While investors are once again worried that the Fed's action and statement will lead to more fears over inflation, a look at the chart of gold shows a different picture. After closing significantly below its uptrend line earlier this week, gold made a new low today, trading below its early April low. This is not the type of pattern one would expect to see if inflation was going to be the number one worry down the road.
Since the onset of the credit crisis last Summer, the S&P 500 has now had four rallies of more than 5% (using closing prices), which are highlighted in the chart below. Many investors believe that the market has a different and more positive feel during the current rally, and when we compare it to the prior two rallies, they have a point. Prior to this run, the S&P had two rallies that lasted two weeks or less. With the current rally continuing on for more than thirty trading days, things should feel different.
However, before we all call an official end to the market's declines, we would note that from last August through October, the S&P 500 rallied by more than 11% over a 38-day period. The current rally, on the other hand, has shown a gain of 9.77% over a 33-day period. Until this rally shows that it has more staying power (in time and/or magnitude) than any of the prior head-fakes, investors should continue to keep a cautious stance, and keep tight stops on their short-term positions. With a flood of economic and earnings reports, an overbought market, as well as a Fed meeting which could set the stage for a pause in rates, the reaction to this week's news will tell a lot about the market's health.
Since the St. Patrick's Day inflection point, spreads on high yield corporate bonds are down over 20% from their high of 862 basis points (bps) versus US Treasuries (based on the Merrill Lynch Index of high yield debt). As long as spreads can continue to come in, the environment for equities should remain positive, but at a level of 685 bps, spreads remain over 180% off their lows last June.
April 25 (Bloomberg) -- A gauge of investor confidence in the U.S. leveraged-loan market is headed for its biggest monthly increase since being created last year as banks find ways to sell loans they have been stuck with the past 10 months.
The LCDX index is rallying as Citigroup Inc., Deutsche Bank AG and the rest of Wall Street whittle down their leveraged-loan liabilities to about $91 billion from a peak of $237 billion in August, according to Bank of America Corp. strategists led by Jeffrey Rosenberg in New York.
The LCDX Series 9, a credit-default swap index tied to the loans of 100 companies in the U.S. and Canada, has climbed 3.5 percentage points to 96.9, according to Goldman Sachs Group Inc. A newer version LCDX 10, used to hedge against losses or to speculate on the ability of companies to repay their debt, is up 2.1 percentage points to 99.1 since it started trading April 8.
``It's been quite a euphoric run for the market,'' said Alan Alsheimer, who trades the LCDX contracts at Goldman Sachs in New York.
As banks are able to move the loans off their balance sheets, they also have been unwinding LCDX trades that were used to hedge against potential losses from those loans, Alsheimer said. Hedge funds and other institutional investors with bearish bets have followed suit as prices rose.
``Banks are unwinding their hedges after selling their loan exposures,'' Stephen Antczak, a high-yield strategist at UBS AG in Stamford, Connecticut, said in a telephone interview.
LBO Debt
The LCDX indexes are linked to much of the debt committed by banks to fund a record amount of leveraged buyouts last year before the collapse of the U.S. subprime-mortgage securities sparked a freeze in debt markets. The index includes credit-card payment processor First Data Corp., acquired by Kohlberg Kravis Roberts & Co. last year, and newspaper publisher Tribune Corp., which was taken private by billionaire Sam Zell.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt or hedge against the risk they won't. They cover losses on underlying debt if the borrower fails to make payments.
The LCDX Series 9 has soared more than 6 percentage points from a low of 90.8 on Feb. 20, Goldman prices show.
The market is now ``at an inflection point,'' Alsheimer said, as investors weigh the potential effect of slowing economic growth, rising fuel and production costs and increased financing costs.
``We are in the early stages of what is expected to be a sustained move higher in actual defaults,'' Alsheimer said.
As we've done in the past, below we have updated the current and historical weightings of the S&P 500's sectors. As recently as two days ago, Energy had the second biggest weighting in the index. It currently ranks third, but that's much higher than its 7th place ranking as recently as the end of 2005. Financials still rank first at 17.1%, followed by Technology at 16.3%. These weightings change dramatically due to sector rotation over the years. Back in 1992, Consumer Discretionary had the biggest weighting in the index, but it's now ranked 7th at just 8.5%. Technology got all the way up to 29.2% back in 2000 during the Internet bubble, but its weighting was cut in half by 2002.
As shown in the individual charts of sector weightings, Energy has really taken share from other sectors in recent years. Just like the spike in Financials that was seen in 2006, these big rises should flash warning signals for investors.
This story about rice shortages -- which we covered yesterday and has today reached the "general" media -- is a good example of how the public can misunderstand an event.
There are two things going on here:
1) stories about food commodity prices rising over the past few months has attracted speculative investment, and
2) a few stories in the popular press about the increasing price of foodstuffs has caused a small percentage of the population to act, by buying much larger quantities of certain foodstuffs than they normally would. A small percentage (my guess is maybe 3-5 percent of the households) may actually be "hoarding," that is, buying far larger quantities of food than they could consume in several weeks.
But is there a physical shortage of rice? The answer seems to be no; but if that is so, why is CostCo limiting sales?
The answer lies in how a modern economy works: just-in-time inventory has become the standard. Under this methodology, stores do not stock large supplies of food, clothing, or anything else; they rely on computer models to accurately predict supply and demand. They rely on a supply chain that replenishes the products on a daily basis.
According to NewScientist:
1) a typical city has a 3-day supply of food;
2) a typical hospital has a 2-day supply of oxygen
Sound shocking? It hasn't bothered anyone, and it works fine, as long as something strange -- like hoarding -- doesn't occur.
Because when hoarding occurs, when even, say, 10 percent of your customers suddenly buy 10 times the amount of a single product than they normally would buy, the product is quickly exhausted and the supply chain will have trouble immediately providing the product.
So there is not a physical shortage of rice; there is a problem with the supply chain because hoarding has stressed the system.
Of course, if everyone decided to start hoarding, there would be a problem with the actual supply of rice. My point is that this story happened for a different reason.
Don't get me wrong -- there are long-term factors increasing demand for protein-based foods, and the grains that are used to feed the livestock.
Potash this morning included a long essay in its earnings report, noting that people in developing countries where populations are increasing "require more food and can afford a more nutritious diet that includes protein from meat sources. This requires an ever-increasing number of animals for food production and millions of additional tonnes of feed grains."
But that long-term issue is a far cry from the so-called shortage of rice we are seeing.
In trading Thursday, the yield on the two-year Treasury note poked back above the federal-funds target of 2.25%, something that’s rarely happened in the past three years. Furthermore, the two-year note’s yield of late is higher than the expected federal-funds rate six months from now, a dramatic reversal from a trend that has persisted since March 2005.
“This could be the watershed, the inflection moment we’ve been waiting for,” says George Concalves, chief Treasury and agency strategist at Morgan Stanley. “We’ve been so tightly wound up in rates because of strong flight-to-quality flows, which was justified cause people trying to figure out where the problems were with the banks. Now, we’ve seen that come off.”
Of late, the two-year note was traded with a yield of 2.34%. For most of the past three years, the two-year note’s yield has been trading anywhere from 0.25 percentage point to 0.5 percentage point below the expected federal-funds rate six months down the road as determined by federal-funds futures contracts. Bond investors were worried about the specter of a severe slowing in economic growth and were running ahead of the expectations for monetary policy.
“People had priced in a lot of bad news,” says Thomas Roth, head of Treasury trading at Dresdner Kleinwort. “No one wanted to buy anything but Treasurys. They weren’t concerned about return on principal, just return of principal.”
That started to change in December, when the Federal Reserve announced the formation of the Term Auction Facility to assist in lending to banks. By then, the difference between the two-year note’s yield and the expected funds rate had widened to about 0.75 percentage point. It started to reverse, but still held below the anticipated Fed target through the first four months of the year.
It has now broken above that level, which Mr. Concalves says may hasten the exits from low-yielding Treasurys to riskier investments. It also suggests greater concern about inflation, and the low-yielding two-year note currently does not compensate investors in the case of high inflation.
“There’s going to be uncertainty on the inflation front over the next two years,” Mr. Concalves said. “Companies that were exporting deflation are now exporting inflation. As an investor, 2% is not going to cut it — it’s hard to justify Treasury rates at these low levels.”
Now someone has finally brought many of these concepts together in one place. “Portable Alpha: Theory and Practice” (US link) edited by PIMCO’s Sabrina Callin has just hit bookstores. If you read Peter Bernstein’s “Capital Ideas Evolving” (see related posting), you may recall that PIMCO is considered to be one of the early pioneers in portable alpha strategies.
Naturally, we’re working our way through it right now and are so far impressed with the holistic nature of the content (including contributions by Rob Arnott, Bill Gross and several PIMCO managers).
Yesterday, AAA media partner HedgeWorld ran an interview with Callin for its premium subscribers. With permission from our friends at HedgeWorld, we have re-printed the interview in its entirety below.
But before you read the interview, here’s a quick footnote. It appears that Portable Alpha has a lot of fans in the UK and Singapore. A Google search of this book returns the publisher’s country-specific websites in the following order: UK, Singapore, US, Germany, Canada. A flagrantly un-scientific observation for sure. But curious nonetheless…
Portable Alpha in Difficult Markets
By Chidem Kurdas, HedgeWorld New York Bureau Chief, Tuesday, April 22, 2008
But hedge funds that correlate with the market, as many strategies did in March, are particularly dangerous in a portable alpha setting where they can cause double market exposure. At the same time, the credit crunch threatens the solvency of counterparties to derivatives deals.
HedgeWorld asked Sabrina Callin, executive vice president at Pacific Investment Management Co. and head of a team responsible for the firm’s global alpha equity business, how the portable alpha approach will fare in the current environment. She is the author of Portable Alpha Theory and Practice (2008; John Wiley & Sons Inc., Hoboken, N.J.).
HedgeWorld: The idea of separating alpha from beta is not new, is it?
Sabrina Callin: It goes back to the early 1980s, when equity index derivatives were introduced. PIMCO decided to use these in an enhanced a cash product, StocksPLUS. The derivatives add an equity market return to a diversified portfolio designed to outperform money market interest rates. More recently, the same concept was applied by PIMCO and others to replicate various market exposures using derivatives and collateralize that with a variety of different investment engines designed to generate alpha.
HW: There are many potential sources for above-market or uncorrelated returns, hedge funds among them. How do you decide on the alpha source?
SC: We carefully listen to the needs and objectives of our clients. We have introduced combinations that we believe offer attractive long-term returns with limited risk. The client can choose from different market exposures including global equities, small-cap stocks, regional equity markets, commodity exposure, even real estate investment trust exposure. The choice for alpha engine includes enhanced cash, active fixed-income strategies and hedge fund-type strategies.
HW: How does an investor pick from these various components?
SC: Different investors choose the combination that works best for them. It’s very customizable to an investor’s specific considerations. That’s one of the great benefits of this concept. Investors are not limited to managers with a skill in a certain market. They can decide they want that market exposure but then separately select a source for excess return depending on their risk-return preferences.
HW: Have recent market conditions changed the way the portable alpha approach is used?
SC: The broader context of how investors view strategies and markets has changed a lot, but not the way PIMCO does things. Even a year ago, a lot of people were focused on returns and not much on risk. Now the market has come around to the idea that risk matters and therefore diversification of risk matters. Portable alpha can be a fantastic opportunity to diversify risk to provide attractive risk-adjusted returns above a given market index. We’ve always been concerned about keeping risk transparent and at an acceptable level. But investors are now more focused on that.
HW: Has there been a shift in the strategies chosen as alpha source?
SC: The short message is that people want returns uncorrelated to markets. There is greater realization that not everything offered as an alpha strategy with uncorrelated returns can deliver. It may have flaws that will make it correlate with broader markets at times of market stress. I think investors are now placing more value on transparency, which is critically important with portable alpha because you have more exposure.
HW: Regarding the swaps and other derivatives used to get market exposure, is there greater counterparty risk because of the credit crunch?
SC: In the cases where you have liquid futures contracts that you purchase in exchanges, the counterparty risk is minimal. When it comes to swap contracts, we diversify our counterparty risk as part of our established business practice. There are strict controls. For instance, the counterparties never owe any material amount of money to us. The flip side of what’s going on in volatile markets is the power of counterparties to call in the collateral. That caused problems for levered players in the past year. With our portable alpha strategies, the alpha source is highly liquid, so even if there is a decline in the market, we have adequate liquidity. This provides protection if there is a counterparty collateral call.
HW: A portable alpha portfolio is levered up by the use of derivatives. Doesn’t that mean greater risk in the current environment?
SC: Leverage by itself is neither bad nor good. You can have a combination of alpha source and derivative that has less negative return than stand-alone exposure to a market. But the incidence or magnitude of negative return can be higher if the alpha source is high-risk or is significantly correlated with the beta exposure. What matters is that investors take this into account and not assume that this is similar to a stand-alone market exposure.
HW: Is there an estimate of how large the current portable alpha market is?
SC: That’s the million-dollar question! The challenge is how you define portable alpha. For some, it’s just the money in the alpha engine within a portable alpha context. If that were the definition, PIMCO would have more under management because others buy our stand-alone strategies and layer on the beta. From the investor’s standpoint, that’s a portable alpha investment. But we would not include that in our portable alpha number because the investor bought just the alpha engine from us. Our integrated portable alpha strategies are at about $55 billion. There are a number of large pension plans that buy alpha engines and separately implement derivatives positions themselves or through an overlay manager.
HW: Funds of hedge funds manage portable alpha packages. Where do those fit in?
SC: Apart from integrated products like PIMCO’s, there are also semi-bundled products often offered by funds of hedge funds. The derivative and the alpha source are not managed together but the fund of funds offers them as a package. Market neutral funds of funds in particular are increasingly used for portable alpha, with the derivative supplied by the manager or separately obtained by the investor. I haven’t seen any estimates of the assets in semi-bundled products.
HW: What do you see coming in this area?
SC: For an investor who wants to increase return but not take on more downside risk, there are only two options. One is diversification and the other is higher alpha. Those two ways to increase returns are available to a greater degree with portable alpha than with traditional approaches where you have a manager picking stocks or structuring a bond portfolio. That doesn’t mean traditional management is obsolete but it does mean there is a lot of value in the concept of portable alpha because of the much broader opportunity to seek alpha and diversification beyond a selected market.
Below we highlight one-year charts of trailing 12-month P/E ratios for the S&P 500 and its ten sectors. The red dots highlight where the P/Es stood when the market peaked on October 10th. Since the market is down significantly since October 10th, it's not good to see its P/E higher than it was back then, as that means earnings are declining faster than the price.
Remember when everyone was saying Financials were cheap in late 2007 based on its P/E ratio? That argument didn't hold for too long. Materials and Energy have also seen their P/Es rise, but prices have also risen for these sectors. And unfortunately, we didn't include Consumer Discretionary or Telecom because Discretionary's P/E is in the 100s and Telecom's is negative. Industrials, Health Care, Consumer Staples and Utilities have fortunately seen their P/Es decline slightly, and Technology's valuations have fallen significantly since earnings have held up well for that sector.
Bill Miller's quarterly letter to shareholders was released earlier this afternoon, and even though his performance has lagged over recent quarters, his letter is still considered required reading for investors. While a full copy of the letter can be found on Yahoo, some of the highlights include:
"We have had 3 worse quarters in absolute terms: the quarter the market crashed in 1987, the 9/11 quarter, and the third quarter of 1990."
"I think we will do better from here on, and that by far the worst is behind us."
"Most housing stocks are up double digits this year despite dismal headlines, a sign the market had already priced in the current malaise. I think likewise we have seen the bottom in financials and consumer stocks, but not necessarily the bottom in headlines about the woes in those sectors. Although the economy is likely to struggle as it did in the early 1990s, the market can move higher, as it did back then."
"I agree with George Soros that commodities are in a bubble, but it also appears he is right when he describes it as one that is still inflating, and we still have the summer driving and hurricane season with which to contend."
"The Fed could help a lot by halting its interest rate cuts."
"Yet valuations in general are not demanding, interest rates are low, and corporate balance sheets, especially in the U.S., are in excellent shape. That sets the stage for what should be an improving environment for investors in stocks and in spread credit products, if not in government bonds where risks are high and opportunities low, in my opinion."
Mercer is excited about the future of portfolio management. On March 21, the LA office of Mercer Investment Consulting gave a presentation to the Arizona State Retirement System called “Investment Industry Trends: Implications for ASRS”. Amongst the discussion of equity markets and interest rates, you’ll find this interesting passage:
“New approaches to addressing the balance between desire for return and the tolerance for risk will be developed.
“It would appear that some investors will go back to making money the old fashioned way-generally earning it with traditional investments in traditional structures.
“There will be room for innovation, in fact, given low expected returns, innovation will be required.
“However, the innovation will not be the result of sophisticated financial engineering but rather in finding new asset classes which have much in common with traditional assets.
“Other investors will adopt a portfolio structure, employing many new sources of beta and different conceptions of sources of alpha with explicit risk budgeting and management techniques.
“A Prediction: For those investors taking the new path, the portfolio structures and management techniques used will be as different in five years as the present portfolio structures and management techniques are from those of thirty years ago.”
A lot has changed in 30 years. Then again, the Time magazine covers from April 1978 do look oddly familiar…
On March 27th, we posted charts of three "credit crisis" indicators highlighting that the pain was beginning to subside. We have updated these charts after about a month has passed, and they continue to show signs of relief.
The first chart below is an index that measures credit default risk for 125 investment grade companies. After peaking on March 10th, the default risk index has fallen 45% back to levels seen at the start of the year.
The second chart is an ETF that tracks the S&P National Muni Bond Index (MUB). When the auction rate securities market froze up in late February, municipal bonds cratered as tax-free yields rose above those of many taxable bonds. Since then, however, muni bonds have risen and stabilized as yield-hungry investors flocked to them.
The last chart is Bankrate's national average for 30-year fixed mortgage rates. When all is said and done, things won't get better until homes start selling again, whatever the prices might be. For buyers to buy, rates need to be attractive, and the Fed has tried their hardest to lower borrowing costs by dropping the Fed Funds Rate. Unfortunately, even as the Fed was cutting, mortgage rates actually in February and early March as banks shied away from risk. By the end of March, mortgage rates finally dropped from the low 6s to the mid-5s. Over the last week, however, rates have spiked as bonds in general have sold off.
Below we highlight the ten-year yields on government debt for six international markets. With the exception of Australia, interest rates have been in steady downtrends since last Spring. However, in many of these markets there are signs that this downtrend may be nearing an end, which could be a signal that investor aversion to risk may be waning. While Treasury yields in the US, Canada, and Japan still have some room before breaking their downtrends, bond yields in Europe and the UK have already made higher highs.
Municipal-bond yields, which soared this winter as hedge funds dumped the bonds, have finally begun coming down.
Still, yield-hungry investors shouldn't fret. Muni yields are likely to remain elevated compared with taxable debt such as Treasurys -- just not at the sky-high levels reached earlier in the year.
![[Chart]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_vCERZ18ySmeL42PcoPFsFN3ZA4T9N-aPUU-Y_U4TcEq8tIgX-ZcP3n4KTdY5h-fdjWYtAo-uO2GHxPQu1ks4GEiSmVkydNXESNPocFyVSyYdmj-4n3J39HtgPMZUa2meHK8y651eV5rDRhpElL=s0-d)
What happened was that buyers such as mutual funds, lured by the high yields, piled back into munis in recent weeks and reversed the impact of a winter selling frenzy by hedge funds. With bonds, yields move in the opposite direction from prices. So the new bidding action pushed up prices and thus reduced yields from high levels.
Mutual-fund manager Joseph Deane of Western Asset Management said that as March began, "I was buying my shoes off."
But the buyers' rekindled ardor for munis has cooled as yields have fallen. "We have been selling into this market," said Mr. Deane, who helps oversee about $38 billion at Western. "We've come a long way from where we were five weeks ago."
The yield on the average triple-A-rated municipal bond has fallen to 4.60% -- or 0.09 percentage point above that on a 30-year Treasury, according to Thomson Reuters. That is down from a record gap hit in March, when muni yields were 0.72 point higher than Treasurys. On top-rated 10-year muni debt, yields averaging 3.60% now are 0.14 point below Treasurys. In late February, the average 10-year muni was yielding 1.17 points more than Treasurys.
While muni yields may not be the kind of screaming buy they were five weeks ago, they're still attractive. Historically, municipal debt yields less than Treasurys because holders don't pay federal taxes on the interest income. And the tax exemption means that an investor in the highest federal tax bracket earns the equivalent of a 6.96% yield lately on a 30-year municipal obligation. That plus munis' longtime low default rates were enough to lure investors in the past.
At the center of the recent turmoil in the municipal market are the hedge funds and other traders. They loaded up on munis, using even cheaper short-term debt -- as low as 1% not long ago -- to buy them and benefited from the spread.
Then in late February and early March, the traders ran into trouble from higher short-term rates and the credit crunch. The traders needed to raise cash to shore up their balance sheets. So they unloaded their muni positions.
The flood of munis over the winter sent the bonds' prices plummeting. Muni yields jumped.
Contributing to the muni price plunge was the plight of bond insurers, which many state and local governments use to protect their bonds -- and win them lower interest rates. Bond insurers such as Ambac Financial Group Inc. and MBIA Inc. were themselves burned badly by their guarantees of mortgage-backed investments, and their insurance didn't look so solid anymore.
Another problem for muni issuers was the seizing up of the market for debt known as auction-rate securities. Many local governments also used these instruments to raise money. These are essentially debt vehicles carrying floating rates that are reset weekly or monthly. But the banks that run the auctions stopped committing their own money to make sure the sales ran smoothly.
Eventually, muni yields rose high enough to tempt buyers. A rally took hold in late March and early April as the forced selling abated and customary buyers of muni debt -- mutual funds, individual investors and insurance companies -- came off the sidelines.
"When yields got up to 5% on 30-year [triple-A] debt, there was very strong demand," says Basil Williams, chief executive at hedge-fund managers Concordia Advisors.
Other factors helped boost demand. Recently, the Securities and Exchange Commission began temporarily allowing local governments and other auction-rate issuers to buy back debt that didn't get enough demand at the auctions. In addition, some in the market expressed concerns about its ability to absorb about $125 billion of these orphaned securities that municipalities and organizations planned to reissue as debt backed by strong guarantees to appeal to money-market funds. Those reofferings, though, have gone far better than expected.
Nevertheless, restoring the customary set-up, in which munis yield less than Treasurys "is likely to take us a little bit of time," said Philip Fischer, municipal-bond-market strategist at Merrill Lynch. Mr. Williams is even more pessimistic: "It's unlikely we're going to get back anywhere near the levels we had seen in late 2005 through early 2007."
Headwinds include pent-up issuance, which means more new muni bonds will be on the market, further holding down prices; the economic woes of some governments that will depress prices on their paper; and the lingering financial troubles of bond insurers. The hedge funds which once propped up prices appear to be gone from the field.
Even if the conditions for munis improve, trouble elsewhere in the fixed-income world could well continue to damp enthusiasm for them, according to Merrill's Mr. Fischer. "This problem will persist in varying forms well into the summer," he said.
Treasury Prices Fall
The week ended with another day of losses for the Treasurys market, as surging stocks and the prospect of fresh supply next week weighed on the market for most of the session.
The 10-year note ended down 4/32 point, or $1.25 for every $1,000 invested, to yield 3.743%, up from Thursday's 3.729%.
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By LAWRENCE C. STRAUSS STEVE TANANBAUM'S ROOTS ARE IN HIGH-YIELD BONDS, which he began analyzing at MacKay Shields in 1989. He became head of the department two years later, while still in his mid-20s. Since then his horizons have expanded to all sorts of asset classes, including equities. No surprise, he remains a value investor. Eager to run his own firm, Tananbaum left the mutual-fund world in 2000 and launched GoldenTree Asset Management. With nearly $14 billion in assets, much of it in hedge funds, the New York firm devotes a lot of its time and energy to alternative assets. One of Tananbaum's favorite investment themes right now is bank loans used to fund leveraged buyouts. Amid the credit crunch, which has caused the spread between yields on high-yield bonds and Treasuries to widen, these loans have come under pressure. This kind of debt isn't widely available to retail investors, though some mutual funds, such as Eaton Vance Floating Rate1 Fund (ticker: EVBLX) and AIM Floating Rate2 Fund (AFRAX), specialize in bank loans.
So-called loan-participation funds haven't done well lately, and are down about 4% year to date through April 14, according to Lipper. But that's better than the broader market's total return of minus 9%. GoldenTree's flagship offering, the $5 billion Master Fund I, which looks for value in equities and bonds, was down 5.39% in this year's first quarter, but more than two percentage points ahead of the Merrill Lynch high-yield credit index that's used as a benchmark. The fund's five-year annual return of 11.34% bests the high-yield index by nearly three percentage points, as of March 31. Barron's recently caught up with Tananbaum, 42, at his midtown office, which houses a portion of his art collection, including the spacesuits by artist Tom Sachs shown in the photo at right. Barron's: What is happening in the credit markets, where conditions since August have been very tough? Tananbaum: The credit problems that started last year, and which were perceived to be isolated, really spread throughout the system. In different pockets of credit, things were mispriced. Right now you're seeing a repricing of credit. Whereas last year you were being underpaid to own credit, now you are being overpaid. You mean, in terms of much wider spreads? That's right. Against that backdrop, the investment banks have been damaged. Normally they provide credit to the financial system. But things aren't working the way they normally do. You're seeing the banks' inability to provide credit to a lot of their corporate customers. Are the banks lending less because they have to put more of assets on their balance sheets? The banks are playing defense. They are more worried about their current relationships than beginning new relationships. Are hedge funds paying higher interest rates to borrow from banks? The terms are different from what they were six months ago. The banks are looking to provide less leverage at wider spreads, and only on larger pools of assets. How has that impacted GoldenTree? First of all, most of the money we run isn't levered. We have about $10 billion of alternative assets, of which $7 billion to $8 billion doesn't have any leverage associated with it. Also, we have favorable terms, with four to five years left on our credit facilities, so nothing is coming due right away. Having said that, if you have access to borrowing money, then bank debt, or leveraged loans, is very attractive. That's because the spreads on bank debt have widened considerably, to somewhere around 600 basis points [six percentage points] above Libor [the London interbank offered rate], meaning the prices have come down significantly. Those spreads are as wide as they've ever been. In the next two years, you could see spreads going back down to 400 basis points. That would give you double-digit returns over the next two years. So this is a good time to be buying? This is a great opportunity to be buying. It reminds me of earlier credit crises, such as the ones involving Mexico in 1994 and Russia in 1998, and the one that unfolded at the end of 2000. It was clear: The markets correctly predicted that defaults would pick up, and there is usually indiscriminate selling at those points. That's what we have today. But the credit market right now favors those with the money to buy. Earlier in the year, some of the easiest purchases were investment-grade names like American Express [AXP]. It had a new debt issue that was trading 362 basis points, or 3.62 percentage points, over Treasuries. That's what the high-yield index was yielding about a year ago. Now that debt's spread is in the mid-200s above Treasuries, meaning the price has appreciated. But there was definitely a disconnect. What was driving bond prices to such low levels? Leverage was a big part of the story. The first phase, as I said, was indiscriminate selling, much of it driven by a lack of liquidity. A lot of people had taken out lines of credit, leveraging up in some cases on bank debt, or loans used to finance buyout deals. When the value of the bonds went down, say 10 points, these investors got margin calls and were forced to liquidate, because they couldn't come up with any equity. It was basically a bunch of margin calls in February, and then in March it became a systemic issue with Bear Stearns [BSC]. What is your take on Bear Stearns' collapse last month, and its pending acquisition for about $10 a share by JPMorgan Chase [JPM]? The Bear Stearns situation initially was about whether fraud was involved. The market got comfortable that it wasn't about fraud, but more about Bear not having the right capital structure. Then there was a run on the bank. The market has gotten healthier since the Bear episode, and the Fed has done a terrific job providing liquidity and telegraphing they intend to provide more. What's the next step in the credit markets? On the debt side, it's about finding companies whose balance sheets work. By that I mean which companies are self-sustaining in the current environment, as opposed to which balance sheets potentially are at risk of defaulting. The debt of Calpine [CPN], which has emerged from bankruptcy protection, was a large holding for the investment banks. Calpine had too much debt. But now, after the restructuring, it's a healthy company. The leveraged loans of Clear Channel Communications [CCU], the radio and entertainment company whose buyout has been stalled, could be a more challenging investment. Table: Tananbaum's Picks…3 Do you hold Calpine bank debt? Yes. On the bank-loan side, we are focusing much more on companies where we are at the top of the capital structure. Calpine and TXU Energy, the Texas utility taken private last year, are interesting loans. What does it mean to have a good position in a company's capital structure? It means you get paid before others if things go wrong. You're first in line, ahead of the common equity holders. As investment opportunities, how do you view junk bonds versus leveraged loans? A lot more leverage was used for investing in bank loans. There wasn't as much leverage in high yield. Bank debt had a lot of margin calls at the beginning of this year, creating buying opportunities. And because there was such an overhang from the investment banks that held these loans on their balance sheets, it was a more attractive market. There was no forced selling in high-yield bonds. Thus, bank debt, which is more senior in a company's capital structure, fared worse than junk bonds that were more junior. Bank debt offers better relative value than high-yield bonds. What is on the horizon for bank debt? April is starting off terrific, but there will be twists and turns. At the end of the day, what is going to determine returns, whether for high-yield bonds or leveraged loans, is the performance of the company. When certain companies can't grow into their balance sheets -- they can't, in effect, make their debt payments -- that's going to create opportunities, as well. Any examples? First Data, a financial-services company that helps process credit-card transactions, comes to mind. They were taken private last year. They have a big capital structure, and it will be hard for them to pay off debt. Bank loans aren't readily available to retail investors, though there are some bank-loan mutual funds. Let's talk about some themes that have a wider appeal. We've always looked at arbitrage between the public and private markets. In equities, there was a big discount to the private-market values of deals. That's opened up some terrific values because there is no private-market value right now. Many companies, including some in the media industry, traditionally were valued off of private bids. Now, in many cases, there is no private- market value because deals can't get done. Some argue it's still too early to get into bank debt. Should you wait? It depends on the situation. If you're talking about retailers or home builders, absolutely, it's early. We are avoiding home builders and retailers. The bonds of home builders, particularly the investment-grade issues, look extremely rich. But that's not true of all industries. Some bank loans related to utilities look attractive. For those companies, it depends on the dynamics of the region a utility is operating in. Tell us about some equity holdings. The television market in general has very good fundamentals. This is a presidential- election year, and the expectation is this will be the biggest spending year ever for TV broadcasting in terms of advertising. We are long the equity of Sinclair Broadcasting Group [SBGI], which owns a string of television stations around the U.S. It's a well-managed company with strong free-cash flow. And they have been benefiting from retransmission. Which is? Basically, getting fees from cable companies for their stations. We also like some cable companies, including Time Warner [TWX]. These companies have always traded at discounts to their private-market values. But we expect them to have high-single-digit cash-flow growth this year. Warner has a catalyst, given that [President and Chief Executive Jeffrey] Bewkes has telegraphed he's going to be splitting up the company. Time Warner trades at a significant discount to what we think its intrinsic value is, and it doesn't have a lot of debt. We believe, whether it's through dividends or buying back shares, they are going to releverage their balance sheet. Time Warner and other cable companies are pretty much going to deliver the growth rates they've achieved over the last 10 years, yet their valuations are around 40% of what they've been historically. As recently as six months ago, these cable companies had double-digit multiples, based on earnings before interest, taxes, depreciation and amortization. And you can buy them for roughly half that now. Any other thoughts on the cable industry? We like international cable a lot. There's less competition overseas and we feel good about earnings. Liberty Global [LBTYA], is our largest holding. Where else do you see value? With casinos, take a look at MGM Mirage [MGM] compared to Harrah's Entertainment [HET]. Recently you could buy the debt of Harrah's, which has a better collection of assets, yielding close to 15% and trading at six or seven times cash flow. At the same time, MGM's equity was trading at about 10 times cash flow. We felt Harrah's debt was a better buy. We were short some MGM equity earlier this month, given that growth in Las Vegas is under some pressure in this economic environment, but we covered after the shares went down. MGM is a terrific company, but it turned out to be a good short for us. Thanks very much, Steve. | ||
While the front page story of today's Journal focused on a 1% decline (approximately 100,000 barrels) in Russian oil production in the first quarter of 2008, not all the news is bad. On page 14 of today's issue, the Journal ran a story highlighting a potential 33 billion barrels in new supply off the coast of Brazil. If confirmed, the discovery would represent the largest ever new discovery of oil in the world. Why the 100,000 barrels in decreased production made the front page, while the 33 billion in potential new supply was relegated to page fourteen is not clear, but net net, you would expect these two stories to have a negative impact on the price of oil.
While it may seem like years ago, it was only two months ago that the direction of the market seemed to hinge on the daily fluctuations of Ambac (ABK). Remember that Friday in February when the Dow rallied over 200 points off the low on rumors of a bailout for the company? Luckily for the market, investors have moved on from watching ABK. Since the early March capital injection into the company, ABK shares are down 44%.
While the Dow is trading down nearly 1.5% due to GE's earnings miss, GE itself is having a relatively minor impact on the total decline in the Dow even though it is down 12%. The reason for this lies in the way the Dow is calculated. Unlike every other major index, stocks in the Dow are weighted according to their price instead of their market cap. Therefore, the lower the stock's price, the smaller its weight in the index. Additionally, when a stock in the index splits, its weighting is automatically cut in half even though nothing has really changed about the company.
As of last night, GE closed at $36.75, giving it a weight in the index of only 2.4%. This contrasts to IBM which is the highest priced stock in the Dow with a weight of 7.7%. Below, we highlight the impact in Dow points of a 12% decline in each of the Dow components. As shown, GE is only having a direct impact of 36 points. If IBM traded down 12%, its impact on the index would have been a decline of 117 points!
With today's market declines, the S&P 500 is in danger of breaking its short-term uptrend line as well as its 50-day moving average. The index is currently trading just a half of a point below its 50-day moving average and will need to close above that level for the uptrend to hold.
Clever Felix over at Market Movers has an issue with hedge fund returns and volatility. He links to a Bloomberg article which points out that not only the pre-eminent Quant still extant, James Simons, but also ex Tiger sidekick and champion fundy Steven Mandel, have had severe drawdowns lately.
“Much of the problem this year has come from extreme price movements in different markets,” writes the author of the article, Katherine Burton, trying to explain. Felix’s plaintive reaction speaks volumes about one of the great misconceptions about managing long short money:
I have to say I don’t get it. Aren’t hedge funds precisely the asset class which is meant to benefit from volatility
Baruch is here to help, and the answer is no, no and double no. Hedge funds hate volatility. Note I mean real, up and down volatility, not the purely downward kind. You all know what stops are: when a stock or position moves against you, through a pre-assigned loss level, it gets taken off, sold if long, bought back if short, liquidated, whatever. Stops are an essential risk management tool, an insurance policy to protect your fund from significant drawdown if a position goes against you. All hedge funds use them.
There is a mysterious process by which stocks tend to get drawn towards widely held stop levels in highly volatile markets, in which the blasted thing moves against you, until you are out, with, say a 7% loss on a position you thought would make you 20%. And then it moves rapidly in the way you wanted it to in the first place. You re-enter the position, determined not to let one mistake beget another, at which point — you guessed it, you get rapidly stopped out again for another 7% loss. If you simply stayed in the position you would be flat, but instead are down 14%. Your stop policy has become a false friend. If anyone is watching, you appear deeply stupid.
Hedge funds as I know them are like every other fund: they like long, visible trends, clear cues to go long or short stocks. The problem is that hedge funds are sold as Felix says, and the fallacy is widespread – for example, the strategists at my beloved employer told the punters, correctly, that this year would see a lot of volatility in equities. So, they said, increase allocation to equity long short, which struck me as precisely the wrong thing to do. Paradoxically in times like this it is the dumb, directional money, the long only crowd, who can ride out volatility better. But of course with them you can only “lose less money” in long-lasting bear markets.
Incidentally this March – Baruch is reliably informed – has been one of the worst months ever for hedge fund returns in any class, but particularly long short equity. 75% of them are supposed to have lost money. No prizes for noting that March has been one of the most volatile months in ages, encompassing the rally post the Bear rescue and 75bp rate hike, and the awful swoon beforehand.
No, proper schmalpha is very hard to come by in volatile times.
For those interested, below we highlight the historical trailing 12-month P/E ratio of the S&P 500 since 1942. The green and red shading represents bull and bear markets of the S&P 500. Bull markets are rallies of 20% that were preceded by a decline of 20% and vice versa for bear markets. Generally you see P/E expansion during bull markets and P/E contraction during bear markets. However, the most recent bull market saw P/Es contract from high levels, and during the recent correction, P/Es have expanded. The current trailing 12-month P/E of the index is 20.5 versus an average of 15.90 since 1942.
Information is freer flowing than ever. As a result, gaining an information advantage – the foundation of alpha generation – is becoming notoriously difficult. Despite what the media says about institutions seeking fantastic returns from alpha, most institutions are painfully aware of how hard it is to beat the market over the long term (i.e. to produce true alpha). Far from being dreamers who have fallen under the spell of money managers (as some have accused them), institutions remain remarkably pragmatic.
A recent survey by consultancy Greenwich Associates hits the point home. The firm surveyed 583 institutions and found that the average expectation for alpha was actually a paltry 1.2% per annum.
As the chart below from the report shows, small public pension plans have the most optimistic view of their manager’s skill-level. Conversely, small private pension funds have the least rosy view of their managers’ ability to deliver alpha (chart shows annual alpha expectations in basis points)
While small in relation to beta returns, Greenwich says that even 121 bps is pretty high and “not in line with historic results.” (which according to the firm are below 100 bps). But a look under the surface yields some interesting observations about different asset classes and investor types…
In contrast to popular perception, institutions also don’t expect their hedge fund investments to outperform their traditional investments. In fact, overall return expectations from hedge funds were about the same as the expectations from US equities.
However, this is not to suggest that institutions see both of these asset classes producing the same level of alpha. According to the survey, endowments expected over 1.5% alpha per annum, higher than both public and private pension plans - and perhaps not coincidentally, Greenwich also found that endowments also had the highest allocation to hedge funds.
Comments the report:
“Institutions’ optimism appears to reflect a basic confidence in the new products and strategies they have incorporated into their portfolios.”
“It’s hardly a surprise that institutions are ratcheting up their alpha expectations after implementing new strategies designed to boost risk-adjusted returns. “There are tools for institutional portfolios that are much more efficient than the traditional equity/fixed income asset allocation model,” says Dev Clifford. “And to some extent, the changes in investor outlook reflect pensions’ realization that these products and strategies often work as advertised.”
The report also contains a chart titled “Alternatives No More” showing how institutional allocations to private equity, hedge funds and 130/30 have taken off over the past year. This, as the firm points out, may be one of the key drivers behind the (measured) alpha optimism.
Buyers of gold in 1980, when the metal was 'hot' and inflation was rampant, were told that the precious yellow would protect their buying power over time.
Goldman Sachs (GS) taking the rest of Wall Street to the cleaners is nothing new, but now comes word that Goldman played a direct role in the destruction of Bear Stearns (BSC). According to Fortune's Roddy Boyd, several days before the collapse, Goldman decided to stop backing up Bear Stearns derivatives deals--and it announced this decision to hedge-fund clients in an email that spooked an increasingly panicked Wall Street:
[On the morning of Tuesday, March 11], Goldman Sachs's credit derivatives group sent its hedge fund clients an e-mail announcing another blow. In previous weeks, banks such as Goldman had done a brisk business (for a handsome fee, of course) agreeing to stand in for institutions nervous, say, that Bear wouldn't be able to cough up its obligations on an interest rate swap. But on March 11, Goldman told clients it would no longer step in for them on Bear derivatives deals. (A Goldman spokesman asserts that the e-mail was not a categorical refusal.)
"I was astounded when I got the [Goldman] e-mail," says Kyle Bass of Hayman Capital. He had a colleague call Goldman to see if it was a mistake. "It wasn't," says Bass, who is a former Bear salesman. "Goldman told Wall Street that they were done with Bear, that there was [effectively] too much risk. That was the end for them"...
When word of the Goldman e-mail leaked out, the floodgates opened. Hedge funds and other clients, eventually running into the hundreds, began yanking their funds.
The next afternoon, Bear CEO Alan Schwartz announced on CNBC that everything was hunky-dory (which, according to Boyd, it wasn't). And two days later, Bear Stearns effectively went bankrupt.
Should Goldman be blamed for this? Absolutely not. Bear Stearns was under-capitalized, over-leveraged, and stuffed to the gills with crappy debt. Once again, Goldman seems to have outsmarted the rest of Wall Street, spotting a problem before everyone else did. Because "runs on the bank" are often started when smart players cut and run, however, Goldman's decision appears to have at least contributed to the stampede.
Goldman Sachs: Giving new meaning to "crushing the competition."
Credit from equity. It’s not a new concept but haven’t yet seen it represented as neatly as in this graph.
The team at Bank of America have produced this effort, which shows just how richly equities are trading on a historical basis relative to credit spreads. Credit, they add, appears to have overshot.
But they fear that further significant government intervention, say to stem the downwards spiral of US house prices, may come only after a greater hit to the market most watched by policy makers - stocks.
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The Fortress Investment Group is riding to the rescue of a hedge fund that sought to profit from betting on fine art and real estate, according to The New York Post.
SageCrest, a $650 million fund, is set to obtain a $150 million financing line from Fortress to stave off an April 30 default of its credit facility with Deutsche Bank, The Post reported citing unnamed sources.
The fund has seen the value of its assets drop precipitously as it struggles with the mire of the credit markets. Separately, SageCrest is closing in on a settlement of a year-long fight with Christie's, the auction house.