Bud Fox

in siouxland

2012-01-25T15:30:00.001-08:00

: 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

2012-01-25T15:29:00.001-08:00

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

2012-01-25T15:25:00.001-08:00

Click for a larger image

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

2012-01-25T15:21:00.001-08:00

As a profit-making endeavor,managing other people’s money is hard to beat. The businessrequires very little invested capital. There are no worriesabout getting paid in full when the bill comes due, sincefund managers control their customers’ money. Andlackluster performance is no bar to hefty profits becausefees, 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 lawsof economics. Most active money managers produce worsereturns than an index, such as the Standard & Poor’s 500.But making enough money to look respectable to clients hasbeen relatively easy as long as falling interest ratesboosted the value of most asset classes.
What’s more, new competitors constantly enter thebusiness, 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 losseswhile seeking a hot slot machine. This has given thebusiness a pricing umbrella that shelters it fromcompetition.
From the owners’ standpoint, all this has beenfabulous. They work in a business that produces abnormallyhigh profits and forgives incompetence, a rarity in moderncapitalism.

Human Nature

Human nature being what it is, I have never metany money managers who believed their own bad results hadanything to do with personal incompetence. Rather,investment firms are keenly aware that the talent theypossess costs money; hence managers feel no sense of ironywhen summing up a laggard year with, “It was a good yearfor us. I only wish it had been a better year for ourclients.”
But after a couple of decades in which asset managersfloated along in ease and splendor, economics is nowgrinding down the business. The easy money is going away.Investment management is in the early stages of a historictransformation. Like most tectonic shifts, it probably willtake years to fully develop.
The signs are clear. Stanley Druckenmiller, who had along record of prescience as the founder and chairman ofthe $12 billion Duquesne Capital Management LLC, was thefirst notable figure to act on the new reality. He returnedhis clients’ money in 2011 because managing such a largefund was “having a clear impact” on his performance, hetold Bloomberg News in 2010.
Druckenmiller and others who followed his example arealready rich. This is not true (in the Wall Street sense of“rich”) for a lot of others who work in the industry, orwould like to. Despite deteriorating fundamentals, a near-record number of hedge funds and exchange-traded fundsstarted up last year.
That certainly did not occur because clients faced adearth of choices. It was driven more by the insouciantattitude of “Apres moi, le deluge,” or “After me, theflood.” (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 toolate to drown them -- justifying the French royalties’excess and debauchery.)

Poor Performance

The first sign of the investment-management flood waslast year’s manifestly poor performance, just as it wassaturated with competition. The average hedge fund lost 4.9percent and diversified U.S. equity mutual funds lost 2.2percent. This came on the heels of three shocks: the 2008financial crisis, the 2009 market panic and the 2010 “flashcrash.”
It also followed an entire lost decade for the equitymarket. Investors’ disenchantment shows in outflows fromequity funds. In 2010, stock funds (including mutual fundsand exchange traded funds) had a total inflow of $36billion. But in 2011 investors took back almost all of thatmoney by pulling out $35 billion. The sophisticated andflexible hedge-fund business saw no basic change in itsoverall assets (including all types of funds).
Within that industry, though, funds are flowingfuriously toward the largest managers because people wantthe tried-and-true, lest they wind up trusting anotherBernard Madoff. The assets of the 26 largest hedge fundsgrew 12.3 percent in the 18 months ended June 30, 2011. Ofthe total assets added by hedge funds in the first sixmonths of 2011, more than 11 percent went to just onemanager, Bridgewater Associates LP.
More assets in the hands of a single manager increasethat manager’s fees. In the long run, however, fees arelinked to performance, and concentration is a drag onperformance, as Druckenmiller noted. Huge amounts of moneymake it harder for managers to stake out unique non-consensus positions. Funds that must deploy huge sums windup crowded into the same list of assets, overlapping theirportfolios.
Diversity of market opinions once meant a widedistribution of fine, granular bets. More and more, ahandful of viewpoints dominate the markets. The result isbig market swings with small changes in sentiment. Yet mostmanagers are being paid partly to defend their clients fromvolatility.

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 theyear ending September 2011, were at 1.57 percent of assetsversus the standard 2 percent, while performance fees (as apercentage of returns) are running at 17.56 percent (versusthe standard 20 percent).
Also telling is the transition of money from mutualfunds to exchange-traded funds, which charge lower fees forexpenses. Equity mutual funds lost $99 billion of assets in2011, and $64 billion of that money went right back intoexchange traded equity funds. This long-term trend issucking assets out of mutual funds and jeopardizing theirfuture.
By implication, the whole asset management industry isgoing to consolidate and shrink; its cost and fee structurewill also need to adjust to more competitive levels.Meanwhile, the trend toward lower fees and the preferencefor larger managers pinch smaller funds even more nastilybecause of the way these developments interact with thesecond reason for the industry’s fundamentaltransformation: rising costs.
The Dodd-Frank Wall Street Reform and ConsumerProtection Act is one culprit here. It forces more funds toregister with regulators; imposes heavy reporting burdenson even small investment advisers; requires complianceofficers and programs, and expands asset managers’ fraudliability in several areas.
A hedge fund with more than $150 million in assets(small in reality) is considered “large” under Dodd-Frankand is required to have a full-time chief complianceofficer and meet other compliance and monitoringobligations. A fund of this size that charged a 2 percentmanagement fee would collect about $3 million to cover allits expenses. Dodd-Frank costs would consume a large andpossibly fatal percentage of that.
Dodd-Frank has a lighter impact on large managers. Inthe big picture, though, the outlook for costs isn’tpositive for anyone. The pro-regulatory climate suggestsrules are more likely to be added than taken away.Meanwhile, the political environment demands austerity, andCongress might respond by imposing transaction taxes,levies on fund managers’ performance fees, or othermeasures designed to be “tough on Wall Street.”

Headwinds

These trends -- too much money concentrated in too fewhands, higher costs and downward pressure on fees -- arefundamental enough to reshape the business. But there’s yetanother factor and its effect is overwhelming.
For more than two decades, the asset managementbusiness has enjoyed a tailwind of falling interest ratesand growing tolerance for leverage. With the leverage boomthat began in the 1980s, falling rates and easier creditstandards boosted growth in the global economy. Assetvaluations (on which fees are based) increased and newopportunities arose for money managers to devise investmentstrategies based on leverage. If the passive benefit fromfalling interest rates and leverage could be backed out ofinvestment returns for the past two decades, a lot of whatlooked like successful asset management would really besecond-rate performance.
We now live in a world where second-rate performershave nowhere to hide. Interest rates are low, but will riseonce growth resumes. This is a headwind, not a tailwind.
Consider what it means for money managers to live in adeleveraging world. It may not be universally accepted yet,but in this new era, 4 percent is a good return. This willnot justify paying 2 percent of assets as a management fee(to say nothing of 20 percent of returns as performancefees). A similar problem exists for mutual fund companies,most of which have high overhead, including managers whoget seven-figure bonuses.
Of course, a really good manager will always be ableto earn an honest and lucrative living. They just aren’tnearly as numerous as the pretenders. This is why, facingthe future, some of the brightest asset managers welcomethe thought that the untalented are getting flushed out.For them, the story is, “Apres le deluge, moi.”
(Alice Schroeder, the author of “The Snowball: WarrenBuffett and the Business of Life” and formerly a top-rankedinsurance analyst on Wall Street, is a Bloomberg Viewcolumnist. The opinions expressed are her own.)

The Bond/Equity Disconnect

2012-01-22T07:30:00.001-08:00

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.

2011: Disastrous Year For Mutual, Hedge Fund Managers

2012-01-17T11:19:00.000-08:00

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.
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Click to enlarge:
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^[4]
More Charts on under-performance after the jump
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^[6]
All Charts Bianco Research ^[7]
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Sources:
Rich managers, poor clients: A devastating analysis of hedge-fund returns ^[1]
Buttonwood
The Economist, Jan 7th 2012
http://www.economist.com/node/21542452
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
http://www.bloomberg.com/news/2012-01-10/hedge-funds-sit-out-rally-with-speculation-on-stock-gains-close-to-09-low.html
Mutual Funds Trail S&P 500 Index Most Since ’97 ^[9]
Lu Wang
Bloomberg, Jan 10, 2012
http://www.bloomberg.com/news/2012-01-10/funds-trail-s-p-500-index-most-since-97.html

Breaking down 2011’s monster move in USTs

2012-01-17T11:18:00.000-08:00

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

2012-01-17T11:16:00.000-08:00

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.

Oil

2012-01-17T11:15:00.001-08:00

Global Trend Indicators

2012-01-16T13:53:00.001-08:00

(click here if chart is not observable)

The Treasury Rally that Keeps on Trucking

2012-01-16T13:52:00.000-08:00

The WSJ reports on the Treasury Rally that Won't Die:

According to investment-research firm Morningstar, a portfolio of U.S. Treasurys with an average maturity of 20 years—the quintessential safe haven—rose 28% last year, even better than its 26% jump in 2008. You would have to go back to 1995 to find a better year.

More confusing still: Last year's surge came in the 30th year of a historic rally. Since 1981, long-term Treasury bonds have returned 11.03% annually, 0.05 percentage point better than the Standard & Poor's 500-stock index.

This comes a full year and a half after the WSJ said Treasuries weren't only overpriced, but that we were experiencing The Great American Bond Bubble (my rebuttal 'Bond Bubble Blasphemy' is here, while my rationale for the value of Treasuries at the time can be found here).

One of the charts outlined in my post back then (and updated below, but brought back to 1941 using data from Shiller) shows the takeaway... treasury rates have been a reflection of the historical growth of nominal GDP going back 50 years. Before that there was a huge disconnect following the Great Depression (when nominal GDP dropped by ~50% between 1929 and 1934... yes 50%!) and World War II, which conveniently allowed the U.S. to grow out of the massive amount of debt the nation had accumulated.

By this measure, the 3.8% annualized nominal GDP growth over the past ten years makes the current sub-2% interest rate seem low, but not as much when you take the following into account:

Five year annualized GDP growth is only 2.2% (i.e. we are trending down)
The Fed has made it clear they won't be raising short-term rates anytime soon / they have taken significant Treasury supply out of the market with quantitative easing programs
Deflationary pressures / potential shocks from Europe remain
Investors continue to flee risk assets into "safe" assets

So, does that make me a buyer of Treasuries at these levels? Not necessarily. I'd rather take a barbell approach to investing by allocating to return seeking assets on one side (I'll never tell you where) and cash on the other (for preservation of capital purposes). 2% is just not worth it for me and the beauty of investing for the average investor is we don't have to manage our own investments to a benchmark. That said, I don't think Treasuries are ridiculously priced given the circumstances.

Source: Federal Reserve / BEA

It’s Not You, It’s Me…..

2012-01-13T10:54:00.001-08:00

It’s not you, it’s me…. I think everyone has used that line at some point, but nobody does it better than George Costanza!
I have been putting data together to update our white papers. It’s no secret that running a Global Tactical Asset Allocation (TAA) strategy was difficult last year. But when I looked at the data it was very clear that the problem wasn’t the strategies. The real problem was how the market behaved during 2011. It’s not you, it’s me. It’s not your trend following strategy, it’s what you’re trying to follow. The market was essentially a psycho, stage 5 clinger last year!
The data I will reference in this post is an extension of the data we published last year in two white papers. If you haven’t read them you can find them here. Our research process for this dataset takes a diverse universe of ETF’s and creates 100 different equity curves for a number of different momentum factors. The universe has a number of different asset classes represented including Equities (Domestic & Foreign), Bonds, Commodities, Currencies, and Real Estate. The results provide a good idea about how a momentum-based, global TAA strategy would have performed. By creating 100 different equity curves we are taking luck out of the equation and showing a realistic range of outcomes from buying high relative strength securities out of our universe.
Most of the momentum factors we follow underperformed last year. The factors we are showing refer to the lookback period to do our rankings. The 1MORET factor (1-month return) means we used 1 month of data to calculate our momentum ranks (all securities are held until they fall out of the top of the ranks, which might be as short as one week or as long as a couple of years). The 12MORET factor uses the prior 12 months of price data to rank the securities. The 3-month factor actually performed the best in 2011, but only 40 out of the 100 trials outperformed the S&P 500, so you needed some luck to outperform. The 6-month factor was the next best, but only 1 trial outperformed so you needed to be really lucky. All the other trials were very poor. There was so much short-term volatility back and forth last year that the very short 1-month formulation period was deadly. It paid not to be too quick on the trigger last year!

Full Year 2011

(Click To Enlarge)

But looking at 2011 in aggregate doesn’t really tell the whole story. The beginning of the year was good for these strategies. That person you were dating held it together pretty well for the first couple of dates! Through the end of April, most of the strategies were outperforming the S&P 500 on average. The 6-month factor was doing great as all 100 trials were outperforming. Ironically, the factor doing the worst was the 3-month factor.

2011 Through April

(Click To Enlarge)

The problems for trend following strategies began in May. There were a series of sharp trend reversals in a number of different assets: Bonds, Stocks, Precious Metals, Currencies (Yen & Swiss Franc). No matter what factor you were using from May to the end of the year it was difficult. It was tough to get traction anywhere. The only factor that did even so-so was the 3-month factor, and that was the worst factor through April. That’s just one of many examples of how crazy the 2011 market was!

2nd Half 2011

(Click To Enlarge)

So where do we go from here? Well, the, “It’s not you, it’s me…” line always leads to a breakup. That’s probably not a bad idea when dealing with something that doesn’t change. Does that psycho, stage 5 clinger ever get any better? Nope. It only gets worse.

But markets change, and TAA based on momentum is very adaptive. We will not be in a choppy, range bound environment forever. Trends will emerge. (If they don’t, it will be the first time in history.)

Investors were euphoric about momentum-based TAA strategies in the first part of the year. Looking at the data you can see why – they were working exceptionally well. After the last few months, people are certainly not as excited. In reality, now is the time to be really excited about relative strength strategies, not back in April. Now is the time you want to be adding money.

Understand that Underperformance is Inevitable

2012-01-11T07:53:00.000-08:00

"The basic question facing us is whether it’s possible for a superior investment manager to underperform.... The assumption widely held is 'no.' And yet if you look at the records, it’s not only possible, it’s inevitable."

Quote from Wall Street People, by Charles D. Ellis

When faced with short-term underperformance from an investment manager, investors may lose conviction and switch to another manager. Unfortunately, when evaluating managers, short-term performance is not a strong indicator of long-term success.

The study below illustrates the percent of top-performing large cap investment managers from January 1, 2001 to December 31, 2010 who suffered through a three year period of underperformance. The results are staggering:

93% of these top managers' rankings fell to the bottom half of their peers for at least one three year period.

A full 62% ranked among the bottom quartile of their peers for at least one three year period, and

31% ranked in the bottom decile for at least one three year period.

Though each of the managers in the study delivered excellent long-term returns, almost all suffered through a difficult period. Investors who recognize and prepare for the fact that short-term underperformance is inevitable—even from the best managers—may be less likely to make unnecessary and often destructive changes to their investment plans.

Source: Davis Advisors. 192 managers from eVestment Alliance’s large cap universe whose 10 year average annualized performance ranked in the top quartile from January 1, 2001–December 31, 2010. Past performance is not a guarantee of future results.

Best performance amongst large hedge funds - 2011

2012-01-11T07:50:00.001-08:00

1. Tiger Global, YTD total return: 45% (assets, in billions: 6.0)
2. Renaissance Institutional Equities, 33.1% (7.0)
3. Pure Alpha II, 23.5% (53.0)
4. Discus Managed Futures Program, 20.9% (2.5)
5. Providence MBS, 20.6% (1.3)
6. Oculus, 19.0% (7.0)
7. All Weather 12%, 17.8% (4.4)
8. Dymon Asia Macro, 17.8% (1.6)
9. Citadel, 17.7% (11.0)
10. Coatue Management, 16.9% (4.7)
11. Stratus Multi-Strategy Program, 16.6% (3.7)
12. OxAM Quant Fund, 16.4% (2.0)
13. SPM Core, 15.7% (1.0)
14. Pure Alpha I, 14.9% (11.0)
15. Autonomy Global Macro, 13.9% (2.1)
16. BlackRock Fixed Income Global Alpha, 13.8% (2.4)
17. SPM Structured Serving Holding, 13.5% (1.6)
18. GSA Capital International, 13.0% (1.0)
19. JAT Capital, 12.7% (2.5)
20. Brevan Howard Master, 10.8% (26.4)

Back to fundamentals in 2012

2012-01-02T12:31:00.001-08:00

Imagine playing a football game in a driving rainstorm on a muddy field. Players slip and slide all over the place. The quarterback has trouble throwing the ball. Receivers can't grip thrown balls. Running backs are virtually skating on the field and can only occasionally get good footing. Kickers can't judge the wind as it shifts at a moment's notice.

That was the story of disappointing returns in 2011 for many hedge fund and active investment managers, which I wrote about last week.

Consider the experience of star hedge fund managers like Mark Kingdon and John Paulson, who can be described as the proverbial smartest guys in the room. The Wall Street Journal reported that Kingdon and Paulson were whipsawed by the market action in 2011:

Like other high-profile investors, Kingdon has been whipsawed throughout the year by stock market swings that have been hard to predict, turning on a dime. John Paulson (who had a terrific 2008) has had the most humbling year of his own storied career, with his largest funds sinking in value amid wrong-headed bets on an economic recovery.

Indeed, the chart below of the S+P 500 shows that the stock market was trendless in the first half of the year and trendless and marked by extreme volatility in the second half. Investable swings, shown in red, were few in number. Many of the swings seen in the second half, shown in green, lasted less than a week – and woe to anyone who tried to invest on news flow in the second half as whipsaw would be the inevitable result.

2011 was an extremely unfriendly environment for investment managers because politics and policy, not fundamental and economics, drove market returns. The market began to worry about an extreme tail-risk, or black swan, event such as a Lehman-like crisis in the second half of 2011. Every news headline moved the markets and it, in a binary risk on/risk off framework, it was virtually impossible for an investment manager to discern direction.

It is therefore no surprise that managers with the freedom to be long or short performed poorly in 2011 because of the lack of a trend, or direction in the market. On my previous post, I showed that the worst performing hedge fund managers were Market Directional, Equity Hedge, or long-short equity managers, and Fundamental Value.

Bimodal distributions and multiple equilibria

Like the metaphor about the football players, the reason why hedge fund managers had disappointing returns in 2011. The environment was unfriendly to their approach. Like the football players, it didn’t matter how skilled they were, they kept slipping in the rain.

That’s because most managers are trained to focus on fundamentals and economics while largely ignoring politics. In a year where politics and policy decision dominated the investment environment, it is no wonder that managers showed disappointing returns.

Moreover, the investment term “multiple equilibria” or “bimodal distribution” began to pop up in year-end letter to investors. As an example, Pimco manager Vineer Bhansali wrote about this topic in an article entitled Asset Allocation and Risk Management in a Bimodal World. In the article he wrote:

For example, the policy risk that pervades the markets today causes high correlations among asset classes and a temperament of “risk on/risk off” among investors. This phenomenon can be traced to the connectedness of markets, the ease by which market participants can access these connected markets, and the speed of assimilation of information in response to political events. (See V. Bhansali, The Ps of Pricing and Risk Management, Revisited, Journal of Portfolio Management, Vol. 36, No. 2, Winter 2010.) This environment creates the possibility of multiple equilibria in the market, as well as trends that move markets between these equilibria, and once settled, restraining forces that trap markets in those equilibria (See V. Bhansali, Market Crises -- Can the Physics of Phase Transitions and Symmetry Breaking Tell Us Anything Useful?, Journal of Investment Management, 2009).

Even though predicting which force will win is next to impossible given the real-time evolution of the interaction between markets and policy, we can still ask an important question: What would happen if the distribution of returns from a hypothetical portfolio looked more like the one shown in the chart on the right of Figure 1, i.e. a “bimodal” distribution with more than one peak? The bimodal distribution has two peaks, and interestingly, even though it is generated as the result of mixing two normal distributions, each from a different regime, it can exhibit both fat tails (a higher probability of larger losses due to unusual events results in a “fat tail” on the left side of the distribution curve) and skewness (a lack of symmetry between the left and right sides of the peak).

In other words, classical investment theory posits that investment returns follow a bell-shaped distribution, like the figure above on left. In the current environment where investors oscillate between a “risk-on” and “risk-off” trade, the true distribution may look like one with two peaks like the figure on the right. Under these circumstances, techniques used to manage funds assuming a bell-shaped distribution will not work in a multiple equilibrium world (like 2011).

The outlook for 2012
What happens now? Will the environment of 2011 persist into 2012 and the future?

The market should return to focusing on fundamental and economics in 2012. The financial market was largely driven by European news in 2011 as it was concerned the possibility of a Lehman-like market crash. When the news flow indicated that the Financial Apocalypse might be near, stocks sold off. When the European governments tabled a plan that indicated that the day of execution might be delayed, the markets rallied.

The events of 2008 are instructive for evaluating the current market environment. In 2008, the markets were concerned about the housing collapse and its effects on the markets and economy. Fast forward three years, the problems with the US housing market hasn’t gone away, nor have the concerns about the weakness of the American consumer and his balance sheet. But the fear of another Lehman-like Apocalypse in the United States is gone today.

Similarly, the ECB’s Long-Term Refinancing Operation (LTRO), which offers to lend eurozone banks unlimited amounts of money for up to three years, has largely taken the risk of Lehman-like event off the table. The long term problems of over-indebted eurozone sovereigns, weak European banking system and the competitiveness and productivity gap between Northern and Southern Europe remains.

Is the panic getting overdone? Probably. Given that the ECB has taken the market crash scenario off the table, the markets can now go back to focusing on what matters, such as earnings, growth outlook, interest rates, etc.

Under these circumstances, fundamentally driven investment strategies that depend on traditional techniques such as valuation, growth, momentum and trend spotting are likely to perform better in 2012 and beyond.

So... what happened to asset classes in 2011?

2012-01-02T08:21:00.001-08:00

Bonds crushed equities. Real assets were mixed.

Warren Buffett's Berkshire Hathaway Beaten by Flat S&P in 2011

2012-01-02T08:19:00.001-08:00

BERKSHIRE HATHAWAY STOCK VS. S&P 500 INDEX
ANNUAL GAINS

Year	BRK.A Close	BRK Pct. Change	S&P Close	S&P Pct. Change
2011	114,755	-4.7%	1257.60	0.0%
2010	120,450	+21.4%	1257.64	+12.8%
2009	99,200	+2.7%	1115.10	+23.5%
2008	96,600	-31.8%	903.25	-38.5%
2007	141,600	+28.7%	1468.36	+3.5%
2006	109,990	+24.1%	1418.30	+13.6%
2005	88,620	+0.8%	1248.29	+3.0%
2004	87,900	+4.3%	1211.92	+9.0%
2003	84,250	+15.8%	1111.92	+26.4%
2002	72,750	-3.8%	879.82	-23.4%
2001	75,600	+6.5%	1148.08	-13.0%
2000	71,000	+26.6%	1320.28	-10.1%
1999	56,100	-19.9%	1469.25	+19.5%
1998	70,000	+52.2%	1229.23	+26.7%
1997	46,000	+34.9%	970.43	+31.0%
1996	34,100	+6.2%	740.74	+20.3%
1995	32,100	+57.4%	615.93	+34.1%
1994	20,400	+25.0%	459.27	-1.5%
1993	16,325	+38.9%	466.45	+7.1%
1992	11,750	+29.8%	435.71	+4.5%
1991	9,050	+35.6%	417.09	+26.3%
1990	6,675	-23.1%	330.22	-5.8%
1989	8,675	+84.6%	350.67	+26.3%
1988	4,700	+59.3%	277.72	+12.4%
1987	2,950	+4.6%	247.08	+2.0%
1986	2,820	+14.2%	242.17	+14.6%
1985	2,470	+93.7%	211.28	+26.3%
1984	1,275	-2.7%	167.24	+1.4%
1983	1,310	+69.0%	164.93	+17.3%
1982	775	+38.4%	140.64	+14.8%
1981	560	+31.8%	122.55	-9.7%
1980	425	+32.8%	135.76	+25.8%
1979	320	+110.5%	107.94	+12.3%
1978	152	+10.1%	96.11	+1.1%
1977	138	+55.1%	95.10	-11.5%
Average		+26.5%		+8.6%

Vitaliy Katsenelson on Krugman’s Missed Call

2012-01-02T08:17:00.000-08:00

Vitaliy Katsenelson, CFA, is chief investment officer at InvestmentManagement Associates, Inc., a Denver-based money managementfirm. Vitaliy is also the author of the highly acclaimed books The LittleBook of Sideways Markets (Wiley, 2010) and Active Value Investing:Making Money in Range Bound Markets (Wiley, 2007). His web site isContrarian Edge.

Paul Krugman wrote about China in his New York Times column last Monday.That’s a topic that you have researched closely. He said that "China’s story justsounds too much like the crack-ups we’ve already seen elsewhere," referring to thefinancial crisis in the US and the Japanese lost decade. Do you agree with hisassessment?
Yes. You can draw a lot of parallels between the Japanese and US real estate bubbles.But China’s bubble is much larger; it spreads beyond residential real estate to commercialreal estate, the industrial sector, and infrastructure. Also, though there were governmentfingerprints on the US and Japanese real estate bubbles, the Chinese real estate bubblewas directly and entirely caused by the Chinese government.
The Chinese bubble has been inflating for years. It should have popped during 2008recession. But China fire-hosed a stimulus equal to 12% of its GDP into its economy andwas able to keep the bubble growing.
When is it going to pop? It has already begun. You see sales volumes and pricesplummeting at double-digit rates in second-tier cities.
I agree with Krugman’s assessment. What perplexes me is why the Nobel Prize-winningeconomist wrote this column now, when the problems he describes are plain for all to see,and not a few years ago. You’d think he would have been alarmed over the consequencesof monstrous government intervention in an economy the size of China’s. But perhapsKrugman, who describes himself as a liberal economist, secretly hoped that the Chinesegovernment would be able to manage the economy better than the free market.

But even over the last few years China’s growth has remained relatively strong –certainly as compared to the rest of the world – just not as strong as it was in theyears prior to that.
It was completely driven by fixed-asset investment and the bad loans that came with that –not a sustainable type of growth.
One of the things Krugman pointed to was the lack of reliable data from the Chinesegovernment. To what extent does that cloud your analysis, and how certain can yoube in your forecast and your analysis, given the uncertainty, or unreliability, ofChinese government data?
He is right. When you look at Chinese government data, it has a couple of biases. Numberone is in the way they collect data: it comes from municipalities and local governments thatare given growth targets. The federal government says, “You need to grow, let's say 10%of GDP per capita, for your municipality.” The local bureaucrat has to get that growth. Theeasiest way to do it is to build, and that is why they have had a real estate bubble.
But the problem is, if the local bureaucrats fail to deliver the growth they know they'll losetheir jobs. So they start cooking the numbers, and they start sending numbers to the topthat are falsified. That is the number one bias.
The second bias is that this is a government that is very concerned about its image. It isvery good at propaganda. The government puts people in jail for writing anti-governmentarticles. The economic statistics are the output of a propaganda machine. You truly can'ttrust the data coming from the government.
But that is why you look at anecdotal evidence, and the data points they can't or just don'tbother to cook. During the 2008-2009 recession, the global economy was contracting andthe Chinese government was showing that GDP was growing at a fairly healthy pace.However, other data points, like the tonnage of goods shipped through railroads, weredown by double digits. Electricity consumption declined too.
Eventually, we started seeing empty cities popping up here and there.
What made it easy for me to understand China is that I was raised in Soviet Russia for thefirst half of my life. This experience helped me to understand how inefficient,dysfunctional, and corrupt an economy that is run by the government can be. You startseeing and piecing together the small bits of anecdotal evidence. You build a frameworkthat helps you to understand their economy.

Are there any policy options that are still available to the Chinese government, forexample, stimulus measures that it could take to avert the kind of crisis thatKrugman predicts and that you say is already occurring?
I am fairly certain that, once the pain of economic slowdown is felt, the government will dowhat it did in 2008: It will try to re-inflate the bubble. But that will add another layer offuture problems on top of the existing ones. For instance, according to Pivot Capital, toxicshadow banking, which was almost nonexistent in 2008, is estimated to be $250 billion in2011. The Chinese government may manage to keep the bubble from bursting for a littlelonger, but at some point the basic laws of economics will assert themselves, and there isabsolutely nothing the Chinese will be able to do.
What will be the spillover effect in the United States?
This is very interesting. Look at what is going on in Europe today. Let's say the euro willnot blow up. In other words, Europe is still going to have a monetary union consisting ofthe same 17 members going forward, but a byproduct of that will be austerity, and they willconsume less. We are going to sell fewer goods to Europe. Europe will be consumingfewer goods from Japan and from China. So what happens in Europe could acceleratewhat is already happening in China, and that may hasten the bursting of its bubble.
Japan’s largest trading partner is not the United States, but China. (China accounts for of19.4% of Japanese exports; the US is only 15.7%.) We are all concerned about Europe,but Japan is in much worse shape than Europe. Italy has debt-to-GDP of 120% and it ispaying 7% for its 10-year bonds, while Japan’s debt-to-GDP is over 200% and its 10-yearbonds yield less than 1%. Japan has even worse demographics than Europe, which ishard to imagine. The Japanese government was able to amass an enormous pile of debtbecause it borrowed internally from its citizens, who had a very high savings rate. Thesavings rate, however, has declined over the last decade as Japanese society ages. Theeconomic crisis in China will likely cause much higher unemployment in Japan and thus afurther decline in the savings rate.
Suddenly, the Japanese government will have to borrow money externally, and US andEuropean investors will not be buying Japanese 10-year bonds for 1%, I assure you. Evenbigger budget deficits will result – and Japan is already running 8% shortfalls – or theJapanese will print money, which will cause huge inflation. Most likely, both will be thecase.
China may accelerate the bursting of the Japanese debt bubble. The Japanese bubblehas been developing for a long time. We may see contagion in ways we haven’t seenbefore. Of course, the obvious consequences are in the area of industrial commodities.Because China builds so much, it consumes a lot of them, and their prices will plummet.Also, commodity-exporting countries (Australia, Brazil, and others) that appear immune to

the tornadoes sweeping through the global economy will suffer. It is very likely that we’llsee much higher global interest rates.
The collapse of Chinese residential real estate will make a lot of Chinese angry. TheChinese government set bank interest rates at below-inflation levels, thus pushing itscitizens into becoming real estate speculators. A collapse in real estate prices will wipeout a huge chunk of generational wealth and may cause political unrest. We are seeing alot of stories already of people who bought homes and condos, lost 30% in just a fewmonths, and are now storming offices of real estate developers to demand refunds.
Let's turn to Europe. Do you see an inevitable outcome for that region in terms ofhow it will resolve the crisis over the euro and its member nations’ sovereign debt?
There is a very high probability that the European Union will become more fiscallyintegrated. This crisis will bring them closer, not pull them apart.
It is like getting married and having 20 children – it is very difficult to get divorced. If themonetary union falls apart, the weak countries – Spain, Greece, etc. – will suffertremendously, because if they have to convert back to their own currencies their bankingsystems will collapse almost overnight. Everybody will rush to the banks to get theirmoney out, which is already happening in Greece to some degree. Their debts will be ineuros, and their local currencies will depreciate.
The strong countries will suffer as well, especially Germany, since it is a very largeexporter to the rest of Europe. If Germany leaves the European Union, then thedeutschemark will appreciate, and it will hurt their economy.
German banks have huge exposure to the rest of Europe. By bailing out Europe,Germany is basically bailing out its own banks. Germany cannot bail out all the weakcountries. Germany, because of what happened during the Weimar Republic, does notwant to do that, because they fear inflation. They saw what inflation did. But they’ll havelittle choice.
I never thought I’d say this, but printing money is a lot more democratic than bailing outother countries. I believe Europe will print.
There is a 70% probability that the European countries will become much more fiscallyintegrated than they were before. However that will be accompanied by austerity.Austerity means government deleveraging, which will bring higher unemployment. Atsome point you may have people rioting in the streets, as has happened in Greece. I cansee people saying, “If being in the monetary union means we don’t have jobs, then wewant no part of it.”

Just to be clear, for Europe to remain integrated, does it require what you describeas “printing more money”? Is that essentially having that ECB buy the badsovereign debt that is on the books of the banks?
What we keep learning is that financial geeks are very creative, even more creative thanthe geeks in the Silicon Valley, and they find vehicles that we didn't even know existed. Inever thought the IMF would be able to put in place a bailout mechanism for Europe. ButItaly will contribute $23.5 billion to the IMF to bail out itself! I've learned never tounderestimate the creativity of financial geeks, and they have a lot of them in Europe.
I have no idea exactly how they are going to print money, but they will figure out a way todo it. It's going to be through the ECB, and through euro-bonds or through some othervehicle that we don't know about yet. We are going to have a much greater money supplyin Europe.
Will they avoid inflation, because at the same time they will be undergoing a deeprecession?
To some degree they will, because the prices of necessities will go up, and at the sametime wages will stagnate or decline (as unemployment rises). So it is very difficult to sayright now. You are going to have a much greater money supply, but you don't know what'sgoing to happen to the velocity of money and thus inflation.
Let's turn to the United States. You've written about the fact that the US is in asideways market. What do you mean by that? More importantly, where are we arenow in that cycle and what is the timing, in terms of when we will emerge from thesideways market into either a bull or a bear market?
Think about market cycles in this way. In the long run, stock-price returns come fromearnings growth and from change in price-to-earnings ratios. In the very long term,changes in price-to-earnings tend to cancel each other out, so therefore in the very longrun stock prices really go up with earnings growth, which equals GDP growth. In theshorter term, a combination of earnings growth and change in the P/E gives you the returnfor the stock market. You add dividends on top of that, and now you have total stockmarket returns.
Whenever you have a secular bull market, which lasts about 15 years (plus or minus afew), you have two elements. You have earnings growth and price-to-earnings ratios thatare expanding. At the beginning of the bull market, price-to-earnings ratios are very low,let's say seven to 10. By the end of the bull market, the ratio has run through the averageto an above-average level, let's say to the 20s.
A sideways market happens at the end of a bull market. Earnings are still growing duringa sideways market. P/Es, though, are declining, going from above-average to below-average. Earnings growth and P/E contraction cancel each other out, and this is why themarket goes sideways.

When I say sideways, don’t confuse it with a kind and placid market – there can be a lot ofvolatility and a lot of cyclical bear and bull markets embedded in a sideways market. Infact, the last sideways market, from 1966-1982, included five little bear markets and fivelittle bull markets – so a lot of volatility.
Finally, you have a third type of secular market. It is the bear market, which happens a lotless often than you would think. Bear markets start with high valuations, which we had inthe late 1990s, and prolonged contacting earnings. So you have two negatives, decliningearnings and declining P/Es. Together you have very poor returns, because you add twonegatives.
Over the last 10 or 11 years earnings have grown and P/Es have contracted, so we'vebeen in a sideways market.
Going forward, are we going to be in a sideways market or a bull market?
This is where I just gave you a framework, and you can use your own assumptions. Ifwe're still going to have positive growth in the long run, then we are still going to be in asideways market. If we are going to have a contracting economy for a long period of time,however, then all the bets are off and we are in a bear market, as today’s valuations arestill high. I am not saying this because I am hedging my bets. This is a very simpleframework, and all you have to do is figure out one thing: Are we going to have economicgrowth, or not?
What is your answer to that question?
In the context of what is going on Europe, China, Japan, and the US, the next decade willbe payback time for all the partying the global economy did previously. Our economy willstill grow, but at a slower rate.
Actually, let me clarify this: It is the nominal earnings growth rate that really matters. Soeven if real earnings growth is low, there is a good chance that inflation will pick up and thenominal growth rate will be higher than we are used to. So you have to make anassumption about what will happen to inflation and deflation in the future as well.
The second part is this: How long until the end of the sideways market? This is where itgets tricky. The market is only cheap today because profit margins are still high.Corporate profit margins are about 50% above their average [see the chart below]. Oncemargins start normalizing (or, in this instance, decline), profits will either stagnate or fall.So the market is not cheap.

Sideways markets end with lower P/Es, with one important point caveat: P/Es can stay atbelow-average levels for a while. Right now, we are at average to slightly above-averageP/E ratios, if you normalize earnings for current profit margins. If you assume that weneed to spend some time at below-average P/E levels, then we still have some painahead. We still have at least five or 10 years of sideways market left before we get to thebelow-average P/Es, and we could stay there for a while. So we are not there yet.
But the good news is that once sideways markets end, it is usually bull market time.
You are saying that unusually high profit margins are holding up valuations rightnow, and that eventually there will be a reversion to the mean. But can't profitmargins stay at a high level for a long period of time, just as you said that P/Emultiples can remain in a low range for a long period of time? Can't this reversionto the mean occur over a protracted period?
Profit margins usually can’t hang in there as long as P/Es – just a few years. Becausewhen one company starts making abnormal profits, competition comes in and erodesthose profits.

Let me give you this example. Apple made terrific iPhone and iPads. Several years later,there is now a lot of new competition that has introduced products that are almost as good,or products that are not as good but are much lower-priced (such as Kindle Fire). Andguess what? At some point, Apple, to be competitive, is going to have to lower its prices;and therefore its profit margins, which are at their highest level ever, will have to decline.
The same thing applies for the economy as a whole, with some exceptions. There aresome industries that can maintain high margins for a long period of time. But for theeconomy overall, competition either forces lower prices or offers products or services thathave more features for the same price, and in the end profit margins decline.
Why don't we turn to one of your stock selections. I saw you wrote recently thatMicrosoft is a company you like. It is also one of Seth Klarman’s holdings. How canit be that a stock as prominent as that, which is followed by as many analysts as itis, can offer the margin of safety that a value investor like you would require?
That’s what is interesting. If I gave you Microsoft’s financial statements and I didn't tell youwhat company it was, you would say it was an incredible business. The company hasmore than doubled its earnings over the last five years and has a huge, cash-rich balancesheet, an enormous return-on-capital of nearly 40%, enormous cash-flow generation, anda near-monopoly in a lot of businesses where it operates.
Then you look at the stock price and you say, “Huh, this company hasn't gone anywherefor the last 12 years.” Microsoft, to some degree, is a very typical sideways-market stock.Its P/E was extremely high and its earnings were very high at the end of the last bullmarket, and its P/E collapsed. Its P/E was 50; and now, if you take out cash, it is at about6.5 to 7 times earnings. There is a psychological element, where people look at the stockprice and are fatigued by the nonperformance of the stock.
But there is another element that is very specific to Microsoft. Even if you take thesideways market psychology into consideration, this company should not be trading at thisvaluation. Wall Street lost confidence in the company's management. Microsoft’s businesswas so good that it was able to grow earnings on autopilot.
There is a lot more competition now, like Google and Apple. They are very strongfinancially. They're dominating their main markets.
The market is saying Microsoft is going to become a dinosaur. It's going to decline intoobsolescence. This is where Klarman and I disagree with the consensus.
Look at Windows Vista; it was a horrible product. But it was still a financial success,because Microsoft had a monopoly. Then Windows 7 took over from Windows Vista andfixed it. Windows 7 was not an innovative product, but it was a good solid product.

Then, a few months ago, Microsoft showed Windows 8, which is going to come out nextyear. This was the first time I looked at a Microsoft product and said “Wow!” It was createdby a company that is paranoid about competition, not something that Microsoft ever wasbefore. It is a very good product that is going to work not only on PCs and laptops but alsoon tablets, which is very important, because tablets are the piece that Microsoft wasmissing.
Apple and Google were attacking Microsoft on the tablet front, and Microsoft did not havea product. Microsoft used to sell Windows for Netbooks, which were underpoweredlaptops. That category of products is gone. Microsoft is going to have a very solid productwith which to compete against Apple and Google next year.
What are your thoughts on the new partnership between Microsoft and Nokia?
What I really like is that Microsoft did something uncharacteristic of itself. It did not go outand buy a company, but created an alliance with a company that was extremely desperatefor an alliance – Nokia. Nokia was always great at making cell phones and hardware. Butwhen the smart phones came around, Nokia could not come up with good operating-system software.
Then Nokia’s new CEO, who came from Microsoft, struck a deal by which Nokia is going tobet its future on Microsoft software. All the smart phones that Nokia is going to make inthe future will be based on Microsoft Windows. Nokia came out with its first smart phone afew months ago in Europe, and it has received great reviews.
What is important about Nokia and Microsoft together is that to be successful in thismarket you have to have the marriage of hardware and software. That's why thecompanies are working together on developing software.
Microsoft says its Nokia alliance is going to be an accelerator. It is going to allow them tobring cellphones to the market very quickly. Nokia still has a very good brand name inEurope, and it has a tremendous distribution network.
Finally, you have a new trend that the media will be making a huge deal over the nextthree to six month: ultrabooks. They are thin, beautiful, powerful laptops. Basically, Inteldid something brilliant; it trademarked the term ultrabook. They are going to spend acouple hundred million dollars promoting the brand. If you are a PC-maker, and you wantto make an ultrabook, it will have to meet very specific criteria that Intel has spelled out: Ithas to be light, have a solid-state drive, a fast boot time, and a long battery life.
You are already seeing these ultrabooks hitting the stores, and we are going to see a lotmore of them. Right now they are expensive, but the price will come down soon. They aregoing to make Windows products sexy again.

Now you have a company – Microsoft – that's actually doing smart things, and its stockprice is incredibly cheap. It has a terrific balance sheet that is still based on a monopoly,for the most part. And you can buy it at one-third the multiple of the market. It’s a no-brainer.
That's why Seth Klarman owns it, and we own it, too.

Why do universities have endowments?

2011-12-29T10:11:00.000-08:00

Why do universities (in the US and Britain only) have endowments, and should they? And why does no one but Henry Hansmann [pdf, eBook version here] write about this question?

Because they can. Tax law doesn’t stop them, and why should a University President spend down the fund? An ongoing high balance in the fund means prestige, a good ranking, and an ability to make credible commitments to quality faculty and quality programs.
Current donors know that their support will feed into something long-run and grand. Rationally or not, it is less persuasive for an alumni donor to hear a pitch like “We will spend down the corpus. Penn State will rise seventeen spots in the ratings, for twenty years, and then fade into obscurity.” Many givers care predominantly about the “here and now,” but they donate to political campaigns, or benevolent charities, not universities.
Ultimately we need a theory of segmented giving, and how board structures of universities support such giving. University board members benefit most from a prestigious school with a high endowment and other prestigious board members. In general those boards will support accumulating the endowment, at least if the school has any chance for prestige in the first place. Spending money within the university instead distributes those benefits to current faculty and students, rather than to the decision-makers over the endowment.
Note that while the most visible colleges and universities usually have large endowments, the median and modal schools have endowments very close to zero. They have no chance of accumulating their way to substantial prestige benefits.

Alternatively, you could drop the fancy institutional economics and apply crude price theory. Universities can borrow or otherwise raise money tax-free, and at g > r you should expect ongoing and rising accumulation.
It is striking how much the list of top U.S. universities does not change over the last century, albeit with some new entries from the west coast. Among other things, that suggests there has been no fancy, expensive and effective new product that a school might invest in and run down its endowment for. This might change in the next twenty years. One can imagine a middling school running down its endowment to spend its way to leadership in on-line education.

I have never seen a good paper on which non-profits accumulate endowments and which do not, and how that difference functions as both cause and effect. I would think, for instance, that the Heritage Foundation has a substantial endowment, but many think tanks do not.

Here is a new paper on university endowments (pdf), by Gilbert and Hrdlicka, asking whether endowments are invested in too risky a fashion. It also raises the question of how well endowment practices will survive in a time with low rates of return. Here is a 2008 dialogue on endowment reform. Here is a 2009 law review piece on university endowments, it is a little slow to load. Here is a TIAA-CREF perspective (pdf) on the investment committees for university endowments; they tend to be run by donors. Here is a look at mandatory payout proposals. Here is a good 2010 paper (pdf) on what happens when endowment values decline, it is called “Why I Lost My Secretary.”

Cutting Buffett Helps Sequoia Fund

2011-12-29T10:09:00.001-08:00

By Charles Stein - Dec 29, 2011

Sequoia Fund Inc., (SEQUX) recommended byWarren Buffett when it opened, beat the U.S. stock market overthe past four decades, in part because a large piece of the fundwas invested in his company, Berkshire Hathaway Inc. (BRK/A)
Heeding Buffett’s warning that Berkshire wouldn’t grow asfast as it once did, the managers of the $4.7 billion fund cuttheir reliance on the stock almost in half in 2010 and put thecash into companies such as Valeant PharmaceuticalsInternational Inc. (VRX), a drug distributor. Sequoia is beating thepack again this year, gaining 14 percent through Dec. 27, betterthan 99 percent of value stock funds, according to data compiledby Bloomberg.
“They have the kind of portfolio Buffett might have if heran a mutual fund,” Steven Roge, a portfolio manager withBohemia, New York-based R.W. Roge & Co., said in a telephoneinterview. His firm, which oversees $200 million, holds sharesin Sequoia.
Like Buffett, the managers of Sequoia look for high-qualitycompanies with competitive advantages that the fund can hangonto for long periods. While the scale of Buffett’s $68 billionstock portfolio forces him to buy mainly the largest companies,Sequoia is small enough to benefit from investments in mid-sizedbusinesses.
The fund beat 97 percent of peers over the past 10 and 15years, according to Morningstar Inc. (MORN) in Chicago. From 1970 to2010 the fund returned 14 percent annually, compared with 11percent for the Standard & Poor’s 500 Index. In its best year,1976, the fund gained 72 percent, according to “The WarrenBuffett Way” (John Wiley & Sons, 1994) by Robert Hagstrom. Itlost 27 percent in its worst year, 2008.

Buffett’s Praise

Sequoia Fund was co-founded in 1970 by Richard Cunniff andWilliam Ruane, a friend of Buffett since both studied underlegendary value investor Benjamin Graham at Columbia Universityin 1951. When Buffett shut down his investment partnership in1969 to concentrate on Berkshire Hathaway, he recommended thathis clients invest with Ruane.
“Bill formed Sequoia Fund to take care of the smallerinvestor,” Buffett wrote in an e-mailed response to questions.“A significant percentage of my former partners went with himand many of those still living have their holdings of Sequoia.”
Ruane ran an unconventional fund, closing Sequoia to newinvestors in 1982 because he didn’t want its size to limit whatthe fund could buy. It opened again in 2008, three years afterRuane’s death.
Ruane also held a concentrated portfolio. In 2003, Sequoiahad 75 percent of its money in its top six holdings, accordingto a regulatory filing.

‘Six Best Ideas’

Ruane believed that “your six best ideas in life are goingto do the best,” David Poppe, who now runs the fund togetherwith Robert Goldfarb, said at a May 2011 investor day for Ruane,Cunniff & Goldfarb Inc., the New York firm that advises Sequoia.
Poppe and Goldfarb didn’t respond to a request to beinterviewed. The two were named domestic stock managers of theyear for 2010 by Morningstar. They are finalists for the sameaward for 2011.
Since Ruane’s death, the firm has hired more analysts andadded more holdings to the portfolio. At the end of 2010,Sequoia held 34 stocks, an all-time high, according to a letterto shareholders in the fund’s 2010 annual report. The sameletter explained why Sequoia reduced its stake in BerkshireHathaway.

Cutting Berkshire

“When Warren Buffett tells the public that Berkshire’sgrowth rate will slow in the future, it behooves one tolisten,” the fund’s managers wrote. Buffett has said on anumber of occasions that a company of Berkshire’s size can’tgrow at the pace it did when it was smaller.
“We know we can’t do remotely as well in the future as wehave in the past,” Buffett said on April 30 at Berkshire’sannual meeting in Omaha.
Berkshire represented 11 percent of Sequoia’s holdings asof Sept. 30, down from 20 percent at the end of 2009 and 35percent in 2004, according to fund reports.
Sequoia’s Berkshire stake has been a drag on the fund’sreturns in recent years, said Kevin McDevitt, an analyst forMorningstar. Over the past five years, Sequoia rose 4.3 percenta year compared with an annual gain of 1 percent for Berkshire.Over 20 years through November, Berkshire outperformed Sequoiaby 2.6 percentage points a year.
“There was a time when you could have said they wereriding Buffett’s coattails,” McDevitt said in a telephoneinterview. “That’s not the case anymore.”

Long-Term Investor

A reduced Berkshire stake hasn’t stopped the fund frominvesting in a style similar to Buffett’s. In 2011, Buffettbought shares of MasterCard Inc. (MA) and International BusinessMachines Corp. (IBM), two companies Sequoia already owned.
Buffett’s portfolio contains stocks, such as Coca-Cola Co. (KO)and Wells Fargo & Co. (WFC), that he has owned for more than 20 years.Sequoia has holdings, including TJX Cos. (TJX) and Fastenal Co. (FAST), thathave been in the fund for at least 10 years, regulatory filingsshow.
TJX, a Framingham, Massachusetts-based discount retailer,has appreciated at a rate of 14 percent a year in the 10 yearsended Nov. 30, compared with 2.9 percent for the Standard &Poor’s 500 Index, according to data compiled by Bloomberg.Fastenal, an industrial supplier based in Winona, Minnesota,gained 20 percent a year.
“As an investor, if you get the people and the businessright, you can let a company do the hard work for you for a longtime,” Thomas Russo, a partner at Lancaster, Pennsylvania-basedGardner Russo & Gardner, said in a telephone interview. Russo,who worked at Ruane’s firm from 1984 to 1989, manages $4billion.

‘Good and Bad’

Sequoia’s patience hasn’t always paid off. MohawkIndustries Inc. (MHK), a carpet maker based in Calhoun, Georgia, and alongtime Sequoia holding, lost 19 percent of its value in thepast five years as the housing slump depressed carpet sales.
“In the short term, holding Mohawk has been a really poordecision,” Poppe said at the 2009 investor meeting.
Such self-criticism is common at the meetings. At onesession, an investment in Porsche Automobil Holding SE (PAH3), theGerman automaker, was described as a “disaster.” At another, amanager admitted the firm was too timid about buying MasterCardafter it went public in 2006.
“They give you the good and the bad,” said Roge, who hasattended several of the firm’s investor meetings.
Sequoia’s managers don’t buy many of the largest stocksbecause the companies are too well-known and too heavilyfollowed on Wall Street. Their preference is to own businesses“where we believe, not always correctly, that we have an edgein information,” they wrote in their 2009 letter toshareholders.

Valeant Stake

Valeant Pharmaceuticals, the fund’s largest holding, had amarket value of less than $7.5 billion (VRX) when Sequoia purchased itin the third quarter of 2010, Bloomberg data show. TheMississauga, Ontario, drug company gained 62 percent this year.
At the 2011 investor meeting, the fund’s managersemphasized Valeant’s unusual business model, which focuses onacquiring drugs with a proven track record rather than spendingmoney on research and development. They also praised the firm’schief executive officer, J. Michael Pearson.
Goldfarb told investors that over time he has becomeconvinced that the right executive is crucial to a business’ssuccess. “We’re betting more on the jockey and a little less onthe horse,” he said in May at the fund’s annual meeting.
Sequoia typically has far more cash than the 3.7 percentheld by the average U.S. domestic stock fund. At the end of thethird quarter, cash represented 27 percent of the fund’s assets,according to data compiled by Bloomberg.

Holding Cash

Other well-known value investors, such as Seth Klarman,founder of Baupost Group LLC, a Boston-based hedge fund, andRobert Rodriguez, the longtime manager of FPA Capital Fund andcurrent CEO of Los Angeles-based First Pacific Advisors, letcash build up when they can’t find enough attractiveinvestments.
“In good markets cash can be a drag, but we have not hadmany good markets lately,” Dan Teed, president of WedgewoodInvestors Inc. in Erie, Pennsylvania, said in a telephoneinterview. Teed, whose firm manages more than $100 million,including shares of Sequoia, said the fund’s cash was a plusbecause it means they “aren’t afraid to take a defensiveposition.”

Debt Dangers

Klarman and Rodriguez have written about the dangers of theincrease in U.S. government debt, warning that it could pose athreat to the economy and the stock market if it is not whittleddown.
Goldfarb normally ducks questions about macroeconomicissues at annual meetings, saying he has no special insight intothe future of the economy, interest rates or the prices of oiland gold.
At the 2011 annual meeting, in response to an investorquestion, he sounded a gloomy note about deficits.
“My own feeling is that we’re just repeating the housingbubble in a different form,” he said. “We’ve substituted anunsustainable buildup of government debt for what is anunsustainable buildup of consumer debt. This one really feelsworse to me and more dangerous. I think we’re living in a timeof false prosperity.”

The Dirty Dozen: Fairholme Fund's 12 Largest Holdings

2011-12-28T09:35:00.001-08:00

If there is one person for whom 2011 cannot end soon enough, it is Bruce Berkowitz. The manager of the Fairholme Fund (FAIRX) has had a year where practically all of his holdings have been taken out to the woodshed one by one, resulting in a year to date decline of more than 30% for the fund.

As if the year wasn't bad enough already, today the fund's third largest holding, Sears Holdings (SHLD), announced a 5.2% decline in same store sales and that it would close more than 100 stores. As a result, SHLD is down more than 25% today alone and 53% YTD. The table below lists the Fairholme funds 12 largest holdings as of its most recent filing. As shown, all but one of the stocks is down on the year, and three are down more than 50%!

Kass: 15 Surprises for 2012

2011-12-27T10:55:00.000-08:00

"Never make predictions, especially about the future."-- Casey Stengel

While I had a reasonably successful surprise list for 2011, with about half my surprises coming to fruition, the real story was that I achieved something that is almost impossible to accomplish.
My most important surprise (No. 4) was that the S&P 500 would end the year at exactly the same price that it started the year (1257) and that the range over the course of the year would be narrow (between 1150 and 1300).
As explained below, both predictions were remarkably close to what actually occurred.

My Biggest Surprise for 2011 Was Eerily Prescient

As we entered 2011, most strategists expressed a sanguine economic view of a self-sustaining domestic recovery and shared the view that the S&P 500 would rise by about 17% and would end the year between 1450 and 1500 vs. a year-end 2010 close of 1257.
By contrast, I called for a sideways market, stating that the S&P would be exactly flat year over year. To date, that surprise has almost come true to the exact S&P point. Remarkably, at around midday last Friday, Dec. 23, the S&P 500 was trading at 1257 -- Friday's closing price was 1265 -- precisely the ending price on Dec. 31, 2010! (There are still four trading days left in the year, so technically the exercise is not yet over.)
A flat year is a much rarer occurrence than many would think. According to The Chart Store's Ron Griess, in the 82 years since 1928, when S&P data was first accumulated, the index was unchanged in only one year (1947). And in only three of the 82 years was the annual change in the S&P Index under 1% -- 1947 (0.00%), 1948 (-0.65%) and 1970 (+0.10%).

In addition to the amazing accuracy of my variant S&P forecast, my forecast for the index's full-year trading range was almost as precise -- in both content and from the standpoint of causality.
As I wrote, a year ago, the S&P 500 would exhibit "one of the narrowest price ranges ever."
The surprise expected was that the S&P would never fall below 1150 (it briefly sold at 1090) and never rise above 1300 (it briefly traded at 1360), "as the tension between the cyclical tailwind of monetary ease (and the cyclical economic recovery it brings) would be offset by numerous nontraditional secular challenges (e.g., fiscal imbalances in the U.S. and Europe; a persistently high unemployment rate that fails to decline much, as structural domestic unemployment issues plague the jobs market; and the continued low level of business confidence (reinforced by increased animosity between the Republicans and Democrats) exacerbates an already weak jobs market and retards capital-spending plans." I went on to write, "Despite the current unambiguous signs of an improving domestic economy, as the year progresses, the growing expectation of consistently improving economic growth and a self-sustaining recovery is adversely influenced by continued blows to confidence from Washington, D.C., serving to contribute to a more uneven path of economic growth than the bulls envision."

Dueling Annual Surprise Lists: Kass vs. Wien

By means of background and for those new to Real Money Pro, nine years ago, I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook, who originally delivered his list while chief investment strategist at Morgan Stanley (MS ) then Pequot Capital Management and now at Blackstone (BX ).
Every year I, and many others, look forward to Byron "Brontosaurus Rex" Wien's annual compilation (hat tip to "Squawk Box's" Joe Kernen for giving him the moniker).
Byron has had a remarkable (and almost uncanny) record of his surprises becoming realities ever since he started his exercise back in 1986. His picks in 2009 were particularly accurate, but his surprises for 2010 were considered by some to be off the mark.
Here is Byron Wien's surprise list for 2011. The tone of almost all of Byron's 2011 surprises was diametrically opposed to my list -- namely, his list was rooted in optimism, while my list was rooted in pessimism. Where I saw slowing and sluggish economic growth, a weak housing market, a European recession by year-end and a lackluster stock market, Byron saw improving prospects. His principal surprises for the economy, interest rates, housing, the eurozone's debt crisis and the housing markets were off the mark in 2011. (Byron is an honest guy, so he would be the first to admit this.)
Specifically, Bryon expected U.S. real GDP growth of close to 5% (real U.S. GDP over the past 12 months saw only a 1.8% growth rate), a 5% yield on the 10-year U.S. note (which now stands at 2.03%, but, hey, I got that one wrong, too!), a year-end S&P 500 close near 1500 (now at 1265), a sharp recovery in housing starts to 600,000 and a rise in the Case-Shiller Home Price Index, and a quiescent and non-market-disruptive European debt situation. He was very correct on the price of gold (where I was far off base) and on benign inflationary pressures.

Lessons Learned Over the Years

"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown."-- Woody Allen

There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:

how wrong conventional wisdom can consistently be;

that uncertainty will persist;

to expect the unexpected;

that the occurrence of Black Swan events are growing in frequency; and

with rapidly changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

Consensus Is Often Wrong

"Let's face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins."-- "UBS's Top 10 Surprises for 2012" (hat tip to Zero Hedge)

Let's get back to what I mean to accomplish in creating my annual surprise list.
It is important to note that my surprises are not intended to be predictions but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these "possible improbable" events. In sports, betting my surprises would be called an "overlay," a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.
The real purpose of this endeavor is a practical one -- that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers/investments.
Since the mid-1990s , the quality of Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and groupthink (or groupstink, as I prefer to call it). Mainstream and consensus expectations are just that, and in most cases, they are deeply embedded into today's stock prices.
It has been said that if life were predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile.
Nothing is more obstinate than a fashionable consensus, and my annual exercise recognizes that over the course of time, conventional wisdom is often wrong.
As a society (and as investors), we are consistently bamboozled by appearance and consensus. Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank Citigroup (C ), the uninterrupted profit growth at Fannie Mae (FNM ) and Freddie Mac (FRE ), housing's new paradigm (in the mid-2000s) of noncyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.

"Consensus is what many people say in chorus but do not believe as individuals."-- Abba Eban (Israeli foreign minister from 1966 to 1974)

In an excellent essay published a year ago, GMO's James Montier made note of the consistent weakness embodied in consensus forecasts. As he puts it, "economists can't forecast for toffee."
Attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future. Even a cursory glance at Montier's Exhibit No. 4 (above) reveals that economists are simply useless when it comes to forecasting:

They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else.... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!-- James Montier

How Did Consensus Do in 2011?

As we entered 2011, consensus estimates for economic growth, corporate profits, stock price targets and interest rates were generally optimistic and, as is typical, grouped in an extraordinarily tight range. Last year, I chose to use Goldman Sachs' (GS ) forecasts as a proxy for the consensus. Here were Goldman's forecasts for 2011, with the likely or actual 2011 full-year returns/results in parentheses:

2011 U.S. real GDP up 3.4% (up 1.8% actual), and global GDP up 4.7% (up 3.8% actual);

2011 S&P 500 operating profits of $94 a share ($97 a share actual);

year-end S&P 500 price target at 1450 (Friday, Dec. 23's close: 1265 actual);

2011 inflation (core CPI) of +0.5% (+1.7% actual); and

2011 closing yield on the U.S.10-year Treasury note at 3.75% (2.03% actual).

How Did My Surprise List for 2011 Fare?

"Those who cannot remember the past are condemned to repeat it."-- George Santayana

My surprises for 2011 attacked some of the closely grouped and nearly universally optimistic consensus expectations on the part of money managers, strategists, economists and members of the fourth estate. My intention was not to be a Cassandra or to be a contrarian for contrary's sake but rather to recognize that most prefer the dreams of the future to the history of the past. My surprises embodied an often repeated lesson of history: What seems easy for (bullish) investors to imagine today might prove more difficult to deliver, as prospect is often better than possession.
Looking at history, there was no better example of misplaced optimism than in the period leading up to the Great Decession of 2008-2009, providing a vivid reminder of the poor forecasting ability and investment risks associated with the crowd's baseline expectations and the value of a surprise list that deviates from that consensus.
Three years ago, only the remnants anticipated anything near the magnitude of the fall in the world's economies and capital markets, despite what appeared to be clear and accumulating evidence of economic uncertainty and growing credit risks (and abuses). The analysis of multi-decade charts and economic series convinced most (along with other conclusions) that home prices were incapable of ever dropping, that derivatives and no-/low-document mortgage loans were safe, that there was no level of leverage (institutional and individual) too high and that rating agencies were responsible in their analysis. Importantly, they also failed to see the signposts of an imminent deterioration in business and consumer confidence that was to result in the deepest economic and credit crisis since the early 1930s.
I expressed in my list last year that many of those who were expressing the most extreme levels of optimism for 2011 were the most wrong-footed three years ago and experienced not inconsequential pain in the last investment cycle.
Back in 2008-2009 and again last year (but to a far lesser degree), many investors appeared similar to victims of Plato's allegory of the cave -- a parable about the difficulty of people who exist in a world shaped by false perceptions to contemplate truths that contradict their beliefs. This is why so many investors were blindsided by the last economic downturn and, from my perch, continued to remain conditioned to wearing rose-colored glasses in 2011.

In the famous simile of the cave, Plato compares men to prisoners in a cave who are bound and can look in only one direction. They have a fire behind them and see on a wall the shadows of themselves and of objects behind them. Since they see nothing but the shadows, they regard those shadows as real and are not aware of the objects. Finally one of the prisoners escapes and comes from the cave into the light of the sun. For the first time, he sees real things and realizes that he had been deceived hitherto by the shadows. For the first time, he knows the truth and thinks only with sorrow of his long life in the darkness.-- Werner Heisenberg, Physics and Philosophy: The Revolution in Modern Science

Last year's surprise list achieved about a 50% success ratio. Forty percent of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, one-third in 2006, 20% in 2005, 45% in 2004 and one-third came to pass in the first year of my surprises in 2003.
My surprise list for 2011 hit on some of the important themes that dominated the investment and economic landscape this year. Below is a list of some of my accurate surprises from last year's list.

Markets: As discussed previously, the market was practically unchanged in 2011, and the year's range almost perfectly coincided with my No. 4 surprise. Also, group performance surprises were fulfilled -- for instance, "During the second half of the year, housing stocks crater, and the financial sector's shares erase the (sector-leading) gains made in late 2010 and early 2011." I also was correct in expecting asset managers' shares to fall lower and underperform.

The U.S. economy: Real GDP in the U.S., as I expected, was disappointing at about half consensus growth expectations. Screwflation of the middle class was a dominant theme, and I incorporated screwflation in my surprise list and in a Barron's "Other Voices" editorial in June. Americans, I thought, would remain in a foul mood, as the jobs and housing markets failed to improve to the degree expected by most. My surprise of social unrest was also realized around the world -- over there in the Arab Spring and over here in the Occupy Wall Street movement.

The European economy: Over there and as I suggested a year ago, "multiple country austerity programs moved Europe back into recession by year-end 2011."

China's economy: I wrote that "China continues to tighten, but inflation remains persistent, economic growth disappoints and its stock market weakens further." All happened.

U.S. politics: I wrote "increased hostilities between the Republicans and Democrats become a challenge to the market and to the economic recovery next year. As the 2012 election moves closer, President Obama reverses his seemingly newly minted centrist views.... The resulting bickering yields little progress on deficit reduction. Nor does the rancor allow for an advancement of much-needed and focused legislation geared toward reversing the continued weak jobs market." Trust in our leaders was indeed lost throughout 2011 -- approval ratings hit an all-time low during 2011 for Congress) and for the president -- and political gridlock and inertia adversely impacted sentiment as confidence figures plummeted by late summer.

Republican presidential candidate: Mitt Romney, as expected, is the Republican Party's presidential frontrunner (but Ryan and Thune never were in the fray).

Commodity prices: Throughout the year, "the rise in the price of commodities was one of the primary market themes and concerns."

Gold: I was correct in expecting volatility in the price of gold but very wrong in the direction of the price of gold when I wrote, "The price of gold plummets by more than $250 an ounce in a four-week period in 2011 and is among the worst asset classes of the new year. The commodity experiences wild volatility in price (on five to 10 occasions, the price has a daily price change of at least $75), briefly trading under $1,050 an ounce during the year and ending the year between $1,100 and $1,200 an ounce."

Takeovers: Though Microsoft (MSFT ) has not yet made a bid, my Yahoo! (YHOO ) deal surprise turned out to be materially correct. "Among the most notable takeover deals in 2011, Microsoft launches a tender offer for Yahoo!.... The private equity community joins the fray."

Internet as the tactical nuke of the digital age: "Cybercrime likely explodes exponentially as the Web is invaded by hackers." Dead on, as serious hacking incidents are occurring with increased frequency.

Expanding insider trading charges: It was a record year of insider trading indictments and convictions, from Raj to many other ne'er-do-wells (including research network consultants, hedge funds, corporations and even a member of the board of directors of Goldman Sachs). "The SEC's insider trading case expands dramatically, reaching much further into the canyons of some of the largest hedge funds and mutual funds and to several West Coast-based technology companies." (Some of us even learned this year for the first time that Congress is legally permitted to be in the insider trading game!)

Where did my surprises for 2011 go wrong?

Though the price of gold was volatile (and did sustain quick $200-per-ounce drops), it did not fall and was among the best asset classes in 2011.

There was no military confrontation between China and India over water rights.

The price of oil didn't soar to over $125 a barrel.

The yield on the 10-year U.S. note did not spike to 4.25%.

Food and restaurant stocks were not among the worst-performing market sectors.

Hillary Clinton and Joe Biden did not switch jobs, though Clinton is resigning her post as Secretary of State.

While Speaker of the House John Boehner's tenure has been uneven, he was not replaced by Paul Ryan.

A third political party did not appear (though it is never too late!).

There was no peaceful regime change in Iran.

What Is Consensus for 2012?

As we enter 2012, investors, strategists and talking heads are again grouped in a narrow consensus, but, in contrast with last year's almost universally bullish views on the economy and on the U.S. stock market, the consensus is far more downbeat, reflecting near universal acceptance of Pimco's Bill Gross's "new normal" of de-leveraging, de-globalization and re-regulation.

Again, let's use Goldman Sachs' principal views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for consensus.
Below are Goldman Sachs' forecasts for 2012:

2012 U.S. real GDP up 1.8%, and global GDP up 3.2%;

2012 S&P 500 operating profits of $100 a share;

year-end 2012 S&P 500 price target at 1250;

2012 inflation of +1.7%; and

2012 closing yield on the U.S.10-year Treasury note at 2.50%.

My 15 Surprises for 2012

"More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other to total extinction. Let us pray we have the wisdom to choose correctly."-- Woody Allen

Ever since 2007, my contrarian and variant surprise lists were almost always downbeat relative to consensus. I adopted a Kafkaesque sense of hopelessness and an almost Woody Allen-like sense of foreboding (see quote above). It was as if I was giving a traffic report from the perspective of chronicling the automobile accidents on I-95.

You'll be swell! You'll be great!
Gonna have the whole world on the plate!
Clear the decks! Clear the tracks!
You've got nothing to do but relax.
Blow a kiss. Take a bow.
Honey, everything's coming up roses!-- Stephen Sondheim and Jule Styne, "Everything's Coming Up Roses"

But, my new surprises for 2012 represent a fundamental turn toward optimism and a marked departure from the pessimism expressed in my recent surprise list history -- as I move metaphorically from the Broadway stage of Woody Allen's 1966 play Don't Drink the Water to Stephen Sondheim and Jule Styne's 1959 Broadway musical Gypsy's "Everything's Coming Up Roses" (see lyrics above).
For the last few years, since the financial and economic crisis of 2008-2009, caution, restraint and the word "no" have characterized and dominated the economic, social and political backdrop. In 2012, however, our surprise list moves toward an inflection point in which bolder steps, expansiveness and the word "yes" begin to dominate the political, economic and stock market stages.
This new, brighter and more positive narrative is the essence and the common thread contained in my surprise list for 2012. (And this year, following each surprise, I am introducing a specific strategy that might be employed in order for an investor to profit from the occurrence of these possible improbables).
Surprise No. 1: The U.S. stock market approaches its all-time high in 2012. The beginning of the New Year brings a stable and range-bound market. A confluence of events, however (discussed further in the body of the 15 Surprises for 2012), allows for the S&P 500 to eclipse the 2000 high of 1527.46 during the second half of the year. The rally occurs as a powerful reallocation trade out of bonds and into stocks provides the fuel for the upside breakout. The market rip occurs in a relatively narrow time frame as the S&P 500 records two consecutive months of double-digit returns in summer/early-fall 2012.
Strategy: Buy out-of-the-money SPDR S&P 500 ETF Trust (SPY ) calls.
Surprise No. 2: The growth in the U.S. economy accelerates as the year progresses. The U.S. economy muddles through in early 2012, but, with business, investor and consumer confidence surging in the fall, real GDP accelerates to over 3% in the second half. Unemployment falls slightly more than consensus, but the slack in the labor market continues to constrain wage growth. Domestic automobile industry sales soar well above expectations, benefiting from pent-up demand and an aging U.S. fleet. Inflation is contained but begins to be worrisome (and serves as a market headwind) in late 2012. Corporations' top-line growth is better than expected, and wage increases are contained. Operating margins rise modestly as sales growth lifts productivity and capacity utilization rates. Operating leverage surprises to the upside as 2012 S&P profits exceed $105 a share.
A noteworthy surprise is that the residential real estate market shows surprising strength. The U.S. housing market becomes much bifurcated (in a market of regional haves and have-nots), as areas of the country not impacted adversely by the large shadow inventory of unsold homes enjoy a strong recovery in activity and in pricing. The Washington, D.C., to Boston, Mass., corridor experiences the most vibrant regional growth, while Phoenix, Las Vegas and areas of California remain weak. The New York City market begins to develop a bubbly speculative tone. Florida is the only area of the country that has had large supply imbalances since 2007 that experiences a meaningful recovery, which is led by an unusually strong Miami market.
Strategy: Buy Home Depot (HD ), Lowe's (LOW ), building materials and homebuilders, and buy auto stocks such as Ford (F ) and General Motors (GM ).
Surprise No. 3: Former Presidents Bill Clinton and George Bush form a bipartisan coalition that persuades both parties to unite in addressing our fiscal imbalances. The Clinton-Bush initiative, also known as "Simpson-Bowles on steroids," gains overwhelming popular support, and despite strenuous initial opposition, it forces the Democrats and Republicans (months before the November elections) to move toward a grand compromise on fiscal discipline and pro-growth fiscal policy. Interest rates remain subdued, growth prospects become elevated and a feel-good atmosphere begins to permeate our economy in a return of confidence and in our capital markets engendered by the Clinton-Bush initiative.
The Clinton-Bush initiative includes seven basic core policies that are accepted by both political parties.

A broad infrastructure program focused on a massive build-out and improvement of the U.S. infrastructure base -- the restoration of our country's highways, bridges and buildings and an extensive internet bandwidth expansion are embarked upon.

The annual increase in government spending is limited to the change in the CPI.

A comprehensive jobs plan includes new training programs -- all veterans are made eligible to tuition subsidies to vocational schools and colleges.

A Marshall Plan for housing is introduced, highlighted by a nationwide refinancing proposal adopted for all mortgagees (regardless of loan-to-values).

A series of new tax increases, including a plan to raise taxes on the families with an income in excess of $500,000 a year (a two-year income tax surcharge of 5%-10%) and some other more imaginative, outside-the-box proposals (e.g., a tax on sugar products) are introduced.

Mean test entitlements, freeze entitlement payouts and gradually increase the Social Security retirement age to 70 years old.

A comprehensive plan is designed to rapidly develop all our energy resources.

Strategy: See No. 1 surprise strategy. Sell volatility.
Surprise No. 4: Despite the grand compromise, the Republican presidential ticket gains steam as year progresses, and Romney is elected as the forty-fifth President of the United States. The U.S. moved to the left politically in the Democratic tsunami in 2008 and to the right politically as the Republican Party gained control of Congress in 2010; the 2012 election is the tiebreaker. The result of the tiebreaker is that Mitt Romney and Marco Rubio squeak by Barack Obama and Joseph Biden in the November 2012 election. All the five swing battleground states (Florida, Indiana, Missouri, North Carolina and Ohio) go Republican. The Romney-Rubio ticket also wins the states of New Hampshire and Virginia, previously won by Obama in 2008, and the Republicans prevail (270 electoral votes to 268 votes) in one of the closest elections of all time. (Here is a great interactive electoral college map that allows you to make your own predictions.)
Strategy: See No. 3 surprise strategy.
Surprise No. 5: A sloppy start in arresting the European debt crisis leads to far more forceful and successful policy. The EU remains intact after a brief scare in early 2012 caused by Greece's dissatisfaction (and countrywide riots) with imposed austerity measures. The eurozone experiences only a mild recession, as the ECB introduces large-scale quantitative-easing measures that exceed those introduced by the Fed during our financial crisis in 2008-2009.
Strategy: Buy European shares. Buy iShares MSCI Germany Index Fund (EWG ) and iShares MSCI France Index Fund (EWQ ).
Surprise No. 6: The Fed ties monetary policy to the labor market. In order to encourage corporations to invest and to build up consumer and business confidence, the Fed changes its mandate and promises not to tighten monetary policy until the unemployment rate moves below 6.5%, slightly above the level at which wage pressures might emerge (the Non- Accelerating Inflation Rate of Unemployment).
Strategy: Buy high-quality municipal bonds or the iShares S&P National AMT - Free Municipal Bond Fund (MUB ).
Surprise No. 7: Sears Holdings declares bankruptcy. In a spectacular fall, Sears Holdings (SHLD ) shares are halted at $18 a share during the early spring, as vendors turn away from the retailer, owing to a continued and more pronounced deterioration in cash flow (already down $800 million 2011 over 2010), earnings and sales. With funding and vendor support evaporating, as paper-thin earnings before interest and taxes margins turn negative and cash flow is insufficient to fund inventory growth. The shares reopen at $0.70 after the company declares bankruptcy and its intention to restructure, as we learn, once again, that being No. 3 in an industry has little value -- especially after store improvements were deferred over the past several years. A major hedge fund and a large REIT join forces in taking over the company. Ten to fifteen percent of Sears' 4,000 Kmart and specialty stores are closed. More than 35,000 of the company's 317,000 full-time workers are laid off. As a major anchor tenant in many of the nation's shopping centers and with no logical store replacement, the REIT industry's shares suffer through the balance of the year, and the major market indices suffer their only meaningful correction of the year. Target (TGT ) and Wal-Mart's (WMT ) shares eventually soar in the second half of 2012.
Strategy: Buy out-of-the-money Sears Holdings puts, go long Target and Wal-Mart, and short the iShares Dow Jones U.S. Real Estate Index Fund (IYR ).
Surprise No. 8: Cyberwarfare intensifies. Our country's State Department's defenses are hacked into and compromised by unknown assailants based outside of the U.S. Our armed forces are place on Defcon Three alert.
Strategy: None.
Surprise No. 9: Financial stocks are a leading market sector. After five years of underperformance, the financial stocks rebound dramatically and outperform the markets, as loan demand recovers, multiple takeovers permeate the financial intermediary scene and domestic institutions enjoy market share gains at the expense of flailing European institutions. With profit expectations low, three years of cost-cutting and some revenue upside surprises (from an improving capital markets, a pronounced rise in M&A activity and better loan demand) contribute to better-than-expected industry profits. P/>

Another tough year
To cover this group
Down 40 to 50
And they're still in the soupRegulation, litigation
And potential mitigation
Time to put it all aside
And enjoy your vacation....
But if Republicans win the White House
It's them I'd like to thank
Cause they'll not only change the top seat
But also the bill of Mr. Dodd and Mr. FrankSo Happy New Year
Hope you found this rap a little clever
And buy some big banks and brokers next year
Don't hide in the regionals forever!
-- "Nomura Securities' Year-End Rap"

Strategy: Buy JPMorgan Chase (JPM ), Citigroup and the Financial Select Sector SPDR (XLF ).
Surprise No. 10: Despite the advance in the U.S. stock market, high-beta stocks underperform. Though counterintuitive within the framework of a new bull-market leg, the market's lowfliers (low multiple, slower growth) become market highfliers, as their P/E ratios expand.
With the exception of Apple (AAPL ), the highfliers -- Priceline (PCLN ), Baidu (BIDU ), Google (GOOG ), Amazon (AMZN ) and the like -- disappoint. Apple's share price rises above $550, however, based on continued above-consensus volume growth in the iPhone and iPad. Profit forecasts for 2012 rise to $45 a share (up 60%). In the second quarter, Apple pays a $20-a-share special cash dividend, introduces a regular $1.25-a-share quarterly dividend and splits its shares 10-1. Apple becomes the AT&T (T ) of a previous investing generation, a stock now owned by this generation's widows and orphans.
Strategy: Long Apple (common and calls).
Surprise No. 11: Mutual fund inflows return in force. With confidence renewed, domestic equity inflows begin to pour into equity mutual funds by midyear and approach a $100 billion seasonally adjusted annual rate by fourth quarter 2012. The share prices of T. Rowe Price (TROW ) and Franklin Resources (BEN ) double.
Strategy: Long Legg Mason (LM ), T. Rowe Price and Franklin Resources.
Surprise No. 12: We'll see merger mania. Cheap money, low valuations and rising confidence are the troika of factors that contribute to 2012 becoming one of the biggest years ever for mergers and takeovers. Canadian companies are particularly active in acquiring U.S. assets. Canada's Manulife (MFC ) acquires life insurer Lincoln National (LNC ), two large banks join a bidding war for E*Trade (ETFC ), and International Flavors & Fragrances (IFF ) and Kellogg (K ) are both acquired by non-U.S. entities. Finally, a Canadian bank acquires SunTrust (STI ).
Strategy: Long E*Trade, Lincoln National, International Flavors & Fragrances, Kellogg and SunTrust.
Surprise No. 13: The ETF bubble explodes. There are currently about 1,400 ETFs. During 2012, numerous ETFs fail to track and one-third of the current ETFs are forced to close. There are several flash crashes of ETFs listed on the exchanges. The ETF landscape is littered by investor litigation as investor losses mount. New stringent maintenance rules and new offering restrictions are imposed upon the ETF business. The formation of leveraged ETFs is materially restricted by the SEC. (Hat tip to Barry Ritholtz's Big Picture.)
Strategy: Avoid all but the largest ETFs.
Surprise No. 14: China has a soft landing (despite indigestion in the property market), and India has a hard landing. India becomes the emerging-market concern. With India's trade not a driver to GDP growth, its currency in free-fall, pressure to keep interest rates high by its central bank and signs of a contraction in October Industrial Output, India's GDP falls to mid-single-digit levels.
Strategy: Long iShares FTSE/Xinhua China 25 Index Fund (FXI ); short WisdomTree India Earnings Fund ETF (EPI ) and iPath MSCI India Index ETN (INP ).
Surprise No. 15: Israel Attacks Iran. The greatest headwind to the world's equity markets is geopolitical, not economic. Israel attacks Iran in the spring, but, at the outset, the U.S. stays out of the conflict. Iran closes the Strait of Hormuz, and oil prices spike to $125 a barrel.
Strategy: Buy Schlumberger (SLB ), ExxonMobil (XOM ) and other oil production and exploration stocks.

S&P 500 Volatility: August - December

2011-12-08T06:40:00.001-08:00

It's no surprise that the S&P 500 has been extremely volatile over the last four months, but the picture below really brings the point home. Going back to the beginning of August, the S&P 500 is down just about 2%, but over that period the index has seen eight declines of 5% or more and eight advances of 5% or more. To put this volatility into perspective, there were two periods in the 1990s where the S&P 500 went more than a year without a single decline of 5% or more.

With the increased volatility of the market, individual stocks have been seeing major short-term moves. To view the list of most volatilie stocks in the S&P 1500 please click here.

Dow Jones Industrial Average 1900- present (log scale, monthly)

2011-11-09T05:39:00.001-08:00

Click for ginormous chart

Source: Monthly Chart Portfolio, Merrill Lynch Market Analysis, November 4, 2011

There are three issues worth noting here plus one important caveat:

1. The long 10-20 year secular bear moves seem to have lots of major rallies and sell offs; the ups and downs are intense, but make little in the way of net progress. After 15 years, the average secular bear is essentially unchanged.

2. The roller coaster ride leaves investors psychologically exhausted. They come to forget the good times of so long ago, and believe there is no way out of the morass. Naturally, they are reluctant to believe in the new bull market once it begins.

3. The major bottom seems to occur about halfway through; this implies that the March 2009 lows will not be revisited (note I only wrote IMPLY and not guarantee or forecast!) If we look at the current Bear versus the ’66-’82 (with lows like ’73-’74), it suggest that 8500-9000 on the Dow is possible, but barring another crisis 6500 is much less likely. And it also suggests that the next secular bull might begin around 2016-18.

Now for the caveat: We have but one century of data, and within that 100 year span, only four examples of long term secular bear markets. We really need 500-1000 years of data, 20-40 secular bears during the era of modern capital markets. That would allow us greater confidence that these four patterns aren’t merely coincidences.

See you around 2900 to validate the data . . .

Say What? In 30-Year Race, Bonds Beat Stocks

2011-10-31T09:01:00.001-07:00

The biggest bond gains in almost adecade have pushed returns on Treasuries above stocks over thepast 30 years, the first time that’s happened since before theCivil War.
Fixed-income investments advanced 6.25 percent this year,almost triple the 2.18 percent rise in the Standard & Poor’s 500Index through last week, according to Bank of America MerrillLynch indexes. Debt markets are on track to return 7.63 percentthis year, the most since 2002, the data show. Long-termgovernment bonds have gained 11.5 percent a year on average overthe past three decades, beating the 10.8 percent increase in theS&P 500, said Jim Bianco, president of Bianco Research inChicago.
The combination of a core U.S. inflation rate that hasaveraged 1.5 percent this year, the Federal Reserve’s decisionto keep its target interest rate for overnight loans betweenbanks near zero through 2013, slower economic growth and thehighest savings rate since the global credit crisis have madebonds the best assets to own this year. Not only have bondsknocked stocks from their perch as the dominant long-terminvestment, their returns proved everyone from Bill Gross toMeredith Whitney and Nassim Nicholas Taleb wrong.
“The generation-long outperformance of bonds over stockshas been the biggest investment theme that everyone has justgotten plain wrong,” Bianco said in an Oct. 26 telephoneinterview. “It’s such an ingrained idea in everyone’s head thatsuch low yields should be shunned in favor of stocks, that noone wants to disrupt the idea, never mind the fact that it hasbeen off.”

Market Returns

Stocks had risen more than bonds over every 30-year periodfrom 1861, according to Jeremy Siegel, a finance professor atthe University of Pennsylvania’s Wharton School in Philadelphia,until the period ending in Sept 30.
U.S. government debt is up 7.23 percent this year,according to Bank of America Merrill Lynch’s U.S Master Treasuryindex. Municipal securities have returned 8.17 percent,corporate notes have gained 6.24 percent and mortgage bonds haverisen 5.11 percent. The S&P GSCI index of 24 commodities hasreturned 0.25 percent.

Falling Yields

While 10-year Treasury yields rose 10 basis points, or 0.10percentage point, last week to 2.32 percent, they are down fromthis year’s high of 3.77 percent on Feb. 9. The price of thebenchmark 2.125 percent note due August 2021 fell 27/32, or$8.44 per $1,000 face value, in the five days ended Oct. 28 to98 10/32, according to Bloomberg Bond Trader data.
The yield dropped 11 basis points today to 2.21 percent at10:21 a.m. in New York.
The shift to debt wasn’t anticipated by Gross, who as co-chief investment officer of Newport Beach, California-basedPacific Investment Management Co. runs the world’s biggest bondfund. His $242 billion Total Return Fund, which unloadedTreasuries in February before the rally, has gained 2.55 percentthis year, putting it in the bottom 18th percentile of similarfunds, according to data compiled by Bloomberg.
Whitney, a banking analyst who correctly turned bearish onCitigroup Inc. in 2007, predicted in December “hundreds ofbillions of dollars” of municipal defaults that haven’thappened. Taleb, author of “The Black Swan” and a principal atUniversa Investments LP, said at a conference in Moscow on Feb.3 that the “first thing” investors should avoid is Treasuries.

What Went Wrong

The reluctance to purchase debt continues. Leon Cooperman,chairman of $3.5 billion hedge fund Omega Advisors Inc., said ina presentation at the Value Investing Congress in New York onOct. 18 that he “wouldn’t be caught dead owning a U.S.government bond.”
What the bears failed to anticipate was that Americanswould continue to pare debt and boost savings. Much of thatmoney found its way into the fixed-income markets as banks andinvestors sought high-quality debt as unemployment held at orabove 9 percent every month except for two since May 2009,Europe’s fiscal crisis threatened to push the global economyback into recession and stock markets fell.
“It’s hard to envision a scenario where we seesignificantly better than two percent growth, with increasedfiscal austerity and headwinds from the leverage bubble andpersistent unemployment,” said Rick Rieder, who oversees $620billion as chief investment officer of fundamental fixed incomeat New York-based Blackrock Inc. The firm is the world’s largestmoney manager, investing $3.45 trillion.

Higher Savings

The U.S. savings rate has tripled to 3.6 percent since 2005and has averaged 5.1 percent since the depth of the financialcrisis in December 2008, compared with 3.1 percent for theprevious 10 years, according to government data. Debt mutualfunds have attracted $789.4 billion since 2008, compared with a$341 billion drop in equity funds, according to data compiled byBloomberg and the Washington-based Investment Company Institute.
Banks, still trying to rebuild their balance sheets aftertaking more than $2 trillion in writedowns and losses since thestart of 2007, have boosted holdings of Treasuries andgovernment-backed mortgage securities to $1.68 trillion from$1.62 trillion in December, according to the Fed. Foreigninvestors increased their stake in Treasuries to $4.57 trillionin August from $4.44 trillion at the end of 2010, according tothe latest Treasury Department data.
The bond market posted its first 30-year gain over thestock market in more than a century during the period ended Sept.30. The last time was in 1861, leading into the Civil War, whenthe U.S was moving from farm to factory, according to Siegel,author of the 1994 book “Stocks for the Long Run,” in atelephone interview Oct. 25.

‘Millennium Event’

“The rally in bonds is a once in a millennium event, butit’s absolutely mathematically impossible for bonds to get anykind of returns like this going forward whereas stock returnscan repeat themselves, and are likely to outperform,” he said.“If you missed the rally in bonds, well, then that’s it.”
Gross eliminated Treasuries from the Total Return Fund inFebruary and owned derivative bets against the debt in March. Hemoved 16 percent of its assets into U.S. government securitiesas of September, saying earlier this month in a note to clientsthat he misjudged the extent of the economic slowdown and calledhis performance this year “a stinker.”
Local government bonds are set for the biggest gains since2009 as defaults fell last quarter. Cities and states arereducing expenses instead of forgoing payments on debt even asthey confront fiscal strains in the wake of falling revenue.

One Miss

Whitney said on the CBS’s “60 Minutes” in December thatthere would be “hundreds of billions of dollars” of municipaldefaults this year. Brighton, Alabama, a city of 2,945 nearBirmingham, was the only U.S. municipality to miss a general-obligation debt payment in 2011. Defaults are about 25 percentof 2010’s $4.3 billion tally, according to Bank of America Corp.
Money has poured into Treasuries even as U.S. budgetdeficits totaled $1.4 trillion in fiscal 2009 ended Sept. 30,$1.29 trillion in 2010 and $1.3 trillion in 2011.
Rising deficits and debt led Taleb, the distinguishedprofessor of risk engineering at New York University, to tellinvestors in February that the “first thing” they should do isavoid Treasuries, and the second shun the dollar. At the sameconference a year earlier he said “every single human being”should bet against U.S. government debt.

Tame Inflation

Since February Treasuries have rallied 7.99 percent and thecurrency has gained 3.2 percent, beating 14 of its 16 mostactively traded peers, according to Bank of America MerrillLynch indexes and data compiled by Bloomberg.
Concerns about inflation have also abated. Consumer prices,excluding food and energy, rose 0.05 percent in September, thesmallest gain since October 2010, the Labor Department said Oct.19 in Washington. Yields on bonds that protect investors fromrising consumer prices suggest the fixed-income marketanticipates inflation will average to 2.15 percent over the nextdecade, down from expectations of 2.67 percent in April.
“The Fed is legally obligated to do everything in theirpower to keep unemployment low, and they have and will continueto do so,” said Chris Low, chief economist at FTN Financial inNew York. “As long as inflation isn’t a concern the Fed isgoing to keep firing until something happens,” Low said in atelephone interview Oct. 21.
Low was one of three economists in a Bloomberg survey of 72forecasters in January to predict that 10-year Treasury yieldswould trade below 3 percent this quarter.

Fed Signals

Fed policy makers, who meet this week, have signaled thatthey are considering more measures to boost the economy, afterholding the target rate for overnight loans between banks atzero to 0.25 percent since December 2008 and expanding itsbalance sheet to a record $2.88 trillion.
Vice Chairman Janet Yellen said Oct. 21 that a third roundof large-scale securities purchases might become warranted. Lastmonth, policy makers said they would replace $400 billion ofshort-term debt with longer-term Treasuries in an effort tocontain borrowing costs.
“The Fed’s hope is that by pushing down Treasury rates,all other rates will follow,” Jay Mueller, who manages about $3billion of bonds at Wells Fargo Capital Management in Milwaukee,said in a telephone interview Oct. 26.
“As a portfolio manager who has been in the business 30years, it’s hard to come to terms where interest rates are, butyou have to come to terms with it,” Mark MacQueen, who overseesbond investments at Austin, Texas-based Sage Advisory ServicesLtd., which manages $9.5 billion, said in an Oct. 26 telephoneinterview. “And when you look at what stocks have done thisdecade it becomes much easier.”

Investors wish for liquid hedge funds

2011-10-31T08:59:00.000-07:00

In the current economic uncertainty, pension funds and other institutional investors are increasingly turning to liquid hedge fund strategies as they seek to have easy access to their money in shifting conditions.

Wishing well: investors seek more liquid strategies such as global macro or managed futures

In a survey last month of institutional investors by data provider Preqin, 12% of respondents said that during this period of volatility they were exclusively looking at liquid investment strategies in their hedge fund portfolios, while 30% would not consider funds that have a lock-up period.

Olivier Cassin, head of research and development at investment consultant bfinance, said: “When there’s uncertainty in the market and heavy government intervention on monetary and fiscal policy, for most of our clients, access to capital outweighs the illiquidity premium that comes from locking up capital. Right now investors desire liquidity far more than the opportunity cost of potentially missing out on a few percentage points of performance.”

Greg Clerkson, director of alternative investments at consultant Russell Investments, said that while there were good opportunities to invest in credit hedge funds, investors were not willing to lock up their money in the face of the current economic uncertainty. He said: “If you go into more liquid strategies such as global macro or managed futures, you can get your money back quickly and, historically, both have shown some degree of equity offset. It’s optionality as much as anything. Historically, it has worked and if it doesn’t work you can get out.”

Economic trends

Managed futures strategies use computer models to try to capture trends in a range of global markets. Global macro is a strategy that trades instruments such as currencies, interest rates, foreign exchange and bonds to take advantage of broad economic trends.

Guy Saintfiet, UK head of liquid alternatives at Aon Hewitt, said that for the past 12 months his firm has been advising clients to add more exposure to global macro and managed futures. He said this was driven by investment opportunity, not liquidity and added: “We believe that these strategies are best placed to capitalise on an environment where markets are driven by high-level newsflow and are not trading on bottom-up fundamentals.”

Saintfiet said that since the financial crisis, pension funds had been focusing on more appropriate liquidity rather than more liquidity. He said that their reaction to Ucits funds, a regulated structure that gives clients access to their money at least twice a month, reflected this. Saintfiet said: “We’ve had very little interest in Ucits from pension funds. In return for the higher liquidity, you typically give up quite a lot of return potential and they don’t want to make that trade-off.”

With assets in the roughly $2 trillion hedge fund industry reaching new highs, the composition of the investor base has changed significantly since the financial crisis. Preqin estimates that 61% of hedge fund capital comes from institutional investors, compared with 45% before the crisis.

Three quarters of respondents to Preqin’s survey said they needed greater liquidity in their hedge fund portfolios in the post-financial crisis period than they had needed previously.

According to Robert Howie, head of alternative investment at consultant Mercer, this is unsurprising. He said: “I can see why there is a focus on liquidity. During the crisis, clauses were suddenly invoked that were very vague and many investors found themselves dealing with gates, side-pockets and suspended redemptions.”

Howie said that investors should look to see that the fund’s liquidity matches its underlying instruments. He said: “Moreover, liquidity is not something that is constant. Investors need to understand what managers will do if their instruments and markets become illiquid.”

Clerkson at Russell said that investors had become much stricter on insisting that the investment mandate should fit the fund’s liquidity terms. He said: “We will give you the discretion but we will put the rules around it. There’s very little benefit of the doubt to be had. Investors have become less tolerant of managers going outside their mandates. There’s very little appetite for a supposedly liquid product with an option to go illiquid without the investor having the call.”

From a manager’s perspective, pension fund capital is attractive because it is perceived to be stable and long term in its mindset. But consultants said that pension funds were keen to ensure that their long-term outlook did not leave them at a disadvantage. Aon’s Saintfiet said: “Institutional investors need to worry about being liquidity providers to a failing business or to other investors with a shorter-term time horizon. During the crisis, people who were locked in for longer ended up holding the baby and the cost for them was much higher than the fee discount they received.”

Investor lock-in

Saintfiet said that pension funds were avoiding managers looking to protect their businesses with overly harsh liquidity terms. He said: “Our focus is on identifying the best managers with appropriate liquidity and a stable client base of preferably institutional investors. There has to be a good reason to lock in your money for longer. It is not really good enough when it’s just about protecting a firm from redemptions and being the last one out.”

Clerkson said: “An investor-level lock is perceived as something that only benefits the manager. Sometimes there is a good reason for it but investors need to understand the rationale.”

Is there a danger that investors are missing out on some good investment opportunities by insisting on investing in liquid strategies? Cassin at bfinance said: “In dislocated markets, there are a lot of opportunities for those with cash and time on their hands.”

But he said that, while pension funds are mainly investing their hedge fund allocations in liquid investments, elsewhere they are more willing to forgo access to their money and gain exposure to the greater returns this can bring. He said: “At an overall portfolio level, we’re seeing a search for yield that is leading investors to look at real assets such as infrastructure, real estate and some private equity. We also see many attractive direct and secondary opportunities at the moment.”

Dividend Investing

2011-10-21T10:10:00.001-07:00

Seeking Alpha – Why Dividends Matter In A Changing Market ^[1]
Lately, it seems that dividend investing has become all the rage. Articles are being written at just about every financial site, talking about dividends. When you look at Money Watch, MSN Money, Kiplinger, Money Magazine, Forbes, Smart Money, and even here at SA, there is no shortage of dividend investing commentary…Mark Hulbert has written an article that I think you might find interesting. He says:
Believe it or not, the stock and bond markets are behaving in a way that, with only one exception at the depths of the 2008-2009 credit crisis, they have not since 1958—53 years ago: The stock market’s dividend yield is now above the interest rate on the 10-year Treasury note.
With dividend yields outpacing the 10 year Treasuries, perhaps we are beginning to see a paradigm shift back to that pre-1958 market model. Investors can now find companies that have a history of paying dividends, companies that are increasing those dividends annually, and companies that have the earnings power to continue making those dividend payments. Dividend investing may very well become the norm moving forward.

Comment

In our current uncertain and volatile environment, investors are seeking safety. So, it should come as no surprise that dividend stocks have gained in popularity especially since many blue-chip stocks pay higher dividend yields?

However, any case for a new era of dividend investing may be a bit overstated. Dividend stocks should simply be viewed as a slightly less risky form of stock investing. As such, we should expect dividend-paying stocks to outperform during bear markets and underperform during bull markets.

By comparing the S&P Dividends Aristocrats Total Return Index ^[2] and the S&P Equal Weight Total Return Index ^[3], we can see this is indeed the case. The S&P Dividends Aristocrats Index measures the performance of stocks in the S&P 500 that have consistently increased dividends for at least 25 consecutive years. The index is equally weighted, so we compare its total return to that of the S&P 500 Equal Weight Index.

During the bear market from October 11, 2007 to March 6, 2009, dividend-paying stocks outperformed the S&P 500 Equal Weight Index by 11.6%. On an annualized basis, dividend stocks returned -35.74% versus -46.10% for the S&P Equal Weight Index.

^[4]

During the bull market from March 6, 2009 to May 2, 2011, dividend-paying stocks underperformed the S&P 500 Equal Weight Index by 42.4%. On an annualized basis, dividend stocks returned 44.38% versus 56.64% for the S&P Equal Weight Index.

^[5]

Finally, during the bear market from May 2, 2011 through last Thursday’s close, dividend-paying stocks outperformed the S&P 500 Equal Weight Index by 8.19%. On an annualized basis, dividend stocks returned -18.34% versus -34.30% for the S&P Equal Weight Index.

^[6]

To be sure that these past few bull/bear markets were the rule and not the exception, we also compared total returns of these two indices on all days when the S&P Total Return Index was up versus all days when the S&P Total Return Index was down. With data going back to the beginning of 1990,dividend-paying stocks returned an average of 66 basis points per day on days the stock market was up. The S&P Equal Weight Index returned an average of 77 basis points per day on those same days. On days the stock market was down, dividend-paying stocks returned an average of -67 basis points per day. The S&P Equal Weight Index returned an average of -80 basis points per day.
Rather than being concerned with reaching for yield, the charts and data above suggest dividend stocks outperform during bear markets and underperform during bull markets. However, if investors are savvy enough to know which way the market was heading in general, why even bother distinguishing between dividend-paying stocks and non-dividend-paying stocks?
Source:
Bianco Research, LLC.

Stocks Have a Fever, and the Only Prescription Is More Correlation

2011-10-20T13:19:00.000-07:00

Why buy or sell one stock when you can just trade them all?
A popular indicator among the stock market technician types are “90%” up or down sessions, days when 90% of the stocks in the S&P 500 move in the same direction.
But in this risk on/risk off world in which we all live, 90% days are happening with remarkable frequency.
Courtesy of Chris Verrone at Strategas Research Partners, we have these charts, which pretty much tell the story. The first chart shows how the number of these days has exploded since 2007.
What’s noteworthy in the second chart is the difference between the first half of 2011 and the tally for the past three-and-half months. Since the end of June, we’ve had more 90% days than in all of 2007, and more than the entire period stretching from 2002 through 2006 combined.
The reasons at this point are well known: rolling financial crises and the explosion of exchange traded fund trading which has made whipping around baskets of stocks a breeze. At this point, there’s little on the horizon to suggest this trend will change soon.

Chart of the Day - S&P vs Earnings

2011-10-20T12:36:00.001-07:00

Is Klarman’s Baupost Seeking Cash from Investors?

2011-10-19T14:12:00.001-07:00

Seth Klarman’s Baupost might soon be looking to raise some cash. The super-secretive hedge fund manager, known for his conservative, measured investing approach, is considering asking his existing investors to give back some of the cash he returned earlier in the year, according to a knowledgeable source.
The source says Klarman is definitely not soliciting outside money, as he did for a short while several years ago.
In early 2008, for the first time in eight years, he opened his funds to new money, drawing on his long waiting list. Klarman pulled in about $4 billion from foundations, educational institutions — especially Ivy League schools — and existing investors who had one shot at deciding whether they were in or not before the door was shut tight again.
At the end of 2010, he gave back 5 percent of his total assets to investors.
Now he is seriously mulling whether to ask for that money back. However, he is definitely not opening to new investors. If he seeks cash, it would be from those earlier recipients, says a knowledgeable source.
The hedge fund manager told clients in a letter this summer that he is generally bearish on the global economy and concerned about the debt woes in Europe.
Still, the fact he is seeking cash from any source is somewhat encouraging. According to the knowledgeable person, Klarman generally feels there are certain times you want cash available and this may be one of those times.
Baupost, which at year-end was the eleventh largest hedge fund in the world with $23.4 billion under management, was down slightly in the rough third quarter and is roughly flat year-to-date. It has outperformed the S&P 500 virtually every year in the past decade, and its oldest partnership has generated a approximately 19 percent annualized return since inception in 1983.
Klarman is known as a global value sleuth, deftly exploiting virtually any undervalued market, including domestic and foreign stocks and bonds; emerging market securities; distressed securities and trade claims; performing and nonperforming bank loans; real estate-related debt and equity; privately negotiated investments; and other illiquid investments.
He earned a BA in economics from Cornell University in 1979, graduating magna cum laude. He was first exposed to value investing principles working during the summer of his junior year at New York’s Mutual Shares, the legendary value-driven mutual fund firm founded in 1949 by Max Heine, and also headed by Michael Price, who in his 20s had become a Heine protégé.
Upon graduation, Klarman returned to Mutual Shares, and after 18 months he left the firm for Harvard Business School, where he earned his MBA and was named a Baker Scholar. He fatefully took a real estate course with professor Bill Poorvu, who asked Klarman to help him and his friends invest their considerable sums of money. Baupost was born.
In his second quarter letter sent to clients in July, Klarman was very worried about the European debt crisis and was concerned that American banks had too much exposure to European debt. As a result, he even feared money market funds might “break the buck,” as happened in 2008.
He is said to have told clients that little has been learned and almost nothing has changed, and that the next crisis could be far worse.
He also was pessimistic about the prospects for the economy, given the huge budget deficits and other negative developments.
Even so, the bottom-up investor stressed it is still possible to find specific investments to be undervalued. At the time he said he added selectively to residential mortgage backed securities and individual securities.
According to regulatory filings, in the second quarter he increased his exposure to U.S. equity-type instruments by more than one-third, to $2.4 billion, compared with the prior quarter. It was spread over just 20 different names. His biggest positions were in Viasat, which produces satellite and other digital communication products and of which Baupost is the largest shareholder; Microsoft, a new position in the second quarter; Newscorp; and Theravance, a biopharmaceutical company.

The New Abnormal: Inflation Expectations & The Stock Market

2011-10-18T10:55:00.001-07:00

There's a rumor going around that the crowd's worried about inflation. Tim Bond of Odey Asset Management speaks for many of this persuasion when he writes in the Financial Times that "the rise in inflation has been the main factor responsible for the sharp slowdown in global growth since the start of the year." Normally, worrying about pricing pressures is an accurate description of how the capital markets respond to higher inflation expectations, and rightly so. Inflation is a corrosive force that eats into wealth. But these aren't normal times.
As a barometer of how abnormal things are, consider the unusually tight relationship between the stock market and the market's inflation forecast, as defined by the yield spread in the nominal 10-year Treasury less its inflation-indexed counterpart. Normally, there's minimal correlation between price changes in the stock market and the market's inflation outlook. The two markets more or less go their separate ways. But in the wake of the financial crisis in late-2008, the normal state of affairs has given way to aberration, as the chart below shows.

Over the past year, for instance, the stock market's moves have been tightly correlated with changes in inflation expectations. Equities tend to rally when the Treasury market anticipates higher inflation, and vice versa. This relationship suggests "that investors don’t fear inflation, they yearn for it," as David Glasner explains. A formal economic explanation for what's happening can be filed under the heading of the "The Fisher Effect Under Deflationary Expectations," the title of a paper by Glasner.
The source of the problem, as Charles Evans of the Chicago Fed suggests, is an erosion of the central bank's credibility though a monetary policy of passive tightening. Speaking at a conference yesterday, Evans reviewed the challenges and the framework for a solution, if only a partial one:

Given the economic scenario and inflation outlook I have discussed, if it were possible, I would favor cutting the federal funds rate by several percentage points. But since the federal funds rate is already near zero now, that’s not an option. To date, the Fed’s policymaking committee, the FOMC, has used a number of nontraditional policy tools to impart greater financial accommodation. I have fully supported these policies. However, I would argue for further policy actions based on our dual mandate responsibilities and the strong impediments of the financial crisis.

Evans goes on to say that the "current financial conditions are more restrictive than I favor, in part because households, businesses and markets place too much weight on the possibility that Fed policy will turn restrictive in the near to medium term." Marcus Nunes simplifies the issue and simply notes that Bernanke "loses it," a reference to the Fed head's former promise to Milton Friedman that he understood the implications of the Fed's past mistakes in the 1930s and would do better in the future.
Changing the expectation that the Fed won't do more won't be easy, in part because central banks have fought long and hard to promote their inflation-fighting credentials and, well, it's hard to teach old dogs new tricks. But inflation fighting at the moment isn't appropriate, according to Evans: "Given this strong anti-inflationary orientation of central bankers, appropriate policy actions may face a credibility challenge of a different nature than we are used to talking about — can conservative central bankers be counted on to commit to keeping interest rates low in the event inflation rises above their long-run target?"
The answer seems to be "no," or so the high correlation between the stock market and inflation expectations imply. If there's any change, we'll likely see it in a disconnect between equity prices and the Treasury market's outlook for inflation. Meantime, the (unfulfilled) yearning continues.

Commodities and (a Lack of) Diversification

2011-10-17T10:09:00.001-07:00

Over recent years, commodity indices have become increasingly correlated with the U.S. stock market, and today, provide little in the way of diversification.
To illustrate, below is the 3-year monthly correlation between the Goldman Sachs commodity index (ETF GSG) and the S&P 500, from 1970. Note right side of graph.

The Goldman Sachs index is the least diversified of the major commodity indices, but this observation extends to all the majors.
Below I’ve compared the GS index (red) to the CRB, Dow Jones-UBS (ETF DJP), and Deutsche Bank (ETF DBC) indices in blue. Note the similar results.

Of the major asset classes, only corporate bonds, Treasuries and gold (and currencies if you view that as an asset class) provide any level of real diversification to equities in this market.
Asset classes which have in the past exhibited low correlation, including: commodities, international stock indices (developed and emerging markets), and real estate, all continue to see high levels of correlation to U.S. equities.
This hurts strategies that use diversification as a way to reduce portfolio volatility, whether it’s traditional MPT or something more active like Tactical Asset Allocation.
None of this is new information and I’m not the first to highlight it – just something that we as investors need to keep on the radar. Reducing portfolio volatility through diversification continues to become more and more difficult.

Farmland Is Pricey. The Fed Is Worried

2011-10-17T09:51:00.000-07:00

Regulators don't want a repeat of the subprime crisis

When regulators come inquiring about loan risks at the Bank of Newman Grove, in Newman Grove, Neb., Jeffrey L. Gerhart, the chairman of the $35 million lender, has a “stress test” ready to show how his bank’s portfolio would fare if rural land prices dropped 25 percent. Or 50 percent. Or even 75 percent.
“I hope it’s not going to go to heck in a handbag out here, but this allows us to look at those worst-case scenarios,” says Gerhart, a fourth-generation banker in this 800-person town two hours west of Omaha, in the heart of the corn and soybean belt. He began stress-testing in the last two years after prodding from the Federal Reserve Bank of Kansas City.
Farmland prices were 30 percent higher in Nebraska in the second quarter than a year ago, according to a survey by the Kansas City Federal Reserve Bank, driven by elevated crop prices, soaring farm income, and record-low interest rates. That’s the high end of increases in cropland valuations of 8 percent and more in the region stretching from Oklahoma to North Dakota and from Nebraska to Michigan. Last March these increases prompted Yale University economist Robert J. Shiller to call farmland his “dark-horse bubble candidate for the next decade.”
Shiller’s warning has the Federal Reserve on guard, based on interviews with Fed regulators, economists, and policymakers. His prediction of a housing bubble in a 2005 edition of his book Irrational Exuberance proved prescient. Regulators missed the risks in residential and commercial real estate that led to the subprime crisis. So examiners at regional Federal Reserve banks and the Federal Deposit Insurance Corp. are scrutinizing the lending standards, loan documentation, and risk management at the country’s 2,144 agriculture banks.
Regulators have highlighted the risks in a series of sessions. The Farm Credit Administration hosted a roundtable in February. The FDIC sponsored a “Don’t Bet the Farm” symposium in March. In July the Kansas City Fed organized a conference on “Recognizing Risk in Global Agriculture.” That conference included officials from the FDIC, the Agriculture Dept., Farmer Mac (AGM) (which functions like Freddie Mac (FMCC)), the Office of the Comptroller of the Currency, the Farm Credit Administration, the Federal Reserve banks of Minneapolis, Chicago, and Dallas, and the Fed’s Board of Governors. The group considered questions such as what would happen if crop prices fell by half, if government subsidies for agriculture or ethanol disappeared, or if land prices tumbled by 30 percent or more.
“It’s not that we think this is going to be the most likely outcome,” says Jason R. Henderson, the Kansas City Fed’s lead agricultural economist. “It’s a discussion of the black swans and fat tails—the low probability events that catch people off guard.”
The Fed’s Beige Book, an anecdotal survey of economic conditions released on Sept. 7, reported that “farmland values rose further” in several districts even as “harsh summer weather strained agricultural activity.” The Kansas City Fed reported land values were 20 percent higher than a year ago. The Chicago Fed reported a 17 percent increase in its district, the fastest increase since the 1970s. Nonirrigated farmland in the Minneapolis Fed district increased 22 percent in price.
At the peak of the housing bubble, real estate prices were rising 17 percent year over year, according to the S&P/Case-Shiller index of property values in 20 cities. Seasoned bankers see a disturbing similarity with the farm boom, as former Kansas City Fed Chief Executive Officer Thomas M. Hoenig told the Senate Agriculture Committee in testimony earlier this year. Hoenig’s big worry, he said, is that imbalances in asset prices “will catch agriculture—and the U.S. economy more generally—by surprise once again.”
Farmland values soared in the 1970s, rising as much as 28 percent in 1976. In the early 1980s the bubble burst, and land prices collapsed. Memories of the 1970s have made regulators and bankers more cautious this time, says David B. Oppedahl, a Chicago Fed economist who compiles the bank’s AgLetter.
On occasion, bankers have found regulators overzealous, says John Blanchfield, who runs the ABA Center for Agricultural & Rural Banking at the American Bankers Assn. “The FDIC is convinced there’s a bubble, and they’re not going to miss this bubble, by God,” he says. Regulators are concerned about banks’ concentrations of agriculture loans, he adds. “How are these bankers supposed to respond to that? Every direction in 500 miles from their bank is cornfields.”
The bottom line: U.S. farmland prices have risen up to 30 percent this year. Regulators and bankers are working to avoid a repeat of the 1970s boom and bust.

The real bull market; Why Americans are making pensions out of prairies

2011-10-17T09:50:00.000-07:00

http://www.ft.com/cms/s/2/6d07c1b4-f524-11e0-9023-00144feab49a.html#ixzz1b3hJsM4q

Indexer? Valuation Still Matters

2011-10-13T14:36:00.000-07:00

Indexing is based on a simple proposition: Net of fees the markets are hard, if not impossible, to beat. The proposition has been tested many times, with supportive results. No surprise then that passive funds' market share has surged to 24% from 11% of all open-end and exchange-traded fund assets over the past decade. But indexing's well-deserved success has coincided with a disturbing abrogation of responsibilities by some investors and advisors. Many believe that they can't or shouldn't estimate expected returns of their investments. They've consigned valuation to the dustbin.
This is wrongheaded, motivated by a view of markets rejected decades ago. The early efficient-market theorists assumed that the market's expected returns, risks, and correlations were constant through time. Almost no financial economist believes this today. The market's expected returns change. And there's heaps of evidence that the market's returns are somewhat predictable over long horizons.
Market Predictability
On an intuitive level, the market must be predictable to some extent. Otherwise, how could investors set prices for stocks versus bonds versus cash? We can also reasonably rule out certain scenarios, such as corporate earnings growing much faster than gross domestic product indefinitely, which would result in corporate earnings eventually taking over the entire economy. That returns are bounded by mean-reverting attributes of the economy points to predictability. Indeed, the evidence is compelling. In the August 2011 issue of The Journal of Finance, University of Chicago professor John Cochrane wrote: ". . . predictability is pervasive across markets. For stocks, bonds, credit spreads, foreign exchange, sovereign debt, and houses, a yield or valuation ratio translates one-for-one to expected excess returns, and does not forecast the cashflow or price change we may have expected." In other words, measures such as dividend/price predict future returns, especially over long horizons. Cochrane is a prominent efficient-markets theorist.
Adding return predictability to classical asset-pricing models, with changing risk, correlations, and expected returns, has surprising implications. In many cases, the hallowed market portfolio, containing all assets in the market weights, no longer guarantees the most return per unit of risk. There's no need to privilege total stock and bond market indexes, or static buy-and-hold strategies. The more realistic models suggest investors should time the market depending on how affected they are by recessions and their estimates of expected returns. An investor who can stomach a lot of volatility should increase his exposure to risky, high-expected-return assets during bad times. This sounds an awful lot like the dictum to "buy when there's blood in the streets." But everyone can't buy at the same time, nor should they. Investors with income or wealth sensitive to the business cycle should put less of their portfolios in value stocks, which are especially hurt by recessions, and possibly even hedge their exposures to their specific industries.
These new and improved models have their impracticalities. Until recently, sticking with a plain market-weighted index fund was perhaps the best course of action for the vast majority of investors. Trading was prohibitively expensive, and it was difficult to cheaply tailor one's exposures to various risk factors. No longer, as decimalization, financial innovation, and competition have slashed costs and expanded the menu of indexlike investments. Investors should take advantage of these circumstances to tailor more-efficient portfolios. However, demanding that advisors and individuals constantly update for every asset class estimate of expected returns, correlations, and standard deviations is impractical. A compromise is to adjust portfolio allocations based on expected returns, perhaps the most important of all three factors. As we'll see, estimating long-run (over a decade or more) expected returns isn't terribly hard.
Expected Returns
Most expected returns can be decomposed into three parts: the current cash flow yield, the cash flow's expected growth rate, and the expected change in valuation (for example, a contraction or expansion of the dividend/price multiple). However, of the three, change in valuation multiples is often the least predictable, most volatile, and the least important in the long run, so investors should focus on current yields and expected cash flow growth. Current yields are easy to find. The trick, then, is to find the most appropriate and predictive cash flow growth figure. Fortunately, long-run historical growth rates provide a decent guide. For most major stock markets, dividend growth has averaged 1% to 2% annualized over the past century. For bond indexes, expected cash flow growth is negative owing to defaults. For U.S. Treasuries and investment-grade bonds, the default rate has historically been zero or close to it, so current yield (or better yet, real option-adjusted yield) provides a good guide to expected returns. According to Antti Ilmanen, U.S. high-yield bonds have since 1920 lost about 4.3% of value annually to defaults (2.6% after a 40% recovery rate is included).

Adding a few bells and whistles seems to help forecasting power, but they're beyond the scope of this article. GMO, a respected asset manager, adds mean reversion in its models. An investor without the time, data, or inclination to estimate expected returns probably would do well to follow the regular valuation estimates GMO publishes for free at its website (registration required, unfortunately).
This doesn't mean you're guaranteed to earn those returns, even over several decades. All an expected return estimate does is offer you a decent idea of the average of the many possible return streams you can reasonably expect from your investments.
Portfolio Implications
How could you integrate expected returns into a portfolio strategy? It could help determine your savings rate. Ask yourself whether you're satisfied with the reward you're expected to earn for deferring consumption. Would you save the same amount if you're only expected to be paid 2% annualized versus 30% annualized on your portfolio? Probably not, yet many investors don't even take a stab at estimating expected returns.
The notion that valuations matter and predict returns is closely related to the idea of recession risk. If high expected returns came with no qualifications, then beating the market would be a cinch. Many efficient-market theorists think of assets with high expected returns as riskier. This means that an exceptionally patient, risk-tolerant investor with a safe job could act as an insurer, buying distressed assets with high expected returns during recessions and liquidity crises. If he's unable or unwilling to monitor the markets for high expected return opportunities, he could maintain a static allocation to value strategies that buy high-yielding or low-price/book stocks. Or he could compromise between market-timing and buy-and-hold by overweighting beaten-down assets during annual or biennial rebalances, a technique advocated by William Bernstein.
The opposite would hold true for an investor sensitive to the business cycle. Perhaps he owns a small business or works in finance. He could overweight high-quality growth stocks and in some cases could justifiably engage in "reverse market-timing," selling stocks when volatility picks up (usually accompanied by market declines), as an insurance scheme.
Integrating expected returns into portfolio strategy just scratches the surface of efficient portfolio construction. In an ideal world, investment bankers would hold few equities and lots of long-duration Treasury Inflation-Protected Securities; landlords would short REITs; bankruptcy lawyers would sell volatility. All of this would be done with an eye toward maximizing the risk/reward characteristics of investors' true portfolios, which include human capital, pensions, and so forth, in addition to stock and bond holdings. In the real world, individuals and advisors are sorely lacking in the tools, data, and knowledge to properly implement such strategies. The very least we can do is assess whether our investments offer prospective rewards commensurate with the risks we bear. And that requires a valuation-based view of the world.

Just how stretched is the 10y?

2011-10-10T11:51:00.001-07:00

Really stretched. The bottom histogram is the percentage which the 10y yield deviates from its 10y (linear regression) trend. We've only been here once before, during the height of the credit crisis in late 2008/early 2009.
Even if you're bearish on the global economy, or expect hard deflation, the pay-off in betting large on US government bonds seems particularly unattractive at this point.

A Few Simple Rules For Money Managers to Improve Performance

2011-10-05T08:40:00.001-07:00

One of the biggest hazards of being a professional money manager is that you are expected to behave in a certain way: You have to come to the office every day, work long hours, slog through countless e-mails, be on top of your portfolio (that is, check performance of your securities minute by minute), watch business TV and consume news continuously, and dress well and conservatively, wearing a rope around the only part of your body that lets air get to your brain. Our colleagues judge us on how early we arrive at work and how late we stay. We do these things because society expects us to, not because they make us better investors or do any good for our clients.

Somehow we let the mindless, Henry Ford–assembly-line, 8:00 a.m. to 5:00 p.m., widgets-per-hour mentality dictate how we conduct our business thinking. Though car production benefits from rigid rules, uniforms, automation and strict working hours, in investing — the business of thinking — the assembly-line culture is counterproductive. Our clients and employers would be better off if we designed our workdays to let us perform our best.

Investing is not an idea-per-hour profession; it more likely results in a few ideas per year. A traditional, structured working environment creates pressure to produce an output — an idea, even a forced idea. Warren Buffett once said at a Berkshire Hathaway annual meeting: “We don’t get paid for activity; we get paid for being right. As to how long we’ll wait, we’ll wait indefinitely.”

How you get ideas is up to you. I am not a professional writer, but as a professional money manager, I learn and think best through writing. I put on my headphones, turn on opera and stare at my computer screen for hours, pecking away at the keyboard — that is how I think. You may do better by walking in the park or sitting with your legs up on the desk, staring at the ceiling.

I do my best thinking in the morning. At 3:00 in the afternoon, my brain shuts off; that is when I read my e-mails. We are all different. My best friend is a brunch person; he needs to consume six cups of coffee in the morning just to get his brain going. To be most productive, he shouldn’t go to work before 11:00 a.m.

And then there’s the business news. Serious business news that lacked sensationalism, and thus ratings, has been replaced by a new genre: business entertainment (of course, investors did not get the memo). These shows do a terrific job of filling our need to have explanations for everything, even random events that require no explanation (like daily stock movements). Most information on the business entertainment channels — Bloomberg Television, CNBC, Fox Business — has as much value for investors as daily weather forecasts have for travelers who don’t intend to go anywhere for a year. Yet many managers have CNBC, Fox or Bloomberg on while they work.

You may think you’re able to filter the noise. You cannot; it overwhelms you. So don’t fight the noise — block it. Leave the television off while the markets are open, and at the end of the day, check the business channel websites to see if there were interviews or news events that are worth watching.

Don’t check your stock quotes continuously; doing so shrinks your time horizon. As a long-term investor, you analyze a company and value the business over the next decade, but daily stock volatility will negate all that and turn you into a trader. There is nothing wrong with trading, but investors are rarely good traders.

Numerous studies have found that humans are terrible at multitasking. We have a hard time ignoring irrelevant information and are too sensitive to new information. Focus is the antithesis of multitasking. I find that I’m most productive on an airplane. I put on my headphones and focus on reading or writing. There are no distractions — no e-mails, no Twitter, no Facebook, no instant messages, no phone calls. I get more done in the course of a four-hour flight than in two days at the office. But you don’t need to rack up frequent-flier miles to focus; just go into “off mode” a few hours a day: Kill your Internet, turn off your phone, and do what you need to do.

I bet if most of us really focused, we could cut down our workweek from five days to two. Performance would improve, our personal lives would get better, and those eventual heart attacks would be pushed back a decade or two.

Take the rope off your neck and wear comfortable clothes to work (I often opt for jeans and a “Life is good” T-shirt). Pause and ask yourself a question: If I was not bound by the obsolete routines of the dinosaur age of assembly-line manufacturing, how would I structure my work to be the best investor I could be? Print this article, take it to your boss and tell him or her, “This is what I need to do to be the most productive.

EM Stock Markets – Destabilized by Currency Sell-offs and Capital Outflows

2011-09-28T14:29:00.001-07:00

Developed market equities are attempting to stabilize based on some more talk from Eurozone leaders who are meeting with the IMF and reported to be discussing items such as expanding the size of the EFSF, creating a TARP-EU, and recapitalizing more of the European financials. Developed market investors are attempting to look ahead during scary times. This contrasts to the overnight session in Asia, which saw another spiral into panic selling towards the Asian close. Most markets were down 3-6% again, and for a short period last night the S&P futures were down 15 points (2.5% lower than 8:00am NY time). There are a number of signs that this round of selling is liquidation with little regard to fundamentals in the region. The selling is indiscriminant when you look across individual stocks across emerging markets in Asia and breadth in the markets is extremely negative. The cause of this selling is temporal in my view, as intrinsic value will support these markets going forward so long as a global financial crisis is avoided. The small cap sector in EM had numerous double digit % stock price declines last night.
The IMF recently came out with updated estimates that emerging markets will be driving 80% of real global GDP growth in 2011 and 76% in 2012. There is simply no way that emerging markets can drive the vast majority of global GDP growth and not see another strong year of growth in corporate sector profits. Developed market companies in the US and Europe continue to point to emerging markets as a growth engine. Companies like Nike haven’t seen any slowdown in emerging market demand recently. It is simply implausible that US companies will continue to see strong growth in the region while the local companies go into decline. So the region will bottom based on improved sentiment which is impossible to forecast and when valuations are stretched to the downside. I believe that we at least have the second condition in place now:
EM currency declines from highs in the past month:

Brazilian Real: 17%
Mexican Peso: 17%
Russian Ruble: 18%
Indian Rupee: 13%
Turkish Lira 9%
Indonesia Rupiah: 8%
Malaysian Ringgit: 8%
Thai Baht: 5%

In conjunction with the currency market sell-off, BRIC stock markets have declined and valuations have contracted sharply. Here are the major EM equity markets:

In destabilized markets, the valuations can get stretched to extremes. There needs to be selling fatigue as you run out of sellers before the markets can really turn. Savvy buyers will attempt to jump in at the first signs that the selling pressure is exhausted. This will be very difficult to time just right, but an approach of scaling into emerging market weakness at this point, without using leverage is a sensible strategy. I prefer overweights in China and Brazil as these markets have declined more, have lower valuations, and the most solid dividend yield support. When one thinks about how the world economy will evolve over the next number of years it is implausible to envision an environment without growth being driven by the BRICs and frontier markets within EM. Investing in EM after a period of a sudden dislocation and liquidity withdrawal has led to numerous instances of outsized returns. With valuations providing strong medium-term support to the markets (when panic subsides) I think it is reasonable to expect 100% returns over the next 2-3 years for investors who scale-in buy from here, without leverage, and can hold their positions while taking advantage of near term volatility and not reacting to the volatility.

Residential Remodeling Index at new high in July

2011-09-21T14:37:00.001-07:00

The BuildFax Residential Remodeling Index was at 130.4 in July, up from 129.5 in June. This is based on the number of properties pulling residential construction permits in a given month.

From BuildFax:

The Residential BuildFax Remodeling Index rose 24% year-over-year--and for the twenty-first straight month--in July to 130.4, the highest number in the index to date. Residential remodels in July were up month-over-month almost a single point (.6%) from the June value of 129.5, and up year-over-year 25.6 points (24.5%) from the July 2010 value of 104.7.
...
In July, the West (3.4 points; 3%) and Midwest (4.9 points; 5%) all had month-over-month gains, while the South (3.3 points; 3%) and Northeast (2.7 points; 3.4%) saw a decline.
...
"As millions of Americans believe that they will not be able to secure a new home due to a variety of factors including tight credit, limited buyers and challenging job prospects, they are more and more turning to renovating and remodeling their current properties, sending remodeling activity to record levels," said Joe Emison, Vice President of Research and Development at BuildFax.

Click on graph for larger image in graph gallery.

This is the highest level for the index (started in 2004) - even above the levels from 2004 through 2006 during the home equity ("home ATM") withdrawal boom.

Note: Permits are not adjusted by value, so this doesn't mean there is more money being spent, just more permit activity. Also some smaller remodeling projects are done without permits and the index will miss that activity.

Since there is a strong seasonal pattern for remodeling, the second graph shows the year-over-year change from the same month of the previous year.

The remodeling index is up 24.5% from July 2010.

Even though new home construction is still moving sideways, it appears that two other components of residential investment will increase in 2011: multi-family construction and home improvement.

Data Source: BuildFax, Courtesy of Index.BuildFax.com

Grantham: ‘No market for young men’ (Buy EM, Japan, & Europe)

2011-09-21T14:35:00.000-07:00

Hey, Young Turks on trading desks, up-and-coming money managers and Wall Street stock jockeys: You want the truth about the global markets today?

Listen to Jeremy Grantham, chairman of Boston-based investment manager GMO LLC: You can’t handle the truth.

Jeremy Grantham.

“This is no market for young men,” Grantham said. “At least us old men remember what a real bear market is like, and the young men haven’t got a clue.”

Women, too, for that matter. And at 72, after 40-plus years in the investment business, Grantham can make this claim unchallenged, but his point is more about the lessons of experience than the limitations of age, and an investor’s ability to build on the former and overcome the latter.

With Greece on the verge of default, and economic growth in even the healthiest developed markets stuck in slow gear, Grantham reserves his harshest words for the leaders of central banks, big money-center banks and governments. The fittest global companies, meanwhile, are getting his firm’s client’s money.

Policymakers and politicians have acted like “children at play,” Grantham has said. As he sees it, they’ve created a tower of debt and an illusion of wealth, and have not been held responsible for their frivolous actions.

“No one has been prepared to make tough decisions,” Grantham said in a recent telephone interview. “Where have the Europeans been for 10 years? None of these things came out of the woodwork two weeks ago. No one attempted to blow the whistle and make tough decisions in a timely fashion.”

Targeting income inequality

“Kicking the can” on deficits and spending delays the reckoning, but only makes it more painful when it comes. Had “grown-ups” been supervising the financial system, the problem might not have gotten out of hand, Grantham noted.

To put the debt crisis in perspective, Grantham suggested imagining multiple stacks of building blocks, “fairly precarious and fairly tall,” each set uncomfortably close to the other. If one falls, it could either take down several others or fall neatly between them. The trouble, Grantham said, is that there’s really no way to know.

Financial markets nowadays are faced with this hit-or-miss scenario, and buyers don’t like the odds. Said Grantham: “We have these basically distinct problems joined only by a general fragility of the financial system. So you can’t know for sure that if China stumbled it wouldn’t set off something else, or if the U.S. goes into a double-dip [recession], it won’t set off a European bank failure.”

Especially worrisome to Grantham is the gulf between wage earners in the U.S. The top 10% of U.S. workers currently receive about half of the nation’s total income, with half of that going to the top 1%. The last time this country saw a wage gap so extreme was just before the 1929 stock-market crash and the Great Depression. By comparison, in the late 1970s the top 1% garnered about 9% of all earnings.

“You can’t run the economy on BMWs alone,” Grantham said. “If the average person is in a pickle, how do you have a healthy economy?”

For starters, he said, you tax the richest more than they’re paying now. Said Grantham: “We have actually made the tax structure friendlier to the top 10%.”

Grantham contends that income inequality at these levels takes a real toll on ordinary workers and society as a whole. To bridge this gap and give average workers a bigger slice of the pie, Grantham advocates investing in education, training, and to “change the tax structure to make it equitable.”

Value stocks, rich market

Grantham also doesn’t approve of Federal Reserve Chairman Ben Bernanke taking steps that he said essentially have put savers in a box. Keeping interest rates low, and stating that rates will remain in the cellar for at least a couple of years, forces people to take more risk with their money if they want yield and capital appreciation.

“You’re transferring money away from retirees” who must either delve into stocks, gold or some other higher-stakes investment, or languish in savings accounts and low-yielding bonds, Grantham said. “They could use that money. They would spend every penny.”

Instead, Grantham said the Fed’s policy puts money “in the hands of people who aren’t spending it — people who only buy BMWs and don’t support Wal-Mart.” This creates a vicious cycle in which, Grantham said, individual savers are penalized and restrain spending, while the beneficiaries are “bankers and corporations that can build factories all over the place — except they won’t because consumption is too weak.”

Accordingly, Grantham sees this path coming to no good end over the short-term. He said he expects another leg down for the U.S. stock market, one where shares could stay low-priced for years while U.S. economic growth plods along at maybe 2% annually instead of the relatively more robust historical average of around 3.4%.

But Grantham is an investor, not a politician, so his job is to hunt down opportunities in bull or bear markets. Nowadays, he’s finding more stocks that fit GMO’s strict value-investing discipline.

“If we adjust earnings to normal and apply an average P/E, you can finally build a decent portfolio today of global equities at a respectable long-term return,” he said.

The potential for gains is “modestly higher” outside of the U.S., he added, other than “high-quality blue-chips.” Mostly, he said he prefers discounted plays that are surfacing in Europe and emerging markets.

“In stocks you will eventually do OK at these prices,” Grantham said.

“The real danger is one or two of these building blocks falling over,” Grantham said. “You can buy a whole portfolio of slightly cheap global stocks, and the risk you take is that you get sandbagged by some of these major problems.”

Indeed, Grantham said that since there’s a “decent chance” of stocks becoming even cheaper, GMO is positioned slightly below normal in equities “because the risk profile of the world is way over normal.”

At the same time, he’s not jumping on the long-term-bond bandwagon. “One day we will have more inflation and our bonds will bleed like a pig,” Grantham said. “The only reason for buying long bonds is short-term or as a desperate haven for terrorized investors. But the potential to make longer-term real money is naught.”

Grantham runs a personal, non-profit foundation dedicated to the protection of the environment. For the foundation he has invested heavily in agriculture, commodities and natural resources. Timber is a favorite, as are fertilizer companies. He’s not a big fan of gold. “I own some myself as a pure speculation,” Grantham said — “just enough to mute the irritation of watching gold [prices] rise.”

For others, Grantham advised taking a page from GMO and buying shares in companies with strong finances and which produce goods that people need, as opposed to luxury items. Look for dividend-paying opportunities in emerging markets especially. “I would own emerging and EAFE (the MSCI Europe, Australasia, and Far East Index), including Japan,” Grantham said.

“In the end everything comes down to value, and they have suffered a lot more recently,” he said of non-U.S. markets. “Yes, it can get whacked in the next 18 months if the wheels come off, and the possibilities are likely, but if you hang in anyway you’ll make a respectable return.”

Beware the market spam

2011-09-16T13:00:00.001-07:00

In light of the news that Goldman Sachs’ Global Alpha — le quant fund extraordinaire – has started “liquidating” its holdings, and that other algorithmically minded unwinds have probably been stalking the markets, we bring you the following chart from Nanex’s Eric Scott Hunsader:

What it shows is the incremental build-up over the last few years of superfluous quote traffic over the course of the day. That is to say, quotes which are entered into markets systems but are never actually transacted. Spam.
The more red, the more recent the data.
As Hunsader notes:

The chart shows how many quotes it takes to get $10,000 worth of stock traded in the U.S. for any point in time during the trading day over the last 4.5 years. Higher numbers indicate a less efficient market: it takes more information to transact the same dollar volume of trading. Quote traffic, like spam, is virtually free for the sender, but not free to the recipient. The cost of storing, transmitting and analyzing data, increases much faster than the rate of growth: that is, doubling the amount of data will result in much more than a doubling of the cost. For example, a gigabit network card costs $100, while a 10 gigabit network card costs over $2,000. A gigabit switch, $200; a 10 gigabit switch, $10,000. This October, anyone processing CQS (stock quotes) will have to upgrade all their equipment from gigabit to 10 gigabit. Which would be fine if this was due to an increase in meaningful data.
We think that a 10-fold increase in costs without any benefits would be considered “detrimental” by most business people.
This explosion of quote traffic relative to its economic value is accelerating. Data for September 14, 2011 is the thicker red line that snakes near the high. There is simply no justification for the type of quote data that underlies this growth. Only the computers spamming these bogus quotes benefit when they successfully trick other computers or humans into revealing information, or executing trades. This is not progress. Progress is almost always accompanied by an increase in efficiencies. This is completely backwards.

This needless to say produces a huge information burden, not only on anyone trying to trade the market, but also any regulatory systems trying to monitor and analyse what’s going on.
Back of an envelope guesstimates from our resident exchange sleuths regarding the data produced by US markets alone run into several hundred terabytes a year. That said, the higher the volatility the higher the data burden. In peak August volatility US markets supposedly generated as much as 1 terabyte of data per day, while previous peaks had been around 600 gigabytes. Add data from Europe and Asia and we could be hitting a figure of several petabytes a year.
It’s worth noting scientists at CERN in Switzerland faced a similar problem when building the Large Haron Collider. Though in their case they were faced with having to analyse roughly 15 petabytes (15m gigabytes) worth of data annually.
That’s the equivalent 1.7m dual-layer DVDs a year, they say.
Being scientists, they opted to get creative. A brand new computer network called “the grid” was the result, designed specifically to cope with information overload. Though to this day, even Cern doesn’t have the capacity to store all the data it produces and regularly chucks as much as it receives back into the abyss forever.
From a regulatory point of view, of course, chucking data away is not really the ideal solution for market data.
Meanwhile, it’s worth wondering how close we are to peak capacity right now.

Jury renders split decision in TCW-Jeffrey Gundlach case

2011-09-16T11:50:00.000-07:00

Star bond fund manager Jeffrey Gundlach was found liable Friday for breaching his fiduciary duty to his former employer, asset management giant TCW Group Inc., which fired him in December 2009.
But in what essentially can be viewed as a win for Gundlach, a Los Angeles jury found no harm to TCW in that breach and awarded the firm no financial compensation.
Further, the jury found that TCW must pay $66.7 million to Gundlach and his three co-defendants for failure to pay wages owed them before leaving the money-management firm to set up a rival company in 2009.
[Updated at 9:51 a.m.: After the jury was dismissed, a smiling Gundlach was asked how he felt about the decision. "Great," he said. "It's 67-to-zero," he added, referring to the wages owed to him and his co-defendants.
[TCW's general counsel, Michael Cahill, said in a statement that the firm was "gratified by the jury's verdict, which speaks directly to the principles at the heart of this case -- integrity, honesty and trust."]
On a separate issue, the jury of five women and seven men agreed with TCW’s claim that Gundlach had misappropriated the company’s trade secrets in setting up a rival firm in 2009, causing harm to TCW. Any damages on that claim will be decided by Judge Carl J. West. TCW is asking for $89 million.
The verdicts were read in a packed courtroom, with Gundlach and many of TCW’s top officers present. The six-week civil trial in Los Angeles County Superior Court had wrapped up on Tuesday afternoon. Jurors took just two days to decide on 37 separate issues on the verdict form.
TCW, which manages about $120 billion in assets for clients, fired Gundlach in December 2009 in a shakeup that rocked the mutual-fund world. One month later the company sued Gundlach, alleging that he and key aides conspired against the firm and stole TCW proprietary information to set up a new fund-management business, DoubleLine Capital, almost overnight.
Gundlach, 51, then countersued and accused TCW, the parent of Trust Co. of the West, of ousting him after 24 years at the firm to cheat him out of a huge chunk of promised income.
The two lawsuits were combined into one trial, which began in late July and has been closely watched on Wall Street.
The trial was an unusual airing of the financial industry's dirty laundry. Most such disputes are settled quietly to prevent potentially embarrassing or damaging information from becoming public. But in this one there was so much bad blood between the two sides that they were unable to reach an out-of-court deal.

TCW alleged that Gundlach, a bond-market genius who had managed more than 60% of TCW's total assets, was secretly planning all through 2009 to abandon the company. He allegedly wanted to take his entire bond team with him to another firm, or one that he created, and leave TCW in the lurch. If he had succeeded, he "likely would have destroyed TCW," TCW attorney John Quinn said Tuesday in closing arguments. Instead, TCW said it used the element of surprise to strike first, firing Gundlach and acquiring another bond firm on the same day to take over the assets Gundlach had managed.
Gundlach denied that he wanted to leave TCW, and alleged that Chief Executive Marc Stern and the company's French parent, banking firm Societe Generale, were plotting in 2009 to oust him in a cost-saving move. Gundlach's attorneys pointed repeatedly during the trial to notes taken at a meeting of TCW executives in August 2009 referring to the idea of firing him.
Gundlach wanted nearly $500 million in damages from TCW, claiming that he would have earned that much through this year based on his contract with the company at the time of his ouster. As one of Wall Street's most acclaimed investors in mortgage bonds, Gundlach had attracted tens of billions of client dollars to TCW over the last two decades. He and TCW had shared management fees earned on the assets. TCW calculated that Gundlach’s compensation since 1991 had totaled $239 million.
During the trial, Gundlach estimated his personal net worth at about $90 million, some of which he has sunk into an extensive collection of modern art.
For much of the six weeks of testimony Gundlach found his personality on trial. TCW lawyers and witnesses described him as arrogant, disloyal and even a “disease” on the company. The jury was told that Gundlach encouraged his staff to refer to him as "the Pope" and "the Godfather."
Gundlach has acknowledged his large ego, but has said his investment results spoke for themselves.
His new company, DoubleLine Capital, has attracted $15 billion in assets in less than two years, despite TCW’s legal onslaught against him. The DoubleLine Total Return Bond fund, Gundlach’s flagship mutual fund, has risen 11.7% over the last 12 months, beating 99% of its peer funds, including the one he left behind at TCW.
Barron's magazine earlier this year crowned Gundlach "King of Bonds." During the trial he estimated his personal net worth at about $90 million, some of which he has sunk into an extensive collection of modern art.
Before the trial, Gundlach and his attorneys accused TCW of engineering a public smear campaign against him. When TCW filed suit against Gundlach in 2010, it included allegations that hard-core pornographic magazines and DVDs and drug paraphernalia were found in his TCW offices downtown and in Santa Monica.
Gundlach said at the time that TCW was resorting to "gutter tactics." Later, he said that whatever the company found in his offices were "vestiges of closed chapters of my life."
TCW wanted to have the jury hear about the alleged porn and drugs, but presiding Judge Carl J. West ruled in July that those accusations weren't relevant to the case, which he said was complex enough.