloomberg)

We now have the explanation for the CS Risk Appetite Index pulling significantly ahead of the Fisher-Gartman Risk Index.  The difference is driven by the underperformance of currencies and in particular commodities that are not present in the CS index.  The question of whether we have pulled out of the "crisis mode" therefore depends on which markets one believes better represent the global risk appetite.

110 years of Dow History Reveals a Little Secret: Volatility Is Normal

What struck me first from the DJIA historical chart above was how many periods of sideways range bound movement had the same volatility (see note below). It showed the 2007-2009 peak to trough was the same in each instance of 1915, 1940, 1975. The real kicker was discovering the trough of 1932 to peaks in 1966 and 1973 lead to repeating ranges in 2008, and 'possibly' higher into 2015. The first range of 33.5 years was near enough to exactly repeat itself (hit the value, but peaked slightly early). The second range of 40.5 years is looking promising to date with an upside target of 14090 on/before May 2015.
However, these peaks previously occurred during a 16 year period of range bound equity performance (in nominal terms). As is plainly evident, there are a multitude of prevailing global conditions that indicate no immediate end to the present turmoil, and the DOW history above suggests a possible sideways churn extending out to Dec2015. So even if the second range eventuates to complete at 14090, there is a period of downside risk remaining based on historical precedence. Also note the containment box does not necessarily imply a lower bound.

Days of Easy Money Are Over for Fund Managers: Alice Schroeder

As a profit-making endeavor, managing other people’s money is hard to beat. The business requires very little invested capital. There are no worries about getting paid in full when the bill comes due, since fund managers control their customers’ money. And lackluster performance is no bar to hefty profits because fees, based on the dollar value of assets under management, are paid even when returns are abysmal.
Wall Street, it often seems, is exempt from the laws of economics. Most active money managers produce worse returns than an index, such as the Standard & Poor’s 500. But making enough money to look respectable to clients has been relatively easy as long as falling interest rates boosted the value of most asset classes.
What’s more, new competitors constantly enter the business, yet rarely discount fees to gain market share. Instead, funds rely on investors to chase the latest high- performing manager, like gamblers who ignore their losses while seeking a hot slot machine. This has given the business a pricing umbrella that shelters it from competition.
From the owners’ standpoint, all this has been fabulous. They work in a business that produces abnormally high profits and forgives incompetence, a rarity in modern capitalism.

Human Nature

Human nature being what it is, I have never met any money managers who believed their own bad results had anything to do with personal incompetence. Rather, investment firms are keenly aware that the talent they possess costs money; hence managers feel no sense of irony when summing up a laggard year with, “It was a good year for us. I only wish it had been a better year for our clients.”
But after a couple of decades in which asset managers floated along in ease and splendor, economics is now grinding down the business. The easy money is going away. Investment management is in the early stages of a historic transformation. Like most tectonic shifts, it probably will take years to fully develop.
The signs are clear. Stanley Druckenmiller, who had a long record of prescience as the founder and chairman of the $12 billion Duquesne Capital Management LLC, was the first notable figure to act on the new reality. He returned his clients’ money in 2011 because managing such a large fund was “having a clear impact” on his performance, he told Bloomberg News in 2010.
Druckenmiller and others who followed his example are already rich. This is not true (in the Wall Street sense of “rich”) for a lot of others who work in the industry, or would like to. Despite deteriorating fundamentals, a near- record number of hedge funds and exchange-traded funds started up last year.
That certainly did not occur because clients faced a dearth of choices. It was driven more by the insouciant attitude of “Apres moi, le deluge,” or “After me, the flood.” (Louis XV or his mistress, Madame de Pompadour, supposedly used the phrase to convey that a coming flood, which turned out to be the French Revolution, would be too late to drown them -- justifying the French royalties’ excess and debauchery.)

Poor Performance

The first sign of the investment-management flood was last year’s manifestly poor performance, just as it was saturated with competition. The average hedge fund lost 4.9 percent and diversified U.S. equity mutual funds lost 2.2 percent. This came on the heels of three shocks: the 2008 financial crisis, the 2009 market panic and the 2010 “flash crash.”
It also followed an entire lost decade for the equity market. Investors’ disenchantment shows in outflows from equity funds. In 2010, stock funds (including mutual funds and exchange traded funds) had a total inflow of $36 billion. But in 2011 investors took back almost all of that money by pulling out $35 billion. The sophisticated and flexible hedge-fund business saw no basic change in its overall assets (including all types of funds).
Within that industry, though, funds are flowing furiously toward the largest managers because people want the tried-and-true, lest they wind up trusting another Bernard Madoff. The assets of the 26 largest hedge funds grew 12.3 percent in the 18 months ended June 30, 2011. Of the total assets added by hedge funds in the first six months of 2011, more than 11 percent went to just one manager, Bridgewater Associates LP.
More assets in the hands of a single manager increase that manager’s fees. In the long run, however, fees are linked to performance, and concentration is a drag on performance, as Druckenmiller noted. Huge amounts of money make it harder for managers to stake out unique non- consensus positions. Funds that must deploy huge sums wind up crowded into the same list of assets, overlapping their portfolios.
Diversity of market opinions once meant a wide distribution of fine, granular bets. More and more, a handful of viewpoints dominate the markets. The result is big market swings with small changes in sentiment. Yet most managers are being paid partly to defend their clients from volatility.

Declining Fees

Coincident with financial shocks and poor performance, holes have appeared in the industry’s price umbrella. According to the website FINalternatives, new hedge funds’ average management fees have been declining and, in the year ending September 2011, were at 1.57 percent of assets versus the standard 2 percent, while performance fees (as a percentage of returns) are running at 17.56 percent (versus the standard 20 percent).
Also telling is the transition of money from mutual funds to exchange-traded funds, which charge lower fees for expenses. Equity mutual funds lost $99 billion of assets in 2011, and $64 billion of that money went right back into exchange traded equity funds. This long-term trend is sucking assets out of mutual funds and jeopardizing their future.
By implication, the whole asset management industry is going to consolidate and shrink; its cost and fee structure will also need to adjust to more competitive levels. Meanwhile, the trend toward lower fees and the preference for larger managers pinch smaller funds even more nastily because of the way these developments interact with the second reason for the industry’s fundamental transformation: rising costs.
The Dodd-Frank Wall Street Reform and Consumer Protection Act is one culprit here. It forces more funds to register with regulators; imposes heavy reporting burdens on even small investment advisers; requires compliance officers and programs, and expands asset managers’ fraud liability in several areas.
A hedge fund with more than $150 million in assets (small in reality) is considered “large” under Dodd-Frank and is required to have a full-time chief compliance officer and meet other compliance and monitoring obligations. A fund of this size that charged a 2 percent management fee would collect about $3 million to cover all its expenses. Dodd-Frank costs would consume a large and possibly fatal percentage of that.
Dodd-Frank has a lighter impact on large managers. In the big picture, though, the outlook for costs isn’t positive for anyone. The pro-regulatory climate suggests rules are more likely to be added than taken away. Meanwhile, the political environment demands austerity, and Congress might respond by imposing transaction taxes, levies on fund managers’ performance fees, or other measures designed to be “tough on Wall Street.”


These trends -- too much money concentrated in too few hands, higher costs and downward pressure on fees -- are fundamental enough to reshape the business. But there’s yet another factor and its effect is overwhelming.
For more than two decades, the asset management business has enjoyed a tailwind of falling interest rates and growing tolerance for leverage. With the leverage boom that began in the 1980s, falling rates and easier credit standards boosted growth in the global economy. Asset valuations (on which fees are based) increased and new opportunities arose for money managers to devise investment strategies based on leverage. If the passive benefit from falling interest rates and leverage could be backed out of investment returns for the past two decades, a lot of what looked like successful asset management would really be second-rate performance.
We now live in a world where second-rate performers have nowhere to hide. Interest rates are low, but will rise once growth resumes. This is a headwind, not a tailwind.
Consider what it means for money managers to live in a deleveraging world. It may not be universally accepted yet, but in this new era, 4 percent is a good return. This will not justify paying 2 percent of assets as a management fee (to say nothing of 20 percent of returns as performance fees). A similar problem exists for mutual fund companies, most of which have high overhead, including managers who get seven-figure bonuses.
Of course, a really good manager will always be able to earn an honest and lucrative living. They just aren’t nearly as numerous as the pretenders. This is why, facing the future, some of the brightest asset managers welcome the thought that the untalented are getting flushed out. For them, the story is, “Apres le deluge, moi.”
(Alice Schroeder, the author of “The Snowball: Warren Buffett and the Business of Life” and formerly a top-ranked insurance analyst on Wall Street, is a Bloomberg View columnist. The opinions expressed are her own.)

Sunday, January 22, 2012

The Bond/Equity Disconnect

Over the past several years, bond yields have correlated pretty well with equity prices—yields rise and fall along with the ups and downs of the stock market. Higher stock prices reflect increased optimism (or less pessimism) about the future, and bond yields move in synch because a more healthy economy increases the odds of higher inflation and a tighter Fed. Most of the time the correlation between stocks and bond yields has been 0.6 to 0.8, interrupted with a few relatively brief periods of negative correlation, as can be seen in the two charts below. Over the past few months, we have once again entered one of those periods where the correlation has gone to zero. Equity prices are up, but bond yields remain very low and relatively stable. As the above chart suggests, either bond yields should be at least 100 bps higher, or equity prices should be a lot lower.

In my view, this disconnect reflects a buildup of tension in the market—something is likely to break pretty soon. Bond yields have been depressed because risk-averse investors have been seeking shelter from a potential Eurozone collapse that might trigger another global recession/depression/deflation. But equity prices have been rising because in the meantime, while the world waits for the Eurozone to implode (and we've been waiting for at least 18 months now), the U.S. economy continues to improve. Bonds are the doomsday trade, while equities are more realistic about what's happening right now.

I can think of an alternate explanation, but it's not very convincing. Maybe bond yields are low because the market is absolutely convinced that no matter what happens to the economy, inflation is going to be very low for a very long time, and central banks, and particularly the Fed, are going to remain at or close to their "zero bound" for as far as the eye can see. To counter this explanation, I note that break-even spreads on TIPS reflect inflation expectations to be in a 2.0- 2.7% range, which is pretty close to the average rate of CPI inflation over the past two decades (2.5%), and during that time 30-yr bond yields have averaged 5.5%. In other words, I find no evidence to suggest that bond yields today are priced to deflationary concerns, so their low levels therefore more likely reflect an intense risk aversion on the part of investors.

In any event, it's unusual and I think unnatural for capital markets to be so schizophrenic. The assumptions driving bonds and stocks should ordinarily reflect the same world view, but these days they don't seem to.

My money is on bonds catching up to stocks—bond yields are more likely to rise than stock prices are to fall. What could trigger this? Maybe the Fed bows to the same realities that are driving equity prices higher, and informs us that with the economy doing better on the margin, the Fed mostly likely won't have to keep yields at zero for the next several years as the market currently believes it will. Or maybe Greece finally executes its default, but the world does not come to an end (after all, a huge default has been fully priced in for a very long time, so it should not prove surprising or disruptive when it finally happens). Or maybe the simple passage of time without anything disastrous occurring will do the trick—markets can't stay priced to disaster forever if a disaster doesn't occur.

Tuesday, January 17, 2012

2011: Disastrous Year For Mutual, Hedge Fund Managers

In 2008, the hedge-fund industry had ~$2 trillion under management. But as Economist’s Buttonwood [1] points out, that year was an annus horribilis for the hedge-funds. “The average performance was a loss of 23%. In cash terms the loss for that single year was more than double the industry’s total assets under management in 2000.

This is detailed in a new book by Simon Lack titled The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True [2]. Mr Lack reckons that hedge funds have lost enough money in 2008 to cancel out the entirety of profits made in the prior ten years.

Mutual funds have not fared any better in 2011. Data from Morningstar shows that among 4,100 funds that invest in large-cap stocks, only 17% beat the SPX. That is the smallest percentage since 1997 beating their benchmark — the S&P500 — since 1997, when 12% beat the SPX. If we look at the percentage of funds under-performing by 250 basis, its the worst since 1998. (See chart below)

If you are looking for something to blame,  consider the unholy trinity of capital outflows, a flat 2011 market and high volatility. That was a challenging environment for hedge funds and mutual funds alike.
I suspect people are  disappointed when a mutual fund under-performs with fees of 0.75 to 1.75%. But the fee structure of Hedge fund managers — 2% + 20% of the profits — is why some of them face real trouble. Its bad enough to under perform, but institutions hate paying up for the privilege.
Perhaps 2012 is the year fund managers mean revert and redeem themselves. If they don’t they should not be surprised at massive redemptions each time their window opens.
Click to enlarge:
More Charts on under-performance after the jump
All Charts Bianco Research [7]
Rich managers, poor clients: A devastating analysis of hedge-fund returns [1]
The Economist, Jan 7th 2012
Why 2011 Was A Bad Year For Money Managers
Conference Call Handout, Bianco Research [7]
January 12, 2011
Hedge Funds Sit Out Stock Market Rally [8]
Nikolaj Gammeltoft
Bloomberg, January 10, 2012
Mutual Funds Trail S&P 500 Index Most Since ’97 [9]
Lu Wang
Bloomberg, Jan 10, 2012

Breaking down 2011’s monster move in USTs

No doubt a big storyline during 2011 was the massive move lower in Treasury yields - particularly at the long end.  Take comfort Bill Gross - there were no shortage of market experts that missed this move.  Consider in late May/early June the most bullish  forecast among major Wall Street economists was for the 10yr (which was trading at ~3%) was to finish 2011 at a 3.25% yield.  The most bullish person expected “only” a 25bp rise in yield.  Among my many misses during the year, I correctly posited in June that the 10yr would hit 2%.

More interesting though, in my opinion, are the component pieces of the 10yr returns.  Contrary to many people’s initial thoughts, inflation expectations on the long end haven’t fallen that much.  To be precise, year over year 10yr inflation expectations (as measured by the 10yr breakeven) have fallen ~35bps.  We know during this same period the 10yr treasury has fallen by ~150bps.  Consider the following charts below:

10yr Breakeven  (down about 35bps YoY)

10yr Yield vs 10yr Breakeven - essentially 10yr Real Yields

As you can see from the chart above, Real Yields on the 10yr have gone from over 100bps to negative ~16bps today.  The vast majority of change in 10yr yields have come from a reduction in real yields - not inflation expectations.  Now clearly, the drop in longer term inflation expectations is nothing to dismiss, but the point remains.  In a time where real yields are significantly negative on the front end, it is understandable that many players are seeing “relative value” in longer term USTs.

S&P 500 Historical Sector Weightings

Now that another year has passed, below we provide updates of our charts and tables on historical S&P 500 sector weightings.  The Technology sector ended the year with a 19% weight in the S&P 500, and that is where it stands now as well.  The Financial sector, which saw its weight bounce significantly from the March 2009 low through the end of 2010, suffered a drop in weight from 16.1% to 13.4% in 2011.  It has, however, bounced by 0.7 percentage points over the first two weeks of 2012 as Financial stocks have gotten off to a good start to the year.

Health Care, Consumer Staples and Utilities saw their S&P 500 sector weightings jump the most in 2011 as investors flocked to high dividend paying defensive names.  Along with the Financial sector, Industrials and Materials are the only two other sectors that saw their weights in the S&P 500 drop in 2011.  Interestingly, both Industrials and Materials have already gained back all of their 2011 weighting losses in the first two weeks of the year. 

Below is a chart of the historical sector weightings shown in the table above that helps to visualize the changes we've seen over the past 20+ years.

Finally, below we provide historical S&P 500 weighting charts for each sector going back to 1990.  The red line in each chart is the average weighting the sector has seen over the entire time period.  Technology and Energy are the only two sectors that are currently well above their long-term averages.  Financials, Industrials, Consumer Discretionary, Materials and Telecom are all below their long-term averages, while Health Care, Consumer Staples and Utilities are currently right inline with their averages.


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.