Firms’ Distressed Debt Cycle Not Over, Pimco Says

 The end is not near for the distressed debt cycle, as many middle-market American companies will still have to be restructured because of debt taken on during the credit boom, Pimco said Wednesday. Reuters reported that while the default rate is falling on junk bonds, it is still rising for leveraged loans to middle-market companies, two Pimco portfolio managers, Stephen Moyer and Michael Watchorn, said on the company’s Web site.


Since November, the default rate on leveraged loans to middle-market companies has risen to about 12 percent from 10 percent, according to Pimco data, which is based on the dollar volume of bonds defaulting.
The dollar-weighted default rate on U.S. junk bonds has fallen to 9 percent from a peak of about 20 percent in November, according to Moody’s Investors Service.

“While many believe the distressed cycle is over, given the rally in the high-yield bond and leveraged loan markets, our research suggests the middle market remains particularly challenged,” the  report said.
Many companies counted on continued economic growth to help them sustain extraordinary debt burdens taken on during the credit boom, Pimco said.

A slower pace of economic growth following the recession will pose a challenge to these companies and their creditors, the fund managers said.

“Many have been bailed out by an accommodative monetary policy that has kept short-term interest rates at near-historical lows and thus reduced interest burdens during a period of declining operating cash flow,” the report said.

“However, these stretched balance sheets are inherently unsustainable in the New Normal,” Pimcosaid, referring to a period of slower growth it expects following the last recession.

Jeremy Grantham: Buy Lumber, Emerging Markets, And "Aberrantly Cheap" Blue-Chip Stocks

Yesterday a host of boldfaced investor names talked up their latest ideas at the Ira Sohn conference.
It doesn't sound as though there were any huge bombshells, though David Einhorn's announcement that he is short Moody's (MCO) and McGraw-Hill (MHP) has generated some headlines (though to be honest, we hadn't realized that was actually news).

Presenting a bullish case was Jeremy Grantham of GMO, who loves blue-chip stocks right now.

Here are the notes of Mike O'Rourke of BTIG:

IN GMO’s 7 year forecast U.S. High quality names are aberrantly cheap and should provide 7.6% real return per year. In constructing a portfolio Grantham said it should be 40% U.S. Blue Chips, 20% Emerging Markets and 30% EAFE Blue chips. Grantham notes that bonds are “grotesquely” overpriced predicted to post a real return 1.7% per year. Grantham’s 3 choices or recommendations are Timber which has 7.5% forecasted real annual return. Then Grantham likes Emerging Markets which he believes will go to a premium P/E to the rest of the world. Finally he likes high quality U.S. blue chaps. They are trading at a 17% discount to fair value and 55% of earnings come from around the world.

The bedrock of Grantham’s thinking is that “Things regress to the mean.” Of the 34 bubbles GMO has identified it takes about 3.5 years for the bubble to run up and it comes back down to the trendline nearly as quickly. All bubbles reverse. Grantham believes both the U.K. and Australia are in housing bubbles. The risks to betting against bubbles are career risk and business risk. Grantham believes debt has nothing to do with growth, and debt has less influence than most think. Grantham concluded by noting the importance of the upward bias in the third year of the presidential cycle.

$SPX is stuck in the middle

Talk about the lost decade. With the May decline, the S&P 500 is trading in the middle of its 10 year range. Note that this is a semi-log scale that reflects percentage change. We are looking at the mother of all consolidations.

Click this image for details

S&P 500 and Sector Valuations

Below is a chart of the trailing 12-month P/E ratio for the S&P 500.  As shown, the current P/E ratio for the S&P stands at 15.68.  This is the lowest level since mid-July 2009.  Since then, the S&P 500 is up 20%, so earnings are up 20% since then as well.  At the market's peak in late April, the S&P 500's P/E ratio was at 17.69, so it has dropped about 2 points since then.  Valuations have dropped the most for Materials, Financials, Energy, and Technology since the April peak.

Going back to the March 9th, 2009 low, the Consumer Discretionary sector has seen the smallest rise in its P/E ratio (15.03 to 15.56).  Back then it had the second highest valuation behind the Financial sector, which had a negative P/E ratio at the time.  Consumer Discretionary now has the lowest valuation of the cyclical sectors, and earnings in the sector have risen significantly along with share prices.

Low Quality Rally Unwind

Bloomberg details:

Corporate bond sales are poised for their worst month in a decade, while relative yields are rising at the fastest pace since Lehman Brothers Holdings Inc.’s collapse as the response by lawmakers to Europe’s sovereign debt crisis fails to inspire investor confidence.

Companies have issued $47 billion of debt in May, down from $183 billion in April and the least since December 1999, data compiled by Bloomberg show. The extra yield investors demand to hold company debt rather than benchmark government securities is headed for the biggest monthly gain since October 2008, Bank of America Merrill Lynch’s Global Broad Market index shows.

Concern that European leaders won’t be able to coordinate a response to rising levels of government debt from Greece to Spain, while U.S. legislation threatens to curb credit and hurt bank profits, is driving investors away from all but the safest securities. The rate banks say they charge each other for three- month loans in dollars has almost doubled since February.

And the corresponding month-to-date low quality (high beta) corporate bond sell-off.

Banks and That Wacky Junk Bond Market

As the high-yield market continues its mystifying robustness, our nervousness grows. Last week, we wondered what lenders and buyers were thinking in fueling all this activity. Today, at the Fourth Annual Debtwire Distressed Debt Forum in New York, we got our answer: the high-yield market is akin to that scene in Reservoir Dogs where five people are all aiming guns at each other. Everyone is fully armed, and someone is going to get hurt.
It turns out that the high-yield market’s record activity is real, but it also disguises some cautiousness and misgivings (whew: we were wondering what they could possibly be thinking). And yet, there is optimism! And yet, that optimism is grounded by fear! Junk-bond pros are on a seesaw.
To get some insight into the market’s ambivalence, we rounded up some of the paradoxes we heard discussed at the conference this morning and contrasted them below, along with our analysis of what it all might mean:

We have record activity: There has been an insanely active high-yield financing market, with a record volume of $33.7 billion in April. Around 75% of the deals are “underwritten,” meaning that banks agree to guarantee the entire loan – the banks will take any unsold portions on their own balance sheets and get hit with the discount if any part of the loan doesn’t get placed with investors. Compare that to 2007, when only 10% of deals were underwritten and more like 90% were “best-efforts” deals in which the banks agreed to guarantee only part of the deal. If the debt didn’t find buyers in a best-efforts deal, the debt itself would be reduced or discounted and the deal shrunk, with no penalty to the underwriters.
And yet we also have: A pool of buyers that has been sliced by half. While there were 300 institutions who were potential buyers of high-yield debt in 2007, there are only 150 such accounts in the high-yield markets of 2010.
What this means: Fewer buyers buying more debt means more concentration - those buyers who are grabbing up high-yield seem to be doing so in quantities. Either they’re really convinced the market will keep soaring, or they’re going to get slammed when it crashes. The fact that so many of the current high-yield deals are “underwritten,” and thus have bank commitments, shows that buyers are looking for more security behind the debt they’re buying.
We have the return of the staple: Even if Fidelity National isn’t happening, private equity auctions are definitely back. Where there are auctions, there are stapled financings: Those little bundles of money that banks promise to buyers to make deals more attractive. True, these staples are not as lavish as those in the boom years, but they are still very popular. One wag we talked to called these more modest staples “paper clips.” There is still one question about them, though: Are they being used? Back in 2006, staples served mostly as a way for buyers to figure out how much of their own financing they needed to raise, and to get a good valuation for the company they were buying. But now, in 2010, financing is hard to come by, and we wouldn’t be surprised if buyers are a little more interested in staples.

And yet we also have: Banks getting more involved in high-yield underwriting than ever, but shying away from underwriting dividend recaps (refinancings of current debt-heavy portfolio companies). These deals have trouble clearing the market. So banks are willing to promise financings upfront (through staples) but good luck getting a commitment once a company is really in trouble after all that debt.
What this means: Smaller deals, but more activity. Staples used to be a feel-good gesture to make deals look friendly, usually in the middle-market range of $200 million to $2 billion. If staples actually come into play more often, banks will be committing to making leveraged loans again and you’ll have to watch their commitments closely. Let’s hope they don’t keep it on their balance sheets this time.

We have the return of bridge financings (even though Jamie Dimon once called them a terrible idea): In a bridge financing, a bank will loan a private equity firm a certain amount of money to cover the costs of an LBO between the time the deal is signed and the time that the longer-term financing actually becomes available. This ended up being full of pitfalls in 2007 as banks had trouble syndicating the loans, or selling them to other investors. The result: hung bridges, bad-loan exposure of nearly $200 billion, and deep writedowns as banks had to reduce the value of loans that became unmarketable.
And yet we now have: Bridges with terms that are designed to protect banks. It is true that banks are promising bridge financings again to private equity firms. But look deeper, and those loan terms show a certain skittishness. Banks are writing the contracts so that they only have to hold the debt for a short period of time, for instance - sometimes as short as four months. They also make more provisions for what bankers call “market-flex,” or the ability to change the loan’s price or structure in order to attract buyers. While PE firms only see that they’re getting bridge commitments from banks again, the banks are protecting themselves.
Overall, the paradoxical state of the high-yield market’s workings show that both private equity firms and banks are pursuing their old agendas again, even if they’ve dressed in stronger armor. They have two common goals:

1. Getting new deals (and thus new fees) in through the door;
2. Pushing off that massive wave of maturities for a little bit longer.

Banks and PE firms need both new fees and later maturities to survive. Finally, aligned interests in the high-yield market. Who woulda thunk it?

Kass: Fear Is the Rational Buyer's Friend

Doug Kass

05/20/10 - 02:00 PM EDT

Coincident with lower share prices around the world, the business media this week have been inundated by negativity on the part of nearly every talking head. This comes as we are told by nearly every heavyweight during a high-profile hedge fund conference in Las Vegas that "risk is coming off," and all of them basically said the same thing to CNBC's David Faber in a series of interviews yesterday.
What is even more surprising is that many of the aforementioned observers and practitioners are so certain in their views. (I wonder at the certainty in an uncertain world, but that is a topic for an entirely different conversation!) This sort of glibness was in place by some of the same people when the S&P 500 recently rose above 1,200, but at that time, they were nearly all bullish.
The negativity of groupthink that exists today was best displayed last night on "Fast Money," when one of the commentators (a friend of mine) even apologized for being bullish!
I know most of the negatives -- I have been writing about the nontradtional headwinds for several months.
High on my list has been the long tail and aftershock of a cycle characterized by the egregious use of debt and credit. Dubai, Greece, Spain and Portugal are the residue of that cycle, but it is also likely the end, not the beginning, of the consequences. The IMF/E.U. financing packages aimed at stemming the contagion are bold, and they have been treated as negatively as the Federal Reserve and Treasury's programs to stem the carnage in the U.S. banking industry and the swift 2008 downturn in the domestic economy. Moreover, the associated austerity measures over there, if enacted, would likely improve the intermediate-term outlook for the affected economies and capital markets.
Also on my list is populist policy (leading to generally increased regulation such as bank and financial reform and higher taxes), which is an outgrowth of a public outcry that reflects the perception of a growing schism between the haves and the have-nots. It, too, is growth-deflating. But, that policy and its ramifications are well known and, quite possibly, serve the public good in the long run.
As stocks drift lower, skepticism ascends and shorts mount up, fear should be seen as the friend of the rational investor, and many stocks that I follow are approaching or are already at attractive price levels.
While most are now fearful, especially those who base their investment decisions on price momentum, I view individual stock opportunities on a fundamental basis, and based on my company contacts and channel checks, the domestic expansion is alive and well. It is interesting to note that the U.S. real private economy does benefit somewhat from slowing developed world (European) growth in the form of lower interest rates and lower commodity prices (especially of an energy kind).
I still have issues regarding a self-sustaining domestic expansion, and I understand that many of these factors limit market and economic upside. Things are different this time, but there is little question that the domestic economy's momentum is relatively healthy.
And while I recognize that the situation over there (in Europe) is trumping the situation over here (in the U.S.), we are, to a large degree, ring-fenced from Europe's uncertainty.
With the domestic economy in gear, an $85-a-share 2010 S&P profit in sight and interest rates/inflation quiescent, stocks, in the aggregate, are moving toward levels of value.
A conservatively constructed valuation model produces a S&P objective of about 1,250 to 1,270 (15 times P/E, which is lower than the long-term average but higher than the current 13 times), for about a 15% upside (based on trendline earnings, normalized interest rates, reasonable inflation assumptions and conservative estimates of the equity risk premium).
Buy high, sell low? Not me.
Color me less bearish.

Deflation Risk is the Bigger Issue

Many economists and analysts are predicting for higher rates due to increasing inflation expectations along with concerns of massive debt supply. According to Bloomberg’s economic forecasts page, surveys suggest that the Federal Funds rate will increase by 25 basis points starting the fourth quarter of 2010. Furthermore, the yield on the 10-Year will have a four handle by the time we ring in 2011.
JP Morgan’s Client Treasury survey released this morning suggests that 92 percent of total institutional clients are either sitting on the fence and are neutral relative to their benchmarks (74 percent) or short (18 percent), which implies they are expecting higher rates. Keep in mind that not all fixed income portfolio managers make interest rate calls and are willing to pick a side. So no matter how extreme interest rates may be, expect a good portion to always be neutral. However, the survey also looks at clients who are considered “active”. Among those active clients, no one is long their benchmarks despite a seismic shift both in interest rates and sentiment with a debt crisis that threatens a global recovery.
I should add that if you look at JP Morgan’s survey data over the last three years, you will find that the predictive power of future interest rates is poor at best. If you were to follow the herd in trying to determine where interest rates are going, you are better served by sitting on the couch, conserving energy and throwing darts at board. (I’ll show my findings another time)
In any event, I still don’t get it. Investors should be concerned about deflation and lower rates, and not inflation.
The Core Consumer Price Index (CPI) which is an inflation measure and excludes prices on food and energy, is dangerously low. While it is still in positive territory, Core CPI could decline even further regardless of the economy experiencing a recovery or not. Core CPI has collapsed after almost every recession dating back to 1958. Of the eight past recessions (not including this most recent one), Core CPI has declined in seven of them. The one time it did not drop was during the recession in the early 60’s where the inflation index moved from 0.7 percent in February 1961 to a peak of 1.6 percent in March 1962. Suffice to say, core inflation grinded its way back to 1.0 percent by May 1963.

Inflation Declines After Recessions (Data Provided by Bloomberg)

In order to have inflation and to drive prices higher, resources need to be relatively scarce in the face of rising demand. Capacity Utilization, which measures the actual output produced as a percentage of potential output given current resources, continues to hover in the low 70’s, citing idle and slack resources in the manufacturing sector. Typically, during periods of growth, the Capacity Utilization percentage should exceed 80 percent.
Along those same lines, unemployment is still high with an uptick to 9.9 percent and to 17.1 percent in the national rate and the U-6 measure, which includes discouraged workers, respectively . With the slack in employment, wage growth, which would translate to higher demand for goods and service, will be subdued for quite some time.
From the onset of this recession, the U.S. economy lost 8.3 million jobs as non-farm payrolls posted negative numbers in 23 of the 24 months for the period ending December 2009. There is reason for optimism though as non-farm payrolls has posted positive gains in 2010 totaling 573,000 jobs added. Unfortunately, we have a long way to go before getting back to employment levels from before the recession. Assuming this rate of job growth remains stable of adding 143,000 per month (573,000 divided by 4 months), it will take roughly five years and get us to the middle part of the next decade to recover from the 8.3 million jobs lost.
Depressed asset prices certainly are not helping the case for higher inflation. Housing prices are still low and will continue to remain low with some people predicting a double dip. Housing price pressures will persist as “strategic foreclosures” become in vogue, where people who are able to pay their mortgage walk away as the value of their homes are marked below the outstanding loan amount. Furthermore, the bigger issue going forward is the large amount of commercial real estate loans that will be coming due in the next four years. These loans, which many of them are underwater due to the massive decline in prices, will need to be rerolled into new debt. Failure to do so, will result in more defaults which will place even greater pressure on prices and loan growth, which is an ingredient to inflation.
Then, there is the argument of higher future taxes due to reining in federal spending and higher debt loads. Higher taxes, which seem certain here in the US, can cripple spending which in turn, leads to slower economic growth. As we all know from what we may see in Europe, the prospects of slower growth could lead to downward pressure on prices.
I am sure people will point out that surging debt levels will ultimately lead to inflation and higher yields. A case in point could be a country like Greece with high debt levels relative to the rest of Europe. While valid, the issue with Greece is not so much of question of debt load but more so an issue of structural issues with the EU and Greece’s inability to devalue and finding lenders willing to finance them.
Japan is probably a better comparison due to the fact that they suffered through a meltdown but has continued support in the capital markets. The country of the rising sun currently has a public debt to GDP ratio of 190 percent surpassing the United States and Greece. Since the beginning of this decade, Japan has increased its debt burden from 103 percent to its current levels. During that time the yield on 10-Year Japanese Government Bonds started at 1.66 percent and has stayed range bound with an average of around 1.46 percent. Currently, the yield is even lower at 1.30 percent.
While the Japanese situation of financing debt with more debt is of great concern and for the most part unsustainable in the long term, higher debt doesn’t necessarily lead to inflation and higher yields in the short term. With Japan, deflation in the aftermath of an asset bubble meltdown followed by slow growth and productivity, is a lingering problem that has plagued their economy for quite some time. Going forward, that trend may continue even further.
Given where the US stands now coupled with the debt crisis in Europe that could lead to another credit crunch, deflation is a bigger risk that most people are not even considering.

Too Early for "Not This Again"?

The pickup in volatility over the last couple of weeks has some investors saying "not this again," as memories of 2008 and early 2009 come to mind.  While volatility has picked up, we've got a long way to go before we get back to the crazy daily moves we saw a couple years ago.  Below is a chart of the one-month rolling average absolute daily change for the S&P 500.  Over the last month, the average absolute daily change for the S&P has been +/-1.32%.  This is the highest level seen since mid-2009, but it was a routine level in 2008 and less than a third of the peak readings seen in late 2008.  From October to December 2008, the S&P was averaging a daily move of 3.5 to 4.5%.  Yes, recent market action has caused some concern, and it could be the start of something bigger (although we don't think so), but on the market richter scale, where now at about a 3.5 if Q4 2008 was a 10.

A DEFLATIONARY RED FLAG IN THE $U.S. DOLLAR

If the chart below doesn’t grab your attention then few things will. In my opinion, the performance of the dollar is the surest evidence of the kind of environment we’re currently in. The surging dollar is a clear sign that inflation is not the concern of global investors. This is almost a sure sign that deflation is once again gripping the global economy and should be setting off red flags for equity investors around the world.
The recent action in the dollar is eerily reminiscent of the peak worries in the credit crisis when deflation appeared to be taking a death grip on the global economy and demand for dollars was extremely high. The recent 16% rally in the dollar is a sign that investors are once again worried about the continuing problem of debt around the world and they’re reaching for the safety of the world’s reserve currency – the dollar. As asset prices decline and bond yields collapse this is a clear sign that inflation is not the near-term concern, but rather that the debt based deflationary trends continue to dominate global economic trends.

This is exactly the kind of market action we saw leading up to Lehman Brothers. In 2008 the dollar rallied as signs of deflation began to sprout up. This was an instant red flag for anyone who understood the deflationary forces at work (and a total surprise for the inflationistas). The dollar ultimately rallied 26% from peak to trough. Coincidentally, the dollar had rallied 16% from trough to peak just prior to the Lehman collapse when the dollar surge accelerated.

Of course, the inflationistas will argue that gold is rising in anticipation of inflation. In my opinion, this is incorrect. First of all, if inflation were a major global concern the Goldman Sachs Commodity Index wouldn’t be almost 65% off its all-time high and just 33% above its 2009 low. Second, and perhaps most importantly, bond yields around the globe wouldn’t be plummeting if there were rampant inflationary fears. For a much more detailed analysis on the reasons why inflation is not a near-term concern please see here.

As for the gold rally, I think it’s clear gold is rallying in anticipation of its potential to become a future reserve currency. The potential demise of the Euro has become a rally cry for inflationistas who don’t understand that the Euro is in fact another single currency system (like the gold standard) which is destined to fail. In the near-term, the rise in gold is likely justified as fear mongering and misguided governments increase demand for the yellow metal. Ultimately, I believe investors will realize that there is little to no inflation in the global economy and that the non-convertible floating exchange systems (such as the USD and JPY) are fundamentally different from the flawed currency system in place in Europe.

Debt deflation continues to plague the global economy. Thus far, policymakers have been unable to fend off this wretched beast and I attribute this largely to the widespread misconceptions regarding our monetary systems. This extends to the very highest levels of government and the misconceptions regarding the EMU, the Euro and the vast differences in their monetary system have only exacerbated the problems and are likely to further worsen the global deflationary threat. The ignorance on display here borders on criminal in my opinion as governments impose harsh injustices on their citizens due entirely to their own lack of understanding.

I’ve mentioned repeatedly over the course of the last 18 months that government responses to the credit crisis were misguided and unlikely to resolve the structural problems. I’ve also mentioned that this was something I have sincerely hoped I would be wrong about as the consequences have the potential to be enormously destructive. Unfortunately, the policy responses have been so tragically misguided that I now believe the global economy is on the cusp of a potential double dip. And as Richard Koo says, the second dip has the potential to be far worse than the first because investor confidence is shattered (which is clearly the case on the back of the recent market crash). Policymakers are doing little to rectify confidence and have in fact, through their ignorance of the way in which our monetary system actually functions, only increased the global risks in the economy. The dollar is the surest sign of the lack of faith in the policy response and an enormous red flag for risk markets. Allocate accordingly.

PS - There is a video going around called “Melt-up” and it is receiving a HUGE amount of attention on the internet. It is regarding the recent melt-up in stocks and how the U.S. is about to enter an inflationary spiral and a currency collapse. I would recommend to the good readers here at TPC to ignore this video. It is 100% factually incorrect (well, more like 75%) and full of the same fear mongering misconceptions that fuel the asset destroying portfolio strategies of well known inflationistas (we all know the names). Videos like these are based on the same misconceptions regarding the monetary system that have actually led to the current debacle. Positioning yourself for hyperinflation and a U.S. dollar collapse has been a recipe for disaster and will continue to be a recipe for disaster as debt deflation remains the single greatest risk to the global economy.

Wall Street 2 Review from Cannes

By: Roger Friedman in Movies // May 14th, 2010 at 4:55 AM EDT

Oliver Stone’s “Wall Street” sequel, subtitled Money Never sleeps, is a hit. It’s a formula Hollywood movie in the great sense. For the first time in a long time, the formula works.
There are many good things to say about Money Never Sleeps. The script sings and zings with excellent dialogue and memorable one liners. It’s a simple story of greed and morality, with a twist you can see from the beginning. But the players are winning, and Stone doesn’t get bogged down. He plays the 2008 financial crisis like an end of the world movie. It’s “Deep Impact” but the falling Dow jones averages are meteors hurting to Earth.
Michael Douglas returns as Gordon Gekko after 23 years. It’s a slow starter performance, deceptively sly. I kind of prefer him this year in “Solitary Man,” but don’t be mistaken: as he says in the film, Gordon Gekko is back.
Lots of great supporting performances: Shia LeBoeuf, Josh Brolin, Carey Mulligan, John Mailer, Susan Sarandon are all great. Eli Wallach is just perfect as the head a sinking Wall Street firm. He’s 93 and better than ever. Charlie Sheen has a welcome, winning cameo as Bud Fox. Sylvia Miles returns as the cranky real estate agent.
WS2 should be released now, not in the fall. It’s very timely. Maybe greed is good now, but so is this movie.
More to come…

Did a Big Bet Help Trigger 'Black Swan' Stock Swoon?

Shortly after 2:15 p.m. Eastern time on Thursday, hedge fund Universa Investments LP placed a big bet in the Chicago options trading pits that stocks would continue their sharp declines.
On any other day, this $7.5 million trade for 50,000 options contracts might have briefly hurt stock prices, though not caused much of a ripple. But coming on a day when all varieties of financial markets were deeply unsettled, the trade may have played a key role in the stock-market collapse just 20 minutes later.

Kara Scannell discusses Congressional hearings that seek answers to last Thursday's sudden market plunge. The exchanges also agreed to new temporary trading limits on individual stock moves, reaching a "structural framework for strengthening circuit breakers."

The trade by Universa, a hedge fund advised by Nassim Taleb, author of "Black Swan: The Impact of the Highly Improbable," led traders on the other side of the transaction—including Barclays Capital, the brokerage arm of British bank Barclays PLC—to do their own selling to offset some of the risk, according to traders in Chicago.
Then, as the market fell, those declines are likely to have forced even more "hedging" sales, creating a tsunami of pressure that spread to nearly all parts of the market.
The tidal wave of selling fed into a market already on edge about the economy in Europe. As the selling spread, a blast of orders appears to have jarred the flow of data going into brokerage firms, such as Barclays Capital, according to people familiar with the matter.
Exchanges, in turn, were clogged by huge volumes of offers to buy and sell stocks, say traders and exchange executives. Even before some individual stocks collapsed to just a penny a share, data from the NYSE Euronext's electronic Arca exchange started to appear questionable, say traders.

Nassim Taleb

In the disarray, some huge superfast-trading hedge funds that now provide much of the liquidity for the stock market pulled to the sidelines. The working theory among traders and others involved in the exchange meltdown is that the "Black Swan"-linked fund may have contributed to a "Black Swan" moment, a rare, unforeseen event that can have devastating consequences.
"Universa alone couldn't have caused the meltdown," said Mark Spitznagel, Universa's founder. "We had reached a critical point in the market, and it was poised to collapse." Barclays Capital declined to comment.
As more details of Thursday's collapse become clear, there is less evidence to suggest a "fat finger" data-entry error caused the collapse. Instead, the picture is one of a rare confluence of events, some linked, some unrelated, that exposed weaknesses in the stock market large and small. Within five minutes, the Dow Jones Industrial Average had lost 700 points as trading seized up in individual stocks such as Procter & Gamble and even exchange-traded mutual funds.
"It did point out that there is a structural flaw," said Gus Sauter, chief investment officer at Vanguard Group. "We have to think through how you preserve the immediacy and yet preserve the liquidity."
The episode highlights a bigger question about the stock market. In recent years, the market has grown exponentially faster and more diverse. Stock trading's main venue is no longer the New York Stock Exchange but rather computer servers run by companies as far afield as Austin, Texas; Kansas City, Mo.; and Red Bank, N.J.
This diversity has made stock-trading cheaper, a plus for both institutional and individual investors. It has also made it more unruly and difficult to ensure an orderly market. Today that responsibility falls largely on a group of high-frequency traders who make up an estimated two-thirds of stock-market volume. These for-profit hedge funds look out for their own investors' interests and not those of investors in the stocks they trade.

Photos from left: Abacausa; Associated Press; Agence France-Presse/Getty Images

Hours before the panic began, there were signs that Thursday wasn't shaping up to be a humdrum day. By 11 a.m., when the Dow was down only about 60 points, selling volume was unusually heavy. One measure of selling—the percentage of stocks falling without first moving upward—was at its highest since the day the market reopened after the Sept. 11 terror attacks, according to Barclays.
By 2 p.m., financial markets of just about every sort were under significant strain. In Europe, the spillover from the Greek debt crisis led to a huge drop in the euro against the dollar and the Japanese yen, as well as a broad bond-market decline. European banks were charging each other higher interest rates to borrow money.
Some 2,800 miles away from Wall Street, in Santa Monica, Calif., Universa placed its trade.
The trade wasn't out of character for Universa, which has about $6 billion under management. Mr. Taleb, who is an adviser to the firm and an investor, gained fame for "The Black Swan," a book that suggested unlikely events in the financial markets are far more likely than most investors believe.
Universa frequently purchases options contracts that will pay off if the market makes a sharp move lower. It posted big gains in the market selloff of late 2008 and launched a fund last year designed to benefit if inflation surges.
Through the trading desks at Barclays, Universa bought 50,000 options contracts, according to people familiar with the matter. The contracts would pay off about $4 billion should the Standard & Poor's 500-stock index fall to 800 in June. It was at 1145 points at the time of the trade.
Back across the country in Chicago, the big trade appeared to have had an immediate ripple in the markets. The traders on the other side of the Universa trade were essentially betting stocks wouldn't post big losses.
But to minimize the risk of losing money, they in turn needed to sell, according to traders.
The more the market fell, the more the traders at places like Barclays had to sell to protect their own positions. This, along with likely dozens of other trades across the market, led to a cascade of selling in the futures markets.
As the stock-trading volume soared, data systems across the stock market began to get clogged. At Barclays Capital, a market data feed that delivers to the firm data on "buy" and "sell" orders went down, although a backup system immediately went online without any impact to the firm.
As the turmoil unfolded, every second saw some 300,000 pieces of stock information—stock prices moves, trades—pour into Barclays's system. A normal peak is some 60,000 ticks a second, says Barclays Capital's head of electronic trading sales, Brian Fagen, who was monitoring the chaos in the market on his screens.
Large hedge funds were juggling huge positions as volume spiked. Two Sigma Investments LLC, a New York hedge-fund manager that engages in complex trading strategies, saw its highest-volume day since launching in 2001, according to a person familiar with the matter.
By 2:37 p.m., the overload seemed to have taken its toll on the NYSE's Arca electronic-trading system. At that point, its rival, the Nasdaq, owned by Nasdaq OMX Group Inc., detected what it felt was questionable information in the data. It sent out a message saying it would no longer route quotes to Arca.

This step, known as declaring "self help," doesn't happen often among the major exchanges. But in the coming minutes, the BATS exchange also stopped automatically routing orders to Arca.
For a crucial set of players—high-frequency-trading hedge funds—all this turmoil was becoming too risky to handle. One fear that would prove all too real was that in the extreme swings, some, but not all, trades would later be canceled, leaving them on the hook for unwanted positions.

—Paul Vermilya

Manoj Narang, whose Tradeworx Inc. firm runs a high-frequency trading operation in Red Bank, N.J., began to worry the extreme volatility could lead to painful losses in his fund.
At about 2:40, he and a small team of traders scrambled to close the positions held by the high-speed fund, which trades rapidly between stock indexes and the individual stocks in the index.
Normally, it takes about a fraction of a second to unwind the trades because of the high-powered computers Mr. Narang uses. But as the market plunged, it took about two minutes—an eternity in today's computer-driven market. Tradebot Systems Inc, a large high-frequency firm based in Kansas City, Mo., was also seeing chaotic action in many of the securities it traded and decided to pull back from the market.
With the high-frequency funds either selling or pulling out of the market, Wall Street brokerage firms pulling back and the NYSE temporarily halting trading on some stocks, offers to buy stocks vanished from underneath the market. Normally there can be hundreds of offers to buy the iShares Russell 1000 Growth Index exchange-traded fund, but at 2:46 p.m., there were just four bids north of $14 for a fund that had been trading at $51 minutes earlier, according to data reviewed by The Wall Street Journal.
Around 3 p.m., the selling pressure abated. Just as swiftly as the market fell, it recovered ground. One factor behind the swift recovery, traders say, were funds that use computers and formulas to sniff out bargains in the market. These funds swooped in on hundreds of cheap stocks, helping push the market higher.

The Dollar's Recent Impact on Stocks

The recent market declines have coincided with a big spike higher in the US Dollar.  When the dollar is declining, companies that generate a large portion of their sales outside of the US benefit.  When the dollar is rising, companies that generate most of their sales inside the US benefit. 

From our International Revenues Database, we pulled all companies that generate more than 50% of their sales outside of the US as well as all companies that generate all of their sales inside the US.  We then calculated the average performance of both groups since the market peaked on April 23rd.  While the average performance of all S&P 500 stocks since 4/23 has been -8.01%, the stocks that generate the majority of their sales outside of the US have declined by 9.32%.  Conversely, the stocks that generate zero revenues outside the US have only gone down 6.74%.  If you're looking to "beat the market," right now it pays to be focused on domestics.

High Yield Bond (HYG) and Preferred Stock (PFF) ETFs Crater

The High Yield Bond ETF (HYG) and Preffered Stock ETF (PFF) have cratered over the last half hour, giving up any gains they've made over the last six months and more.  These are HUGE moves lower that came out of nowhere.

Well, That Was Interesting

This post was timely!

Following a tough two days, we momentarily saw a complete meltdown as liquidity completely disappeared from the market (due to potential computer errors?). The below ETFs broke away from their respective benchmarks at times, but the chart below provides a sense into just how disorderly the sell-off was at times (daily peformance in red, how far things sold-off in yellow).



Update: want some insight into what happened today? I think this covers it.

Where Things Stand

The dust has settled on the trading today, so where does the S&P 500 stand?  On a closing basis, it might not be as bad as you think.  As shown in our trading range chart below, the S&P 500 is now just into oversold territory and trading right at the bottom of a one-year uptrend channel.  From a breadth perspective, only 28% of stocks in the index are now trading above their 50-day moving averages.  This is right near the lows seen during the prior big pullbacks over the last year.  Needless to say, tomorrow and the next few trading days will be very important.

Core-and-Satellite

Quite a number of the financial advisors we work with adhere to a core-and-satellite portfolio system.  But what should be the core and what should be the satellite?  Often funds with broad market exposure, usually indexes, are considered to be the core exposure and anything else is part of the satellite.  However, I have often argued that tactical allocation funds (like our Global Macro separate account, or DWAFX and DWTFX), because of their ability to adapt to numerous investing environments, really should be considered part of the core allocation.
Morningstar’s Christine Benz, in her article  What’s a Core Holding, Anyway? addresses the definitional issue of what constitutes a core holding.  According to her thinking:

One commonly held definition of a core holding is that the investment provides broad exposure to a large part of the market and gives you a lot of diversification in a single shot.

This is pretty much the textbook definition.  She goes on to say that a statistic like r-squared can be used to differentiate core from non-core funds.  Steve Raymond in Dorsey, Wright’s Richmond office, for example, has regularly pointed out that most large-cap funds have r-squares near 0.9, indicating a similar profile to the broad market index like the S&P 500.
But then Ms. Benz gets to the heart of the matter:

However, there’s a big problem with strictly defining what’s core by its level of market correlation. Many great investors–in fact, I’d argue, most great investors–couldn’t give a hoot about whether their portfolio or performance tracks that of a broad market benchmark. Instead, they go where the opportunities beckon, regardless of whether they end up heavily skewed toward a single market segment or not. Such investors’ performance may veer significantly from that of broad market indexes at various points in time–sometimes for better, sometimes for worse. They know that getting ahead of the market over the long haul is what matters, and most would probably argue that concepts like R-squared and “tracking error” are the domain of money managers, not real investors.

This is so great that I wish I had written it!  I added the boldface type, because I think what she said is ridiculously important.  Most great investors don’t care about tracking a benchmark.  They care only about long-term performance and they will go wherever they need to go to get it.  That is the essence of a systematic approach to global tactical asset allocation, and exactly why I would argue that it should be classified as part of a portfolio’s core.

Bye-bye beta-driven opportunities, hello diversity for hedge fund investors

According to the latest figures and accompanying analysis from Credit Suisse Tremont’s April Hedge Fund Index report (click here to download), hedgies are on fire, with collective returns of 3.1% in the first quarter, outperforming traditional equity and bond indices and moving them further towards recouping financial crisis-induced losses.
As of the end of March, funds had earned back more than 90% of losses made in 2008, according to the results complied from the group’s analysis of more than 5,000 funds. Those following event-driven strategies – profiting from things like merger and acquisition activity, bankruptcies and corporate restructurings – were the top performers, posting an average return of 4.8%.
Of particular interest in the report, however, was that while the majority of hedge funds posted positive first-quarter returns, beta-driven investment opportunities generated by the market rallies of 2009 have become scarcer, while most equity market performance expectations remain below their 2009 levels.
“As a result, we believe that manager returns are currently less driven by system­atic or beta risks than they have been in the last five years,” the report said.
This argument is illustrated in the chart below, which shows the 12-month rolling beta of the Broad Index to the MSCI World equity index. On closer look, it can be seen that the beta of hedge funds to global equity markets has continuously trended down since its spike in 2008-2009 and is now at its lowest level since 2004.

Source: Credit Suisse Tremont

The result, according to CS Tremont, is a new wave of diverse strategies that aim to capitalize on distinctive market opportunities, which in turn have allowed hedge funds to produce stable and positive returns irrespective of equity market movements through the first quarter.
Anecdotally, this is true: contrary to before the crisis when the vast majority of new strategies were long/short, a quick glance at BarclayHedge’s new fund launches shows a variety of strategies ranging from fixed-income diversified to distressed, options-focused and even metals and mining.
Event Driven is a particular example, according to the report, where gains were largely gener­ated through exposures to event driven distressed credit opportunities, where the majority of managers’ positions were related to singular market events such as bankruptcy or restructuring situations. Event Driven managers have also taken steps to monetize long equity exposures that have reached price targets while restructuring their remaining exposures to reduce market risk.
“Many believe that expectations for this sector continue to be favorable for the remainder of 2010 as credit opportunities could continue to generate alpha,” the report said. “Some also feel that Merger Arbitrage-focused managers may be in a beneficial position going forward as an increasing number of global mergers and acquisitions, as well as corporate consolidations and restructur­ings, could provide an increased number of prospective deals.”
And the line between hedge funds and other types of retail investment products continues to blur, with hedge fund managers opening their doors to new types of inves­tors through the launch of retail vehicles such as UCITS III funds, exchange-traded products and mutual funds, according to CS Tremont. (Click here for AllAboutAlpha’s recent coverage of UCITS-focused hedge funds).
The report further noted that accompanying better returns was also improved liquidity conditions, particularly with respect to “impaired” assets, and a rebound in asset flows. CS Tremont estimates total assets under management globally at around $1.5 trillion, with expectations of potentially breaching the $2 trillion mark before the end of 2010 (see two additional charts from the survey below).

Source: Credit Suisse Tremont

Source: Credit Suisse Tremont

It’s all yet another feather in the cap for an industry still trying to convince institutions and individuals alike that alternative strategies were – and still are –a good thing, even though they collectively lost close to 20% during the Great Recession.  It’s one thing to produce great returns in bull markets, and not-so-bad returns in bear markets. It’s quite something else convincing investors that losing 20% – and having access to your money cut off – was a lot better than losing 40%.

The Return of Volatility?

The S&P 500 is currently trading down sharply on the day at -2% or so.  If the index closes down more than 1% today, it will have been up more than 1%, down more than 1%, up more than 1%, and down more than 1% over the last four trading days.  As shown below, this would be only the fourth such occurrence over the last 50 years.

Goldman Sachs CDO?

Caveat emptor, caveat venditor, caveat utilitor. Buyers, sellers and users beware of opposite outcomes and opposing forces. What if the Timberwolf and Abacus deals had not blown up? Brilliant buyers treated now as gurus for their perspicacious positioning? Goldman Sachs cited for not disclosing to loser shorts that longs were betting against them? Michael Lewis writing "The Big Long" about credit experts picking off bears that wandered into the doomsday machine? Gregory Zuckerman with the "The Worst Trade Ever" how an obscure merger arbitrage specialist called John Paulson went out of business style drifting into subprime CDOs? Magnetar sucked into black hole oblivion? Dr. Michael Burry back on double shifts at the hospital? Would there still be a misrepresentation case? Would it be on front pages? Rely on deal arrangers or do your own homework? If you need a friend get a dog.

Today I took the risk of renting a car. Driving out of the airport I saw some moving in the OPPOSITE direction. The deal documentation had NO disclosure about this risky two-way flow. Due diligence revealed that despite heavy regulation and licensing, these dubious inventions kill over 1,000 people each DAY from such collisions! Again zero mention in the legal paperwork and scandalous misrepresentation of the hazards. Did they commit fraud by failing to inform of the dangers. I even saw a "rogue" employee knowingly bet against me going north while I was heading south. Such conflicts of interest and idiotic innovation needs to stop before more people die using toxic products like cars. Ban derivatives trading so ban driving since it is more risky? The world thrived for a long time before "monstrousities" like C-D-Os and C-A-Rs were created. Get CDOs wrong and just lose money but with CARs it's lives.

Though synthetic CDOs can't be traded by some individuals, calamitous CARs are widely available. Wary of malicious marketing practices and the non-disclosure of risks and opposing agents of destruction, I fled to the relative safety of the markets. I selected 500 dodgy (in my humble opinion, at the time) reference securities to bet against. Luckily a broker's quantitative geeks had already assembled a structured derivative product for that equity tranche. I short sold the basket portfolio but the intermediary neglected to alert longs that I and possibly traders at the sponsoring firm might bet against them. Even the salesperson herself confided in an email that she was bearish but her function was to facilitate client transactions regardless of personal or her firm's market views. Anyone long the SPY ETF asset-backed security and not made aware of this negativity has recourse to regulators?

Alpha is a war and battles have casualties. Alpha capture is a zero-sum ADVERSARIAL system. Crowded beta is "cheap" but insightful analysis and variant perception costs 2 and 20 and up. Contrasting views make a market. It is naive and suboptimal to presume the counterparty is on your side. The juxtaposition of ideas helps prick bubbles earlier than on a one-way street. If I buy a security I want as many smart people as possible hoping I am wrong. If I short sell I am most comfortable when sophisticated professionals are buying and expert analysts regard it as a core long. You can ONLY find alpha when others lose. A rating of "strong buy" on a stock or "AAA" on a bond is just someone's opinion. It is up to investors to do their own analysis or develop trust in advisors working FOR them. Do your own due diligence or hire someone with rare investment expertise and whose interests and INCENTIVES are aligned with yours.

If I buy then the more shorts the better since there is higher probability of a short squeeze. If "everyone" is buying, it is often time to short sell. Rather than being horrified that others think differently, it is excellent news. When I buy a security I assume and expect people are betting against me. If a market maker has a bid-offer spread and I take the offer, they are often left short temporarily if they don't have inventory. They are therefore then technically betting against a client but does it matter? Any market participant surely knows there will always be opposing positions. Investors are free to choose pure execution-only brokers or investment banks well-known to have large proprietary trading operations that may or may not be betting in a different direction. The only Chinese Wall in the world runs just north of Beijing.

Harry Hindsight lives. The first casualty of war is truth and the first casualty of finance is amnesia. I wonder about that fateful meeting in January 2007 between Goldman Sachs, ACA and Paulson. Would buyers have walked away if all materials had stated in bold red ink on the dealbook cover "A merger arbitrage manager you likely haven't heard of with no known expertise or track record in credit may have helped choose the underlying loans and will likely bet against them". Or "Fabulous Fab and some of the Goldman Sachs GS proprietary credit traders are currently bearish on subprime credit but they have been right AND wrong in the past". How might this have changed things?

Deception? Designed to fail? There are always bears on anything. If then unknown Paolo Pellegrini had shouted from the rooftops his negative views on subprime how many would have acted on it? We now know he was correct but AT THE TIME OF THE DEAL this was an extreme outlier ignored by the street. Even I wrote several bearish posts in 2007 and investors that followed my advice made high returns but the general population ignored those too. Was Fabrice Tourre wrong in his "smoking gun" email to express his then implied view that shorts were more likely to win than the longs? There have been many securities constructed on reverse enquiry from hedge funds where the client ended up being very wrong. I also know of IPOs done for "overvalued" companies considered "bound to fail" that have subsequently gone up 1,000% after listing. Everyone including investment bankers gets it wrong sometimes.

Would regulation and transparency have prevented the credit crisis? There have been many financial panics and real estate crashes in the past. Did CDOs and shorts "cause" those also? Why have there been worse ones where there were no derivatives or shorting? No security EVER trades for what it is worth; differences of opinion fuel all markets. If you short sell something you need as many people as possible to be bullish. Shorting rarely causes a security to go down. When you buy, the preferred situation is that many others are short. Exploiting the madness of crowds is the key factor for alpha. The more investors doing the opposite is POSITIVE if you have an edge. If you've done you're research it ought to increase trade conviction. If you don't have an edge why are you investing?

All deals produce winners and losers. For every buyer there must be a seller and often a short seller. Is it always necessary to disclose that others including originators might bet against you? And if they do should it change your view or rating given your analytical edge? If you are bullish surely more bears should make you more bullish if you are confident of your ability. Blame the crisis on 2 and 20 and deal structurers or the 2 and 28 ARM lenders? Or on the inevitable boom and bust, greed and fear of the crowd. Manage risk and invest in skill to survive PREDICTABLE cyclical behaviour. Variant perception is what creates value for clients. Some speculate on conspiracy and collusion but it is usually just the Emotional Markets Hypothesis at work. All securities at all times are wrongly priced.

Short selling does not force securities to implode. It can however slow bubbles from turning into superbubbles and potentially worse problems. It may be counterintuitive but short selling subprime may have prevented larger losses and bigger issues. Some argue that credit repackaging exacerbated and perpetuated it but do not explain earlier crashes and meltdowns. With only longs, the Japanese credit bubble of the 1980s happened without CDOs, structured products or hedge funds betting against it. Subprime lending was invented in Japan and the crash's effects still exist with the stock AND real estate markets 75% below high water marks. Short sellers and transfer of risk are positives not negatives for economic growth. Real estate booms and busts have occured for centuries. Sovereign defaults and bailouts are very common yet rookies treat the Greek situation like it is unprecedented. Greece has been bankrupt more often than not since 1810.

One of the strangest results of the 2007-2008 post mortem was the slow motion reverberation from credit to equity. Even if you missed the credit short there was plenty of time to get short of equities. No-one could have predicted the crisis? Really? Many correlation "traders" short sold correlation at 0.3 and watched helpless as it gapped straight up to 1.0. Gaussian copulas absurdly assume constant default probabilities just like gaussian Black-Scholes crazily relies on constant volatility to allegedly "price" derivatives. The added complication with credit is the non-linear binary payoff. Either the debt is serviced or bankrupt. With low interest rates, yields often do not compensate for default risk. All an investor can do is their own analysis or hire an expert whose interests are the same as theirs.

Full transparency: at this instant I am short the S&P 500, however I might reverse and buy between 20 milliseconds and 20 years from now. Whatever or whenever an investor buys or sells, it is certain that others are betting the opposite way. To generate consistent alpha it is necessary to have counterparties with differing opinions. It is obligatory for others to disagree with you. I am very appreciative of the many people that provide an essential public service in betting I am wrong. Their existence is mandatory for seeking alpha.

Hedge Funds: Very Short 10 Year Treasuries

Societe Generale is out with the latest edition of their hedge fund watch and in it we see that they've found hedge funds to have the "shortest position ever on bonds." That language is slightly misleading as they've only been tracking these exposure levels since 2005, but still. The fact that hedge funds have more than 270,000 short contracts on the 10 year treasury bond certainly speaks volumes. This comes a few weeks after SocGen initially published research that hedgies were net short 10yr Treasuries. It's very evident that hedge funds are concerned about inflation and the impending Federal Reserve rate hike (whenever it may eventually come). As we've covered numerous times in the past, many hedge funds have put on curve steepener trades in order to play this.

As you'll see from the chart below, hedgies certainly are short bonds:



In their research, SocGen also found that hedge funds still had large short positions in 30 year treasuries as well. They've been net short all year to the degree of around 100,000 contracts on average. So, they are certainly short the 10 year to a larger degree than the 30 year. Retail traders/investors who want to piggyback this play can short the exchange traded fund IEF for the 10 year and TLT for the 30 year. And as always, keep in mind that this should not be construed as a recommendation to buy/sell various securities.

Societe Generale's other main conclusion regarding hedge fund exposure levels was that hedgies are "strong net sellers of the yen (50,000 contracts net short)." Additionally, we see that hedge funds are buying US dollars in spades against all the other major currencies. This falls in line with what we've seen recently as hedge funds were aggressively short the yen. Interestingly enough, after re-shorting the euro recently, we now see that short positions on the euro have been reduced over the past few weeks. If you don't have access to forex markets, you can play the yen via exchange traded fund FXY. You can also play the US dollar via UUP and the euro via FXE.

Lastly, turning to equities, we see that their research comes to similar conclusions as the Bank of America research we typically cover. In that report, we saw that the smart money was selling equities. SocGen confirms this writing, "even though index price is rising, the percentage of non commercial positions on total open interest on the S&P 500 has decreased significantly." Their research shows that hedge funds are now net sellers of the S&P 500 while still slightly net long the Nasdaq.


You can download a .pdf here.

China's Economy May `Crash' Within a Year as Bubble Collapses, Faber Says

A file photograph shows Marc Faber, managing director of Marc Faber Ltd. and publisher of the Gloom, Boom and Doom Report, speaking during an interview in Hong Kong. Photographer: Scott Eells/Bloomberg

China’s economy will slow and possibly “crash” in the next nine to 12 months, Marc Faber, the publisher of the Gloom, Boom & Doom report, said.

“The signals are all there, the symptoms of a major bubble are all there,” Faber said in a Bloomberg Television interview from Hong Kong. “The Chinese economy is going to slow down regardless. It is more likely that we will even have a crash sometime in the next nine to 12 months.”

The Shanghai Composite Index has plunged 12 percent this year, the fourth-worst performer among 92 gauges tracked by Bloomberg globally, as the government stepped up measures to cool the property market and ordered banks to set aside more deposits as reserves.

The latest increase of bank reserve ratios came yesterday after earlier moves failed to halt a record surge in real estate prices. In March, prices rose 11.7 percent across 70 cities from a year earlier, the most since data began in 2005, while consumer prices rose 2.7 percent in February, the largest increase in 16 months.

The clampdown on property speculation may prompt investors to turn to the nation’s stock market, Faber said. Still, shares are “fully priced” and Chinese investors may instead become “big buyers” of gold, he said.

China’s markets are closed today for a holiday.

Faber, who joins hedge fund manager Jim Chanos and Harvard University’s Kenneth Rogoff in warning of a crash in China, said he “would rather stay away” from China and avoid industrial metals from copper to zinc as well as companies that are exposed to Chinese economic growth. He prefers wheat, corn, soybeans and other agricultural commodities.

The opening of the World Expo in Shanghai, China’s richest city, is “not a particularly good omen,” Faber said, drawing parallels with 1873 World Exhibition in Vienna, which coincided with a slump in stock markets and a depression in the 1870s.