Deja Vu: Ten-Year US Treasury Yields

As the yield on the the 10-Year Treasury climbs above 4% for the first time this year, we couldn't help but notice how the path of long-term interest rates bears a striking similarity to last year. The one major difference seems to be that this time less people are talking about it. Last year, there was near hysteria when long term interest rates rose to their highs of the year and above 5%. This year, rates are once again at their highs of the year (although 100 bps lower), but this time around its not nearly as big a story...yet.

Bear or Superbear? The new Draaisma-land

Beyond the call of duty!

Apart from analyzing valuations, interest rates, and growth, the author has also read all the daily Wall Street Journals in the four months surrounding the identified bear market bottoms…

This is Teun Draaisma, Morgan Stanley’s European strategist, reflecting in his latest note to MS clients on his own lessons from reading Anatomy of the Bear, published in 2005 by Russell Napier.

Napier analysed US equities over the last 100 years, observing along the way that every now and then markets go to levels of gross overvaluation - overvaluation events that are invariably followed by a bear market that ends at levels of gross undervaluation.

Four great bear market bottoms are identified - the four best moments in the last 100 years to buy and hold equities for at least ten years: 1921, 1932, 1948 and 1982. The year 1974 almost also made the grade, but didn’t make it into the final selection because the subsequent returns over the next 10-15 years were low in real terms.

Anyway, Mr Draaisma, now famous for his Sell, Sell, Sell last June and his Buy, Buy, Buy last September, enjoyed the book. He has now used the lessons learned as a framework for the “superbear” scenario within his current market thinking — namely that this ‘bear market rally’ is coming to a juddering halt and that steep price falls will follow as real economic slowdown overcomes the underlying economy.

Here are Mr Draaisma’s eight lessons from the great bear markets of the past 100 years:

1. Valuations get very very low indeed. The cyclically-adjusted PE, aka the Shiller PE, represented by the latest price divided by the average earnings of the last 10 years, reaches 10 or even less at bear market bottoms, while Tobin’s Q, the price divided by the replacement value of assets (or price over net worth defined as assets minus liabilities), gets as low as 30% or less. These valuations are the biggest problem with today’s market, as the Shiller PE is more than twice that. Today’s message: Shiller PE is above 20 still, while true bear markets tend to end at less than 10 times (see Exhibits 12 and 13). Equities are not cheap enough and need to decline by at least 50 percent.

2. Equities become cheap slowly. The average duration of bear markets has been 14 years, with the much more rapid 1929-32 episode, when equities went down 89%, the exception. Today’s message: we are in year 8 of a 14 year bear market.

3. Sentiment is not hugely negative at the bottom of the bear market. The popular myth that there are no bulls left at the bottom of the bear market is wrong. Many market commentators are correctly bullish right at the bottom of the bear market. Popular myth has it that talk of ‘equities are dead’ and ‘there is no future for equities’ should be widespread and are classic signals of the end of the bear market. This is far from the truth, it turns out. In related fashion, there is no climactic last and final sell-off on high volumes. Quite the contrary, the final slump is on lower and lower volumes. Subsequent higher volumes at higher levels confirm the bear market is over, with hindsight. Today’s message: do not take any ‘contrarian comfort’ from the fact that many people are quite bearish on the macro outlook, contrary to conventional wisdom, that is not a classical sign of a bear market trough.

4. Patience! Equities do trough during economic recessions, but they do not anticipate economic recovery by 6-9 months. The lead time is much shorter, and often equity and economic recoveries are coincident, and sometimes economies bottom before equities do so. Patience is key. Today’s message: indeed, this is consistent with our finding that one should be patient in bear markets as there is not much discounting of the upturn going on at the end of the bear market, after numerous failed rallies and false hopes (see Exhibits 9 and 10).

5. Times have changed, but most rules have not. Although times have changed dramatically over the last century, and economies have been functioning differently, while investors have arguably become more sophisticated, there are many common signs and characteristics at the bottom of bear markets.

6. Don’t fight the Fed. When the Fed cuts rates and equities are cheap, you should buy. There have been some major exceptions, such as in Nov-1929 (as in Jan-2001 and March-1980), when Fed easing was a false signal to start buying equities. Today’s message: if equities are cheap one should not fight the Fed, but arguably equities are not cheap enough yet (see lesson 1).

7. There are some consistent early signs of economic improvement. The three best are the copper price bottoming out, auto sales improving (or at least getting less bad), and inventories being very low. Today’s message: the copper price has not even fallen yet, so we are far away from the bear market trough.

8. Fixed income markets have given some good warnings signals. Government and corporate bonds rally on average 10 and 4 months, respectively, before equities reach their final trough. Today’s message: similar to the copper price in lesson #7, government bonds have not even sold off yet. Corporate bonds have, of course, and troughed in the middle of March, which in isolation means that equities are close to a trough too. However, in conjunction with the other lessons, we think this does not stack up at all, as valuations are simply too elevated.

Finding Potential for Debt in Distress

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May 25, 2008

By NORM ALSTER

THE credit crisis and economic slowdown have sunk billions of dollars of debt into distressed status — deep in the junk-bond pile. Money managers have traditionally profited in such markets by buying debt on the cheap.

Individual investors can get into the game indirectly, through a small number of mutual funds, including BlackRock High Yield, Mutual Recovery and Northeast Investors Trust, which hold some distressed debt.

“Right now, we think there is going to be tremendous opportunity over the next 12 to 18 months,” said James Keenan, manager of BlackRock High Yield, which has returned 0.41 percent in 2008 and 7.15 percent, annualized, over the last three years, according to Morningstar. (All figures are through Thursday.)

Mr. Keenan foresees raising the fund’s current investment in distressed debt to 10 to 15 percent of assets, from the current 2 to 3 percent, as opportunities arise.

Distressed debt is often defined as the obligations of companies in default or perilously close to it. The term may also be used for debt paying a very high yield — 10 percentage points more than 10-year Treasuries.

Investing in such debt is risky, but handsome profits can be made by converting it into equity ownership as restructured companies leave bankruptcy.

The sharp rise in interest rates on lower-rated debt issues in recent months probably presages a rising tide of defaults, said Kenneth Emery, director of default research at the Moody’s Corporation.

“Historically, there’s a tight correlation between high-yield spreads and default rates,” Mr. Emery said. Already, the global pool of distressed bonds and bank loans is approaching $600 billion, he said.

Little cash has actually been drawn down to buy distressed debt thus far. “There have been a lot of funds raised,” said Michael Embler, chief investment officer for the Mutual Series funds of Franklin Templeton. “Most of the money has not been deployed.”

Oaktree Capital Management, based in Los Angeles, is a longtime investor in distressed debt. The firm has unspecified billions invested in such debt, said Howard S. Marks, its chairman, with $10 billion more ready to be deployed.

The question for Mr. Marks and others is when to start buying in earnest. Early buyers risk “catching a falling knife,” in market parlance, if prices keep tumbling. But late buyers risk losing out on the best deals and the best returns. “We think we have to catch a falling knife,” Mr. Marks said.

Other deep-pocketed buyers seem to be coming to the same conclusion. For example, the Blackstone Group, the big private equity group, has been finding good investments in distressed debt, Stephen A. Schwarzman, the chairman and chief executive, said in a recent conference call.

At Mutual, Mr. Embler is waiting for some of the debt that financed buyouts in the last year to tumble into distressed status.

“There was a tremendous amount of leverage in those buyouts,” he said. “Some of them will hit the wall.”

Just nine months ago, Mutual Recovery held virtually no distressed debt, but with recent purchases of leveraged-buyout-related bank loans, it now has “5 to 10 percent” of its portfolio in the lowest-rated obligations, he said. “We do think there will be more opportunities in the next 6 to 12 months,” he added.

The fund is down 4.31 percent this year and has returned 6.33 percent, annualized, over the last three years.

ALSO prepared to buy, but not convinced that prices have bottomed, is Bruce H. Monrad, who manages the $1.5 billion Northeast Investors Trust fund with his father, Ernest E. Monrad. The fund is up 0.14 percent this year and has returned 5.59 percent, annualized, over the last three years.

“We’re still in the very early innings,” he said. “We’re probably going to see 30 percent of the total junk bond market default over the next five years. And yet fewer than 30 percent of junk bond issues are selling at distressed prices. There may still be a lot of overpriced junk.”

The Northeast fund holds debt from one issuer — the Trump casino empire — that produced a big payday in the past. After Trump Hotels and Casino Resorts filed for bankruptcy in 2004, Northeast received a package of stock and bonds in the restructured company, Trump Entertainment Resorts. Northeast sold the stock but still holds some bonds, whose current yield is roughly 14 percent.

In terms of the broader credit market, Mr. Marks of Oaktree Capital said he saw a possible silver lining in the current situation, at least for investors in distressed debt.

“This could be the biggest credit crisis of our lives,” he said. “And if it is, that argues for higher returns.”

Macklowe to sell GM building to Boston Properties

By Michelle Coffey, MarketWatch

Last update: 4:27 p.m. EDT May 24, 2008

SAN FRANCISCO (MarketWatch) -- Boston Properties said Saturday it has reached a deal to buy the landmark General Motors building and three other Midtown skyscrapers from high-profile New York developer Harry Macklowe for $3.95 billion in cash and debt.

Macklowe will be able to use proceeds from the deal to repay some of the $7 billion he borrowed last year to purchase seven Manhattan towers from the Blackstone Group , as part of Blackstone's acquisition of Equity Office Properties Trust. These included short-term, high-interest loans from Fortress Investment Group and Deutsche Bank in which the GM building and other towers were used as collateral, according to media reports.

Boston Properties will pay $1.5 billion in cash and assume about $2.5 billion in debt, the company said in a statement. The real estate company's partners include Goldman Sachs, the Kuwait Investment Authority and a Qatari sovereign wealth fund, The Wall Street Journal reported, citing people familiar with the situation. The GM deal is expected to close in June, with the purchase of the other properties closing shortly after.

Macklowe purchased the highly coveted, 2 million-square-foot GM building in 2003 for $1.4 billion.

Boston Properties is also purchasing Macklowe properties at 540 Madison Ave., 125 W. 55th St. and 2 Grand Central Tower. The GM building is at 767 Fifth Ave.

Goldman Oil Bull a Nutcase: Here's Why Crash Coming Soon

Henry Blodget | May 22, 08 9:24 AM

China and India scarfing up so much oil that we're headed to $200+ a barrel? Please. Supply is increasing and demand is about to crash. So argues Ambrose Edwards Pritchard in this Telegraph assault on the peak oil story.

Pritchard's bottom line? That crap you're hearing about supply constraints is flat-out wrong: In fact, there's more supply coming online all the time. And then there's the other half of the equation: demand. What do you think will happen to demand when the US, Europe, China, and dozens of emerging economies finally lower the boom on spiraling inflation?

Pritchard:

The perfect storm that has swept oil prices to $132 a barrel may subside over the coming months as rising crude supply from unexpected corners of the world finally comes on stream, just as the global economic downturn begins to bite... The forces behind the meteoric price rise this spring are slowly receding.

Specifically?

• Nigeria has boosted output by 200,000 barrels a day (BPD) this month, making up most of the shortfall caused by rebel attacks on pipelines in April.
• Iraq has added 300,000 bpd to a total of 2.57m as security is beefed up in the northern Kirkuk region.
• Saudi Arabia is adding 300,000 bpd in response to a personal plea from President George Bush, and to placate angry Democrats on Capitol Hill.
• The US Energy Information Agency says non-Opec supply will edge up by 600,000 bpd over coming months as Brazil, Azerbaijan and the Sudan raise production. By next year, the US itself will be producing enough extra oil to shave its import needs.

This increased supply has actually created a surplus in recent months:

• Opec's monthly report says that demand this quarter will average 85.75m bpd. Supply was 86.8m bpd in April. The fresh output from Nigeria, Iraq and Saudi Arabia may push it significantly further into surplus.
• Opec says that stocks held by the OECD club of rich countries are above their five-year average, with "comfortable" cover for 53 days' use. US stocks have edged up for the last four months, though they fell last week.

So what's driving those crazy prices CNBC can't stop talking about? Speculation. Specifically, the oceans of cash flowing into commodity index funds, as investors agree that commodities are a sure thing

Lehman's latest report - Is it a Bubble? - says commodity index funds have exploded from $70bn (£36bn) to $235bn since early 2006. This includes $90bn of fresh money. Energy takes the lion's share. Every $100m flow of investment money into oil lifts crude prices by 1.6pc, it said.

"We see many of the ingredients for a classic asset bubble," said Edward Morse, Lehman's oil expert.

Meanwhile, demand is actually falling:

The International Monetary Fund has cut its forecast for world growth for 2008 three times since last autumn to 3.7pc, and the United Nations is predicting just 1.8pc - technically, a global recession. The major oil forecasters have halved their estimates for crude demand growth to 1.2m bpd.

The bulls say that the US housing crash and spreading contagion in Britain, Spain and Japan do not matter much for oil in the changed world of rising Asia. The US added just 7pc of crude demand growth from 2004 to 2007, compared with 34pc for China, 25pc for the Middle East and 17pc for emerging Asia....

But this could change. Egypt - the most populous Arab country - has just raised petrol prices by 40pc. Rumours swept China yesterday that Beijing was preparing to lift fuel prices.

And then there's that spiraling global inflation thing, which will cause central banks to hit the brakes:

Almost all emerging nations have to slam on the brakes in coming months to curb inflation before it starts spiralling out of control. Inflation has hit 30pc in Ukraine, 22pc in Vietnam, 8.5pc in China, and double digits across most of the Gulf.

The countries that account for the most of the growth in oil demand over the last two years are almost all nearing the limits of easy economic growth.

Pimco’s chief piles into mortgage debt

Bill Gross, the manager of the world’s biggest bond fund, has switched gears to make a big bet on mortgage debt, almost tripling his holding to more than 60% of the fund. Gross’s $130bn Pimco Total Return fund pulled sharply ahead of rivals in the past year after the manager predicted a housing downturn and sold out of housing-related securities and corporate bonds. The fund has returned 12.6% over 12 months, beating 99% of its peers, according to fund tracker Morningstar. Gross said his decision to raise exposure to mortgage debt in recent months was based on the US government’s implicit guarantee of Freddie Mac and Fannie Mae, the government-sponsored mortgage agencies.

Top 100 hedge funds have 75% of industry assets

21 May 2008

The largest hedge funds in the world account for 75% of hedge fund industry assets, compared with 69% the previous year, continuing the trend of larger funds eclipsing smaller players.

The largest 100 hedge funds have $1.3 trillion (€856.4bn) in assets under management, a 35% increase over 2007, according to Alpha magazine’s Hedge Fund 100 report.

JP Morgan Asset Management topped the list with $44.7bn in assets, boosted by Highbridge Capital. The 10 largest hedge funds had assets of $324bn, a 29% increase over last year.

There were some dramatic shifts in the rankings over the previous year.

Paulson & Co rocketed to number eight in the list from 69 last year, with nearly $29bn in assets under management. The fund was boosted by its positions against the sub-prime mortgage market.

Harbert Management, a hedge fund with investments across real estate, private equity, convertible arbitrage and distressed debt and special situations. Its assets have increased from $1.5bn in 2002 to nearly $23bn as of March 1, according to its Web site. Its ranking rose sharply to 16 from 94 last year.

The asset growth reflects the growing number of institutional investors, particularly pension funds making allocations to hedge funds, either directly or through funds of hedge funds.

Separately, hedge fund industry assets declined 1.4% to $2.8 trillion in the first three months of the year, according to a report by hedge fund news service HedgeFundNet.

The decline followed substantial redemptions in the first quarter, following poor performance across the industry.

HedgeFundNet's estimate of total industry assets is relatively high compared with other assessments, which vary from from $1 trillion to $2 trillion.

Deciphering Global Hedge Fund Statistics

"The secret of staying young is to live honestly, eat slowly and to lie about your age."

Lucille Ball
Actress (1911-1989)

One of the biggest problems in the hedge fund space is data mining. Aside from the crazy assumption that historical data and returns can extrapolate into the future, many users of commerically available databases somehow think that they have discovered or uncovered rare secrets from within a mystical hedge fund black box. This is hubris.

Take the latest example unleashed on the world by Pertrac. There are a vast litany of negative concerns related to hedge fund data including self-selection bias, sample selection bias, survivorship bias , backfill bias, and infrequent pricing bias.

Added to these, there are additional very serious classification issues that exist when you have two or more totally different databases with their own labels and you try to fit them together. For instance, where does one put an ABS fund in the HFR database, MSCI database and the Lipper TASS Hedge Fund Database? Is it a fixed income arbitrage fund, a multi-strategy fund or a relative value fund? No-one really knows. But where you put it will certainly impact the data results of risk and return across a number of strategies.

Perhaps the biggest "problem" leveled at databases is that of self-selection bias. While critics point out that only the better funds tend to provide their data to the outside world a reverse argument (and equally legitimate one) is that the best funds do not report to the same databases and so perhaps there are under-reporting biases that should be considered.

Of course, you don't hear much about these funds whenever a news releases comes out!

Which brings me to the case in point. Pertrac, recently analyzed hedge fund data reported to a large number of databases which are consolidated in their analytics package. They claimed that hedge funds report their best performance in their first 2 years. They claimed that a track record of less than two years produced, on average, 11.7% while performers over 2 years produced 10.2% return - a difference of 1.5% on average annual performance.

What the study did not point out was quite a lot. Namely what about the risk-adjusted performance? What about the fact that the smaller funds probably had significantly lower AUM and so in simple numerical terms starting from a lower base their performance was over emphasized. And what about all those closed big funds out there which are not in the databases? The Kensington Global and Medallian Funds of the world...what happens if you include this data into the results?

In fact in an alternative view of the data world a recent comment at a forum in Hawai'i by a academic pointed out just how much of a gap in our understanding of these big closed funds might be out there.

In the presentation covering 20 of these large single manager funds with AUM of over US$6.4 billion there was a definitive performance advantage favoring larger funds. How much? Apparently, an average of over 2.50% per year and for the top performing single managers (top quartile) the number was a staggering 6.00% outperformance per year since 2003!

The reference point for these returns was over the Credit Suisse-Tremont Hedge Fund broad hedge fund index, and, if true, it points to a very significant advantage of big over medium and presumably small too.

Data mining too? Could be. But it might at least shed some light on why the biggest institutional investors in the world are willing to pay higher fees and take on longer lock-ups in order to get access to such funds. It might also explain once and for all the key competitive advantage of the best performing fund of hedge funds - real estate- or simply being invested in the right funds.

And if one wants to focus on age then the average age of those best performing big funds was 13 years. So maybe as Lucille Ball and Marlene Dietrich would have said size and experience matters too. Mahalo.

Largecap, Midcap and Smallcap Performance

As we did yesterday with growth versus value, below we highlight the performance of large, mid and smallcap indices over the entire bull market and since the correction started last October. As shown in the first chart, largecap stocks (as measured by the S&P 500) have lagged mid and smallcap stocks significantly since October 2002. The S&P 500 is up 83.7%, the Smallcap 600 is up 129.2%, and the Midcap 400 is up 136.3% since 10/9/02.

Since the October 2007 top, smallcap stocks have fared the worst and are still down 11.45%. The S&P 500 is down 8.85%, while the Midcap 400 is down just 3.95%.

A beguilingly simple Chart of the Day - real and adjusted gasoline prices.

John Kemp at Sempra Metals notes that the Bureau of Labor Statistics does some serious smoothing of gasoline prices each spring to account for the usual surge associated with America’s driving season — from Memorial Day to Labor Day. In calculating CPI, the gasoline adjustments are substantial, with prices cut by up to 10 per cent in May and then increased them by as much as 9 per cent in Dec and Jan.

The actual gasoline price rose by 12.6 per cent between Jan and Apr, but BLS adjustments turned that into a 2.7 per cent fall.

From next month, however, the seasonal factors will become increasingly adverse. As Kemp pointed on in a note to clients on Tuesday:

Even if gasoline prices level out at the current level (about 385 cents per gallon) BLS will start to escalate them to reflect the seasonal adjustment path. By Dec, BLS will increase its recorded gasoline prices by as much as +15.5% EVEN IF THERE IS NO FURTHER RISE IN PUMP PRICES.

The increase in seasonally adjusted gasoline prices will feed through directly into a steady increase in the headline inflation rate. Gasoline prices account for around 5.5% of the total CPI. If they increase around +15.5% by the end of the year (on an adjusted basis) that will add +0.85 percentage points to the headline inflation rate taking it from +3.9% in the twelve months to Apr to as much as +4.8% in the twelve months to Dec (other things being equal).

So stand by for more benign inflation news in the short term (May’s data will be favourably adjusted) and then a delayed shock thereafter.

Growth Vs Value Performance

Since the bull market began on October 9th, 2002, the S&P 500 is up 84.4%, the S&P 500 Value index is up 102.8%, and the S&P 500 Growth index is up 68.2% (not total return). Since the October 9th, 2007 peak in the S&P 500, however, growth stocks have handily outperformed both the S&P 500 and the S&P 500 Value index. As shown in the second chart below, the Growth index is down 4.93%, while the Value index is down 11.99%. If the market ends up making new highs before hitting the -20% bear market threshold (keeping the longer-term bull market intact), will the second act be led by growth instead of value?

P/E Divergence Between Growth and Value Stocks -- The Wrong Way

Recently, growth and value stocks have seen a big divergence in valuations. One index has an as-reported P/E ratio of 33.66, while the other is at 18.92. The only problem is that it's the value stocks that have the 33.6 P/E, while the growth stocks have the 18.9 P/E. Below we highlight a historical chart of trailing 12-month P/E ratios for the S&P 500 Growth and Value indices. As shown, the Value P/E has spiked significantly in recent months, as supposed value names that typically pay high dividends (financials, etc.) have seen a big drop in earnings. This isn't the first time the divergence has happened, however. After growth valuations spiked during the tech bubble, value stocks followed with their own surge in P/E ratios in late '01 and '02. Ironically, growth stocks have held their value much better than value stocks have in 2008.

The credit crunch in context: banking writeoffs per employee

The credit crunch in context: banking writeoffs per employee

Incredible chart porn from Here Is the City (HT Felix), showing how much firms have either written down or lost, per wholesale banking employee:

The breakdown (headcount estimates are Here Is the City’s own):

1. Mizuho Financial Group - $5.5bn in writedowns / credit losses, 2,000 wholesale banking employees, $2,750,000 per employee.

2. Wachovia - $7bn, 3,900, $1,794,872 per employee

3. UBS - $37bn, 22,000, $1,681,818 per employee

4. Citi - $40.9bn, 30,000, $1,363,333 per employee

5. Bank of America - $14.8bn, 20,000, $740,000 per employee

6. Merrill Lynch - $31.7bn, 48,100, $659,044 per employee

7. Dresdner Kleinwort - $3.3bn, 6,000, $550,000 per employee

8. Credit Agricole - $6.9bn, 13,000, $530,769 per employee

9. Barclays Bank / Barclays Capital - $7.7bn, 16,200, $475,309 per employee

10. JPMorgan Chase - $9.8bn, 25,000, $392,000 per employee

11. Deutsche Bank - $7.6bn, 20,000, $380,000 per employee

12. SG Corporate & Investment Banking - $3.9bn, 10,500, $371,429 per employee

13. Morgan Stanley - $12.6bn, 38,050, $331,143 per employee

14. Credit Suisse - $6.3bn, 20,000, $315,000 per employee

15. Lehman Brothers - $6.6bn, 30,000, $220,000 per employee

16. Goldman Sachs - $4.1bn, 30,000, $133,667 per employee

17. BNP Paribas - $1.7bn, 13,000, $130,769 per employee

The latest missive from UniCredit’s Jochen Felsenheimer argues that times are hard for bears, not least since the recovery in synthetic credit markets

The latest missive from UniCredit’s Jochen Felsenheimer argues that times are hard for bears, not least since the recovery in synthetic credit markets is lasting longer than anticipated.

Moreover, “we are close to very critical levels which might squeeze out the “last bear standing”. This would be the end of the bear market rally!”

The most common arguments why the worst should already be behind us are the following, says Dr Felsenheimer:

i) the recapitalization of the global banking system is in full swing and the fact that financial institutions are able to raise capital in such difficult times shows that the banks are on their way out of the subprime swamp.ii) loss-estimates are exaggerating the severity of the crisis as many losses are only m-t-m losses. Pull-to-par will reduce losses over time, even generating valuation gains in the future.

iii) companies are still in very good micro-fundamental condition. Default rates will not climb to 2002 levels as balance sheet leverage of nonfinancials is not a major threat in this crisis.

But not so fast, because something is different this time - and that’s good news for bears. In other words, the light at the end of the tunnel is the locomotive which is on a confrontation course and will hit us soon:We think that further spread widening is highly likely. While we do not ignore the possibility that we have already seen the spread highs in the synthetic (overshooting) markets, we think that especially cash non-financial spreads will come under pressure.

What could be the impulse for the next widening leg? As already seen two times in 2007 (when officials prematurely proclaimed the end of the crisis), the impulse might come from a side which is right now not on the agenda. In our view, a disappointment on the macro front is the most obvious potential source of further adversity for credit markets.

And it gets better (or worse, depending on whether you’re long or short the iTraxx Crossover):

The latest improvement of sentiment looks to us as wishful thinking rather than marking the spread reversal in credit markets. Many problems are still there and a solution will take longer than currently anticipated. Even US officials are less optimistic than many investors (shareholders). The head of the US Federal Deposit Insurance Corporation said that another wave of more traditional credit stress (linked to an economic slowdown) could come, including mortgage loans.

In addition, there is again bad news from the usual suspects: a Canadian court delayed yet again the restructuring decision for Canadian ABCPs. This is not a big thing, but it will further delay the full re-functioning of the Canadian CP market.

All these arguments are pointing to a longer-lasting problem, which will probably not result in a failure of a big financial institution and not in a fully-fledged credit crunch; but it will have a lasting negative impact on the earnings generation power in the financial industry and weaker growth which will be worse than the slowdown in a “normal” business cycle. This scenario, in our view, is not fully discounted in credit spreads, especially not in synthetic ones.

1990 All Over Again?

In the aftermath of the crisis in the credit markets, many economists have said that the US economy is facing the worst recession in the post WWII area. While the ultimate outcome of the current period is anyone's guess (many are now doubting we will even end up with a recession), we wondered whether investors and economists tend to think every recession (or even period of economic weakness) is the worst ever as they are going through it, and then once it's over say, "Oh that wasn't so bad after all."

For example, the 1990 recession is considered by most to have been pretty mild. But at the time, people thought it was a lot worse. For example, in February 1992 - almost a year after the recession ended - US News and World Report said that, "The current downturn is different. Many cash-strapped homeowners whose houses have fallen in value won't be able to take advantage of the refinancing bonanza promised by the Fed's rate cut. So far, unemployment remains lower than it was a decade ago, but this recession isn't over yet, and the economy's glaring structural problems will stifle growth and new jobs." US News went on to say that the recession would be "unlike any the country has experienced in the post-World War II era, the result of years of profligacy and irresponsible government policies." Sound familiar? For those interested, we highly recommend reading the entire article to see just how negative sentiment was leading up to one of the greatest decades of growth in American history.

In fact, if we were to compare the 1990 period to today, there are many similarities. As just an example, in each period, the dollar was weak, inflation was on the high side, oil spiked, and credit markets were under stress. In both periods there was even a George Bush in the White House! With these similarities, it comes as little surprise that the performance of the stock market has been similar during both periods. In the chart below, we overlaid the S&P 500 in the current period (since October 2007) with the period from June 1990 through June 1991. As the patterns show, for the last six months, the two periods have tracked each other closely. While this is not meant to imply that the S&P 500 is poised for a monster rally, the correlation between both periods is certainly worth noting.

Opportunities from the Credit Crisis?

A presentation entitled: “The Credit/Liquidity Crisis of 2007: Opportunities for US Bond Investors” sounds as though it would leave you with grounds for optimism. Not quite.

Instead, Michael Lustig, a managing director at BlackRock, made it clear that he is extremely pessimistic. The heading for one slide – “Things Are Terrible – And There’s No Sign of a Bottom” – adequately catches the spirit. .

Echoing the Fed’s Janet Yellen earlier in the day, he said he believes the outright falls in US house prices are significant, and make this crisis different from its predecessors. As he said, Americans’ percentage of equity in their homes has fallen below 50 per cent for the first time on record since 1945. This means there is a real danger of negative equity. This time, he fears, is different.

All this being said, he did as promised identify a number of opportunities. They are as follows:

- Cash corporate bonds are cheap compared to synthetic equivalents

- Investment-grade financials may be cheaper than high-yield bonds

- Credit card ABS spreads are at record wides, but biased towards more widening. There is fundamental value in the top-tier names.

- Agency fixed-rate mortgages are cheap, and offer fundamentally good value “even when taking into account the elevated level of volatility, prepayment risk, and negative convexity.”

- Non-agency MBS are historically cheap.

Is this global inflation thing over cooked?

A serious question, in our view, since predictions of Farmageddon (© Donald Coxe) are suddenly everywhere. But witness this chart, using data from the Economist, knocked up by Albert Edwards at Societe Generale:

That’s right - ex-oil, industrial commodity prices have gone precisely nowhere in the past two years.

As Edwards notes in a recent strategy note to SocGen clients, while many general commodities indices have risen some 30 per cent over the past year, the upward move is now very narrowly focused in food and energy. His contention - as controversial as ever:

As US consumption goes into recession, a decline in the US current account deficit will impart a global liquidity squeeze which will, in all likelihood, pop the food and energy bubbles.

Now, Edwards has been around a bit. He’s mindful of the fact that history is littered with examples of protests about food shortages and inflation turning into a fully fledged political protests and ultimately violent revolution:

Amid the mists of time we often forget that it is people’s stomachs rather than notions of political reform that are the catalyst for revolution.

But, while acknowledging the structural arguments underpinning the rise in commodity prices, the SocGen man wonders now whether cyclical market forces might already be saving the skins of the politicos:

I believe it has been the change in the US current account deficit that has been the liquidity pump for the global economy. It is turning and is set to turn even more quickly in the months ahead as the extremely import sensitive US consumer slides into recession. The flip-side of this is that Asian/EM surpluses will decline as exports slow, reducing the rate of FX intervention. This in turn will reduce Asian/EM domestic money supply growth, asset price inflation and hence Asian/EM economic activity still further…

…Until now, continued speculation in commodities was entirely understandable as investors needed to believe in a ‘growth’ story. As in all good bubbles there is truth in the structural bull arguments. I certainly believe them. But the impact of the cycle and liquidity is ignored at investors’ peril. That liquidity pump is about to be switched off. This will be the next round in “The Great Unwind” and will come in addition to the de-leveraging of the credit bubble we have seen to date. Market forces may yet do timid politicians work for them and send food (and energy) prices sharply lower.

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Extra - For those readers expecting some Albert Edward-ian pyrotechnical prose, relax…

The Socgen strategist on UK energy policy:

In the UK for example, PM Gordon Brown recently urged his fellow G7 members to address this issue of the impact of biofuel production on food prices. He wrote “rising food prices threaten to roll back progress we have made in recent years on development. For the first time in decades, the number of people facing hunger is growing”.

Indeed, he has just cancelled the UK’s biofuel subsidy of 20p per litre (the government pockets £550m in the process). How’s that for action? Pretty weird actually when you consider that at the same time the government have introduced the Renewable Transport Fuel Obligation (RTFO) which requires suppliers of fossil fuels to ensue a proportion – initially 2.5% and rising to 5% in 2010 – comes from biofuels. Oil companies will be fined for noncompliance. Call me cynical but methinks the UK’s biofuel policy may have more to do with raising money for the hard up Treasury! Bonkers. Bonkers. Bonkers with knobs on!

The Consensus Play: Hold Tight

One more finding from the poll of CFAs at this week’s Vancouver gathering suggests that they’re still not ripe to make big contrarian plays. There is so much disagreement about where assets should be allocated at present that contrarians do not have a consensus to play against. All the CFAs were asked whether they were advising clients to increase or decrease their holdings in a range of asset classes to deal with the current market environment. The closest approaches to “consensus” plays are that you should not reduce cash (only 16 per cent agree with that) or alternative investments (only 15 per cent propose that) or raise fixed income (proposed by 17 per cent).

On equities, 29 per cent are bulls, calling to increase weightings, and 26 per cent are bears wanting to cut – within the statistical margin of error. There is similar indecision over commodities, the asset class of the moment – 26 per cent want to raise their allocations, and 20 per cent suggest reducing them. Professionals are as confused as everyone else, it appears, by the phenomenal run-up in oil and food prices.

Clients might complain that their managers are not giving them clear guidance. But at least one measure suggests that CFAs have kept their cool, and are satisified that they had it right heading into the critis. For all of the asset classes - equities, fixed income, alternative investments, commodities, or cash - the single most popular option was “no change.”

So if Taleb is so clever...

Nassim Nicholas Taleb ended his speech by predicting that he already knew what the questions would be. And he indeed had a slide ready for the most popular question which was: “If you’re so clever, now that you’ve scared us so much, tell us what we should do to guard against black swans in future?”

Here is Taleb’s list of bullet points for action, from which he swiftly deviated as he warmed to his theme:

1. Sharpe ratios (dividing a poprtfolio’s excess return over a risk-free rate by the standard deviation of the portfolio’s return) are a trap, because they do not predict future Sharpe ratios. So abandon them.
2. Don’t use standard deviations, and instead use mean variation.
3. Diversification doesn’t work. You might need as many as 12,000 companies before it truly works. Another example he uses is profits from the drug industry, which are concentrated in a tiny proportion of successful drugs - so you would need to buy a lot of drugs stocks to be truly diversified.
4. As for derivatives: “Take a walk and see if you can rid yourself of the desire to use derivatives. It’s amazing how little people who claim to know derivatives really know derivatives.”

Perhaps the biggest point he tried to get across in his presentation is that the “black swan” term has been misunderstood. He does not mean that “black swan” events happen a lot, or more often than expected, but that when they do happen they will have truly huge consequences.

Also, he says, people do not understand the link with the concept of volatility. In a market, if returns do not follow a “normal” bell curve distribution (as appears to be the case), volatility will actually be less than the bell curve would predict. For much more than the predicted two-thirds of the time, returns will be very close to the average. Such low volatility, counter-intuitively, is a danger sign that there is a greater risk of true “black swan” events, when returns do deviate from the norm, because it shows that returns do not follow a normal bell curve.

His geopolitical analogy is with Italy and Saudi Arabia. Italy has had many different governments since the war, while the same family has retained power in Saudi Arabia. This means that Italy is the more volatile but, he says, that Saudi Arabia is more risky, because if something does change in the political situation there, it will have much greater consequences.

So on his argument, risk managers should penalise exposure to “tail risks” or extreme “black swan” events. They should not be worried about minimising volatility, as this is not a problem. But, he said in exasperated tones, “we seem to go the other way”.

That, at any rate, is a very brief summary of some of his main points from a long, dense and provocative presentation. He was at least proud that the black swan has now even given its name to a boutique in San Francisco (slogan: “Expect the Unexpected”).

And he did, on occasion, relent in his criticism of his hosts. When one delegate asked if he should bother coming to the rest of the conference, or just take the opportunity to explore Vancouver, Taleb urged him to stay in the conference hall and get more information.

“But if there’s an equation, try to close your eyes until it goes away.”

Seeing the Black Swans coming

Nassim Nicholas Taleb is about to address the massed ranks of the CFA Institute, but it seems plenty of them already know that the market is not totally efficient.

Jeremy Armitage of State Street Associates gave a morning presentation which gave evidence that returns for currencies, bond yields, and the S&P 500 are not “normally” distributed - a key assumption of many risk models which Taleb has gone out of his way to attack. For all three asset classes, the chance of a daily event which is more than 2 standard deviations away from the mean is about 4 per cent, he said. That is significantly higher than you would find under a “normal” bell curve distribution, where this would only happen 2.5 per cent of the time.

In Taleb’s honour, State Street has also gone on a “black swan hunt”. [Taleb’s best-selling book refers to events that could not have been predicted from past behaviour, and which lead to severe market turbulence, as black swans.]

According to Armitage, watching the flows in and out of institutional fund managers can give a clue that a black swan is flying your way. “Black swans migrate,” he says, “when liquidity is at riot point.” This is State Street’s definition of moments when investment flows dry up, showing extreme risk aversion.

Historically, such conditions rarely last long, because they provoke a policy response - generally, the Federal Reserve and other central banks cut interest rates.

But last year, the markets stayed at “riot point” for four months, unprecedented in State Street’s back-tested models. This was a sign that the rally in emerging markets at the end of this year was not to be trusted, and that some black swans may be on their way. With hindsight, we now know this was a good signal.

Other findings from State Street’s research? The foreign exchange carry trade is more or less dead, and will not revive for a while. Using Value-at-Risk models - even though Taleb would disapprove - there is more value at risk now from selling short low-yielding currencies and putting money into high-yielding currencies than at any time in the last eight years.

And the huge divergence between energy and financial stocks does not seem to be driven by liquidity. Indeed, institutions seem to be bullish about financials and bearish about energy, despite the results from the first quarter. That could, according to Armitage, be a signal that the gap is ready to narrow, with financials ready to stage a recovery.

Calling oil wrong

Chart of the day - from John Kemp at Sempra Metals:

Here’s an illustration of how the market has consistently called the future price of oil wrong over the past five years - snapshots of forward prices each November, compared with the reality of crude prices. Since 2003 the forward market has persistently ignored the great oil rally.

So if the market has failed to signal real future prices in the recent past, why should we believe that current market indications will prove more accurate?

It’s an important question - especially when policymakers seem to be citing the curve in forward prices as a signal that oil prices will stabilise in the near-term, taking the heat out of inflation, while hard-boiled oil bulls also use the charts to back predictions that crude will remain above $100 for the next decade.

All of which gets right under the skin of Mr Kemp:

The forward curve does not tell you anything about future realised spot prices AND IT DOES NOT PURPORT TO.

He says there is systematic confusion about what forward prices mean.

The forward curve shows you how much you pay to buy crude oil (or any other commodity) at a future date with a price fixed today. It does not show you how much the market thinks that the commodity will actually cost when that future date arrives. There are a whole variety of premiums and discounts built into the futures prices (including cost of carry, convenience yield, investor premium/normal backwardation, and liquidity) that can cause futures prices to diverge substantially from the market’s best guess of the future spot price (and this is unobservable). Because the premiums/discounts are not static, you cannot back the expected future spot price out from the futures prices.

So, to be clear, the forward price is NOT the market’s collective best forecast for the future spot price.

This is a simple point (well understood as long ago as the 1930s by John Maynard Keynes) but which appears to have been unlearned by much of the investment and policymaking communities in recent years.

Bankruptcies and defaults gather pace

The number of companies defaulting on their junk-rated debt and filing for bankruptcy in North America is now running at its fastest pace in five years. So far this year, 28 “entities” have defaulted, according to S&P. The defaulted debt of the one Canadian and 27 US companies totals $18.4bn, exceeding the 17 US defaults for all of last year. Moody’s said the US is leading the global default rate for speculative-grade companies, which rose to 1.7% in April, up from 1.5% in March and less than 1% last year. The US default rate, however, rose from 1.8% in March to 2.1% in April. Moody’s expects the global default rate to reach 4.98% by the end of the year, with US defaults reaching 5.7%. In Europe, the rate is currently 0.7%.

MCDX: Once munis start down the dark path...

From the people who brought you the ABX, now comes the MCDX, a basket of municipal credit default swaps (CDS). The index will begin trading on May 6 with three, five, and ten year tenors. Markit set the coupon for the MCDX last Thursday night at 35, 35, and 40bps respectively. It started trading today, and traded wider, closing at 42bps for the 5yr tenor and 48bps for the 10-year.

This is a potential game changer in the municipal market. First, we'll go over what the MCDX is, and then how it might change municipals forever.

The MCDX is going to be very similar to the CDX or ABX indices currently trading. It will represent a basket of 50 equally weighted municipal CDS. You can see the list of credits here. These will be recognized by municipal traders as more or less the 50 largest regular issuers of bonds. There are a few AAA credits in there, but mostly AA and A-rated credits. If rated on Moody's Global Scale, the one where Moody's attempts to match muni ratings with corporate ratings, almost all of these issues would be AAA.

There are 26 "general obligation" issuers. These issuers have the legal authority to levy taxes and have pledged their full taxing power to bond holders. 21 of these are states, the other 5 are local municipalities: New York, Los Angeles, Los Angeles School District, Phoenix, and Clark County Nevada.

There are also 24 "revenue" issuers, who don't have any taxing power. The items in the MCDX are of the "essential service" variety, including water and sewer systems, public power, and transportation. The term "essential service" implies that while the issuer does not have taxing power, the local government would have a strong incentive to ensure continued operation. Tobacco and health care issuers are explicitly excluded from the index.

Here is how the index works. A buyer of protection on the MCDX has essentially bought equal amounts of protection on the 50 names in the index. So a $10 million notional trade in the MCDX is de facto $200,000 in protection on each of the 50 names. Should any of the names default, the buyer of protection would deliver an eligible obligation of the issuer to the seller of protection at par. Markit has provided a list of CUSIPs as examples of eligible obligations. Any bond which is pari passu with the listed CUSIP would be eligible.

So why should you care? To date, trading in municipal CDS has been very light, and with good reason. Default rates of general obligation and essential service municipals are almost non-existent. There is a limited number of large and frequent issuers outside of these two categories. So demand from hedgers for specific names is light. There might be demand from speculators who want to bet on the contagion hitting munis. But such a buyer would prefer to make a generalized bet on municipal credit as opposed to picking out individual credits.

The MCDX solves both these problems. Trading desks who want to hedge against municipal credit spreads generally widening can use the basket as a on-going hedge. It wouldn't really matter if the particular names in the index don't match the names the desk owns, since the hedge is really a macro/contagion position. If California runs into major budget problems, odds are that New York CDS would widen at the same time. Obviously this is a better product for a speculator who wants to bet on a broad municipal contagion. So the MCDX is bound to be a hell of a lot more liquid than the single name market ever was.

The implications for the muni market are huge. First of all, it would seem the MCDX will more or less dictate the price of muni bond insurance. It will also heavily influence the spread between insured and uninsured munis. I've heard some talk that such a product would be another nail in the muni insurance coffin, but not so fast. The muni market will remain retail driven, and mom-and-pop investors don't buy CDS. They will still demand insurance.

The MCDX will also heavily influence how munis trade on a given day, especially in institutional size. If dealer desks start using the MCDX to hedge their books, then the daily movement in the index will become part of their P&L. In other sectors, when traders hedges are up, they are a little more willing to cut the price on their long position. The same will happen in munis. If the MCDX is 3bps wider on the day, traders will be willing to sell their bonds 3bps wider too. Well, maybe 2bps anyway. Traders aren't generous people.

It could also start to chip away at some of the old habits of muni buyers. Today municipals are traded mostly on yield. Even if the Treasury bond market is mildly up on the day, muni traders usually don't mark their positions higher. If the MCDX becomes heavily used as a hedging vehicle, traders will want to quote their offerings in terms of their hedges. Thus you are likely to see offering levels altered more often, and possibly even starting to be quoted on spread.

Right off the bat, it almost has to widen. There are going to be more natural buyers of protection (anyone who has a large muni portfolio) than sellers (speculators). So I wouldn't read too much into the movement of the first month of trading. Given that the natural sellers of the MCDX are probably mostly hedge funds and prop desks, I expect municipals to be permanently more correlated with corporate bonds.

All participants in the muni market should become familiar with the MCDX, even if you have no intention of actually trading it. Like the CDX and the ABX before, it has strong potential to alter the market substantially.

Yesterday's Declines Led by Prior Winners

The Russell 1,000 was down 1.73% yesterday. We broke the index into deciles (10 deciles of 100 stocks) based on stock performance during the current rally to see which ones led the declines. As shown in the first chart below, the decile of stocks that were up the most from the 3/10 bottom through 5/6 were down the most yesterday, signaling that investors were simply taking profits in winners.

As in most rallies, stocks with high levels of short interest have been strong performers during the current rally. We also broke the index into deciles based on short interest as a percentage of float to see if highly shorted stocks led the declines yesterday. As shown, the decile of the most heavily shorted stocks was down the most yesterday, while the deciles with lower levels of short interest held up better.

The US Dollar: A Marathon, Not A Sprint

The US Dollar has come in favor to many Wall Street participants in recent weeks. As shown in the charts below, the short-term action of the currency has been bullish, but the longer-term technical picture remains bleak. Using one of the oldest sports cliches in the book, Dollar bulls need to treat this as a marathon and not a sprint.

At its current level of 73.54, the US Dollar index is trading just off the bottom of its long-term downtrend. The next level for bulls to watch is the top of that downtrend at 77. If the currency can break above there, the marathon for a strong Dollar will be about 10% complete.

MERRILL SAYS LEVEL 3 ASSETS JUMP 70% IN FIRST QUARTER

bloomberg

Merrill Lynch & Co. said so-called Level 3 assets climbed 70 percent in the first quarter, as the largest U.S. brokerage reclassified commercial mortgages and other assets as hard to value.

Merrill's Level 3 assets, the firm's most difficult to value, rose to $82.4 billion as of March 28 from $48.6 billion at the end of December, according to a regulatory filing today. The New York-based company's ratio of Level 3 to total assets rose to 8 percent from 5 percent.

Fintag says
Nobody has commented on this. But this is truly shocking and puts Merrill into Bear Stearns territory.

Oil Closing In On $110 Support Level

Oil has been trading in $10 ranges for some time now. Before it broke above $100, oil bounced back and forth between the high $80s and high $90s. After moving above $100, it traded up to $110 and then back down to the $100 support level twice before eventually breaking above $110. Once it moved above $110, it quickly traded up to $120 before once again pulling back. Today's declines in the commodity have pulled it back down to just under $111. The $110 level should act as support here just as $100 did before. If $110 doesn't hold, oil will be in danger of breaking the uptrend that formed from the double bottom made in February.