Why I Fired My Broker

With his 401(k) in ruins, our correspondent visits investment gurus, hedge fund managers, and a freakish Arizona survivalist with one question in mind: How can the ordinary investor recover?

by Jeffrey Goldberg

Also see:

Video: "The Con Game"

Jeffrey Goldberg tells Bob Cohn why he bought gold, stocked up on lanterns, consulted a survivalist—and finally fired his broker.

For most of our adult lives, my wife and I have behaved in the way responsible cogs of capitalism are supposed to behave—we invested in a carefully calibrated mix of equities and bonds; we bought and held; we didn’t overextend on real estate; we put the maximum in our 401(k) accounts; we gave to charity; and we saved, but we also spent: mainly on gasoline, food, and magazines. In retrospect, we didn’t have the proper appreciation for risk, but who did? We were children of the bull market. Even at its top, my investment portfolio was never anything to write home about. Its saving grace was that it was mine. And I imagined that when we did cash out, at 60 or 65, I would pass my time buying my wife semisubstantial pieces of jewelry and going bass fishing like the men in Flomax commercials.

Well, goodbye to all that. I took a random walk down Wall Street and got hit by a bus.

How am I sure it’s goodbye? The signs are rampant, but one has become stuck in my mind: a video of Richard Bernstein, the chief investment strategist for Merrill Lynch (sorry, I mean the Merrill Lynch division of Bank of America, which, by the time you read this, may be the Bank of America division of the United States Government), advising Merrill clients such as myself that one of the best financial strategies to adopt now would be to extend my “investment time horizon.”

“If one were to trade the S&P 500 for one day, the probability of losing money is about 46 percent,” Bernstein states. “However, as one extends that time horizon from one day to one month to one quarter to one year to 10 years, the probability of losing money decreases as the time horizon lengthens.”

To which I would add this observation from Keynes: “In the long run, we are all dead.”

This is what I heard Bernstein say: give up. You’re not going to make money on your investments in the next 10 years, or 15, or 20, so you should stop worrying about your portfolio and go to the movies like everyone else.

I called Bernstein and asked him if he was, in fact, advocating a form of Stoicism. He said I was misinterpreting his views. “This is not some sort of psychological compensation device. What I’m saying is that in looking for investment ideas, we should be looking over a five-, six-, seven-year time period. You have to give an investment strategy time to reach gestation.”

But my investment strategy gestated for 15 years. And then it died.

As I write this, the markets are back down to 1997 levels. In Japan, they’ve sunk to 1983 levels. I pointed out to Bernstein that 1983 was 26 years ago. The investor who bought Japanese equities in 1983 and held on to them has stayed absolutely flat. “That’s not correct,” Bernstein said. “That doesn’t take into account dividend payments.”

Even with all those munificent dividend payments, my net worth has dropped by a third, and new vistas of worry open up for me each day.

I’m not complaining, by the way, and not only because I have no right to complain. I make more money than most Americans. I will ungrudgingly pay more taxes if it means keeping people in their homes—even the schmucks in overleveraged McMansions. My wife and I are lucky. We have substantial equity in a small but perfectly nice house in Washington, D.C., a city that is now, among other things, America’s financial-services capital, which should help keep real-estate prices steady. I have a late-model minivan. Most important, I have a job (and in the thriving magazine industry, no less!). If I lose my job, then I’ll complain (at which point, of course, I’ll no longer have a public venue for my complaints). But for now, no whining: just confusion and bemusement and fear, along with an uncharacteristic sense of paralysis. In the past six months, I’ve bought and sold virtually no equities. And I rarely take the pulse of my 401(k).

I called a psychologist to find out what could explain this weird passivity. Daniel Kahneman is a Nobel Prize–winning innovator in the field of behavioral economics. He explained that my feelings of paralysis were to be expected.

“You no longer know the world you live in,” he said. “You played by the rules, the rules benefited you. The world functioned according to some regularities. Right now, it’s unclear what rules apply. There is a new regime. What seemed prudent earlier has disappeared. I’m surprised Americans aren’t more panicked. Americans seem to accept a level of insecurity in their lives that Europeans wouldn’t tolerate. Paralysis is one response to this level of insecurity.”

This might explain why my wife and I have taken no action to fix our finances. Although it’s also the case that we haven’t heard from our Merrill broker in nine months. The last time he called was well before the day in September when the government encouraged the shotgun sale of Merrill to Bank of America, to keep Merrill from collapsing.

I should have seen the signs of dysfunction much earlier. It was more than a decade ago that our first Merrill Lynch adviser put us in a company called Boston Chicken. A Merrill analyst described it as “the restaurant concept of the ’90s.” It went bankrupt in 1998. Only later did I learn that Merrill had underwritten the initial public offering for Boston Chicken stock, and so had an interest in selling the company to its customers. There were other brilliant pieces of advice—long-term “buy and hold” recommendations that emerged from the Merrill analysis factory: Qualcomm; Sun Microsystems; Nokia; and Citibank, of course, which has recently dipped as low as a dollar a share. The full-service trading fees at Merrill—$80, $100, $130, for modest chunks of stock—were high, but we were told that we were paying a premium for quality research.

In many cases, we were. Bernstein, the chief strategist, has actually been bearish for much of the past decade. Given his recent disposition toward market pessimism, I asked him why he didn’t tell Merrill’s clients to dump their equities seven months ago. “I said it as best as I could within reasonable professional standards,” he said. “I’m not going to yell ‘Sell, sell, sell!’ I’m not going to go out and be irresponsible.”

I imagine that many of Merrill’s clients are now wishing that Bernstein had been more irresponsible. Of course, even if he had said something, my financial adviser might not have relayed the message.

I haven’t depended solely on Merrill Lynch for advice. I believed I could find investments for myself. I stayed away from mutual funds because I couldn’t figure out who ran them. And I applied Warren Buffett’s famous dictum—Don’t buy something you don’t understand—to my trading, so I bought, in our Merrill Lynch account, such companies as Johnson & Johnson and Procter & Gamble and Illinois Tool Works and Caterpillar, and these have been kind to us, until now. (I also bought the Internet company Ariba, because I heard about it from a guy who heard about it from a guy. It went up to about $1,000; I didn’t sell, of course, and now it’s at $8.) And every so often, I would follow the recommendations of the financial magazines, SmartMoney in particular, because for a long while I was an ardent consumer of financial pornography. No more. In the harsh light of recession, I find it hard to believe I listened to a magazine that, in August 2007, recommended American Express at $63 a share (a “conservative way to make hay from global credit-card growth”), which as I write this is selling for $13 a share; Wynn Resorts, $94 then, $20 now; HSBC, $93 then, $25 now; Washington Mutual, $36 at the time, seized by the government last September—rendering the stock worthless.

It turns out that my crucial mistake was believing that the brokers and wealth managers and cable-television oracles who make up the financial-services industrial complex actually had my best interests at heart. Or so say the extremely smart—and wealthy—people I asked to help me figure a way out of my paralysis. One of these people was Robert Soros, the deputy chairman of the fund started by his father, George. I went to see him at his office, where he spent two hours performing an autopsy on my assumptions.

“You think a brokerage should be a place you go to pay commissions for fair and unbiased advice, right?” he asked.

“Yes,” I said.

“It’s not. It never has been.” He then cited another saying of Buffett’s: “‘Wall Street is a place where whatever can be sold will be sold.’ You are the consumer of their dreck. What they can sell to you, they will sell to you.”

“But they told us—”

“They lied.”

He went on: “You should be disheartened and disappointed. But don’t kid yourself. You’re a naive capitalist. They were never your advisers. Do not for a moment think that a brokerage firm is your friend.”

“So who’s my friend?”

“You don’t have one. This is the market.”

“Okay, that’s Merrill Lynch. What about the others?”

“They’re not your friends,” Soros said patiently.

“What about Chuck Schwab?”

“All brokers move products based on volume and commission,” he said.

I had a benevolent, advertising-induced understanding of Schwab. It was the billboards: “I’ve got a lot less money. And a lot more questions. Talk to Chuck.” And: “It’s not just money. It’s my money. Talk to Chuck.”

I thought that perhaps Schwab, a discount broker, might be able to answer the question Soros could not: Why had my full-service financial adviser stopped calling me?

I did what I was told, and called Chuck. His spokesman intercepted the call. I explained that I was trying to understand the role financial advisers play in the life of the small investor, but the spokesman, Greg Gable, said that Chuck would not, in fact, talk.

“We’re not going to be able to help you out,” he said.

Finally, I went to another highly successful financial adviser, named Larry Gellman, who is an iconoclast and a critic of his industry. He came up with a plausible reason why Merrill did not actually seem to care about my financial future, or the financial future of my children.

“Throughout the late 1990s, investors were firing their brokers and money managers because they didn’t own enough tech and Internet stocks, so everybody got loaded up at the tech party right before the cops came,” Gellman said. “Most of them were busted and never even got a drink. Some of them got lawyers and came after their brokers. So the brokerage firms all came away saying, ‘Never again.’

“If the head of Merrill Lynch and every other investment firm had their way,” he continued, “no individual broker would ever recommend an individual stock or bond to a retail client again. They have essentially gotten out of the brokering-and-advising business and gone all in on the ‘wealth management’ business. The new model is to gather assets from wealthy people and then place those assets with a whole bunch of managers who will manage different pieces of it in diversified styles so you don’t lose it all at once. And by the way, people with less than $10 million need not apply.

“People like you are in a sort of purgatory because no one would ever come out and tell you that he doesn’t want your business anymore,” he said. “You had to figure that out by yourself.”

There’s quite a bit I have to figure out by myself now, which was one reason why, on a cold night in February, I turned up at the apartment of my friend Boaz Weinstein, who was hosting a gathering to talk about charity in a time of financial cataclysm. Weinstein lives in a not-overly-luxurious-but-luxurious-enough building on Fifth Avenue. It is not the sort of building I could ever afford, but I tell myself I am not inclined to live on Fifth Avenue anyway; long-term exposure to liveried elevator operators would eventually bring me to Marxism.

“Do you like this job?” I asked the operator in Weinstein’s building. He was a sagging man of 65 or 70; his eyes were rheumy and his nose spider-webbed with disintegrating capillaries.

“It’s a job,” he said. He paused. “I’m retired.”

“But you’re working,” I said.

“Yeah. I’m working.”

The coatrack in the hallway outside Weinstein’s apartment was crowded with sensible coats. The passed canapés inside were utilitarian, as passed canapés go. These were my kind of rich people, I thought, not the piggy kind, no John Thains or Stephen Schwarzmans in the bunch, certainly no Bernard Madoffs. (I met Madoff once. He wasn’t very nice. I think he judged me too poor to bother robbing.) We had gotten together to talk about charity, but I was hoping to learn about my own economic future. These were people who were calculating present values as 10-year-olds; people who had actual Swiss bank accounts; people who short Treasuries on their BlackBerrys; and one person, Weinstein himself, who won a Maserati in a poker tournament.

The writer Jonathan Rosen has described New York now as having a posthumous feel, but this was not entirely the case in Weinstein’s apartment, which was vibrating with superficial good cheer. Economic disintegration provokes in some people strange feelings of lightness. Of course, some of the people gathered there—say, those who spent the past year short-selling bank stocks—were experiencing the strange feeling of lightness that comes from acquiring huge, stinking piles of money. But on the whole, anxiety lurked beneath the bonhomie. Within 10 minutes of my arrival, two friends separately and quietly suggested I buy gold, and right now.

“You have to guard against the massive debasement of the dollar,” one said. I explained to him my theory of market peaks—that the moment I buy a stock or a commodity is the moment it peaks. In any case, I would need substantially more of those soon-to-be-debased dollars to buy gold. But his arguments seemed sound.

Then another friend approached. “You don’t want to be long gold. The dollar is the currency of last resort for the entire world. There’s little chance of debasement.” His argument also seemed sound. Everyone seemed to be in possession of sound arguments. Even people on CNBC sometimes seem to be in possession of sound arguments.

Weinstein stood up to make introductions. He was one of the early innovators in the field of credit-default swaps, and he earned billions of dollars for his former employer, Deutsche Bank—and tens of millions for himself—until last year, when his trades cost the bank $1.8 billion (though some of the bank’s positions rebounded by $600 million). I am in no position to judge what happened; Weinstein’s attempts to explain to me the workings of credit-default swaps have not borne the fruit of enlightenment.

Bill Ackman, the founder of Pershing Square Capital, was to lead the discussion. Ackman is tall, prematurely gray, and immoderately self-assured, the sort of winning figure who could be elected to the Senate one day, if the country ever decides to stop hating hedge-fund managers. Weinstein introduced Ackman as a perspicacious investor, which he is, generally. Early in the current crisis, he suggested publicly that the decision of the bond-insurance company MBIA to guarantee billions of dollars of complicated mortgage investments would come to no good. But, like Weinstein, Ackman was not having the best year; one of his funds was betting solely on the resurgence of the Target corporation’s stock, and Target’s performance was not covering Ackman in glory.

“I thought this was a perfect time to talk about philanthropy and investing, because they’ve merged; they’re both tax-deductible at this point,” Ackman said, opening his talk. He spoke mainly of the psychic rewards of charitable giving, and of specific projects he supported. He asked for questions, which mainly concerned his prodigious charitable giving. Then someone asked a question about Ackman’s reputation:

“It used to be that in America, if you were a successful businessman, you were well-regarded. Now it seems that you are an evildoer if you’re successful, particularly in the financial world. Your profile is getting bigger. Do you think that’s good, or do people say, ‘He should be spending more time in the office and not so much out there’?”

Ackman responded: “A lot of hedge-fund managers I know are incredibly charitable and also fundamentally great people. But the press—first of all, you don’t make that much money working for the press. Take The New York Times. The New York Times doesn’t make that much money, and the people who work there don’t make that much money. So you think about people who work for the press—generally, they resent people who have financial success. A combination of that, plus some bad actors in the business, is a negative. Why did I go on Charlie Rose? Why have I been a little more public? Part of that is to blunt some of the negative associations with our industry.”

Hmmm. Yes, well.

It only seemed right for me to stick up for my fellow ink-stained proles, so I decided to make an intervention. But then I thought, This is Bill Ackman standing before me. He’s a great investor. Maybe he can give me some advice.

So this is what came out of my mouth: “What do you tell the ordinary mortal—say, the person who works in the press that you talked about—what do you say to the person who has $20,000, $50,000, $100,000, or $200,000, maybe, parked somewhere doing nothing? What is your advice right now for that person?”

I looked around. The wizards in the room were having difficulty calculating figures of such humble size. I had thought $200,000 sounded like a large and unembarrassing number. But the room reacted as if I had asked, “Bill, I have 75 cents in my pocket. Do you think I should buy Twizzlers or a big red gumball?”

Ackman answered: “First, it depends on when you’re going to need the money. I’ve always said that if you want to take risk—any risk—you have to be prepared to put your money away for five years or more. If it’s that kind of money, I would give someone a couple of alternatives. Do you have enough money in the bank that if you were to lose your job, you’ve got a good window to get reemployed? You’ve got to make sure you have a safety net. Buy a house. I think it’s a great time to buy a house. But put a 20 percent down payment, get a good mortgage from Fannie and Freddie … It’s one of the best investments you could make. The rest of the money, either invest in a very broad index fund—a Wilshire 5000 type of index fund—or if you want to do a bit of homework, I’d invest in a few great unlevered businesses that earn attractive returns. In my opinion, McDonald’s, Visa, maybe Berkshire Hathaway.”

I think Ackman might not have been accustomed to talking to people like me, which would help explain why he sounded suspiciously like … a Merrill Lynch financial adviser.

He was, however, infinitely more compelling on the macro questions, and this was where the evening took a dark turn. “One of the things that’s interesting about the last year is that you realize how much of our capital system is based on confidence—business confidence,” he said. “If I’m confident I can refinance my debts when they come due, I’ll spend money. If I’m not confident I can refinance my debts when they come due, I’m not spending any more money. So if I can’t renew my home-equity loan and I’m not sure I can keep my job, I can’t spend. And you get into this death spiral.”

I asked him, “What’s the chance we’re going into that death spiral?”

“We’re in it!” he said. “Whether we’re going to die or not is another question.”

“What’s the percentage chance we’re going to move to a barter economy?” I asked.

“I think it’s small,” Ackman said.

“Small”? I had been hoping for “Zero.” “Zero” would have been a fine answer, and not because I have nothing to barter except for a stack of old SmartMoney magazines, but “Zero” because, by the time my 12-year-old turns 18, I would like to be able to use my portfolio of stocks and bonds as a flotation device, and not as kindling.

THE WAY I SEE IT, it’s all a con game,” Cody Lundin was saying. “What I mean is that Wall Street has always been an illusion. Now it’s an illusion that’s crumbling. Wall Street is like someone who’s having heart trouble. It’s in constant need of resuscitation, but after a while, it just doesn’t work anymore. People think that Bernard Madoff was unique, that he was an illusion, but he’s just an extension of the same illusion, the same con game. This is one of the reasons I don’t like to have any debt. When you have debt, you become part of this illusion, and sometimes you get trapped by it.”

We were standing outside in a foot of snow in the mountains above Prescott, Arizona. Lundin was arguing so cogently against the American culture of easy credit, in tones far more thoughtful than one hears on cable television, that I forgot for a moment that he wasn’t wearing shoes, or socks. He was standing in the snow barefoot. Also, in shorts.

“It’s all about regulating core body temperature.” For long hikes in the snow, he wears three pairs of socks, without shoes. He suggested I try this.

Other things Lundin asked me to try include making fire with sticks, eating mice—“a free source of protein in survival scenarios”—and living without electricity for a week to “see where it hurts.” Lundin himself eats mice and rats he traps at his off-the-grid passive-solar house in the wilderness, because “why waste free protein?”

Lundin is a freak; twin blond braids fall from his bandanna-covered head, giving him the appearance of a stoner Viking. But in the event that the economy crumbles, and civilization with it, I would appoint him my financial adviser. He is my favorite survivalist, the author of a book on getting by in the wilderness and another on urban preparedness, and a teacher of primitive-living skills. Survivalist, of course, has ugly political connotations. A long time ago, I visited a place called Elohim City, on the Oklahoma-Arkansas border, that was home to a group of white supremacists. Their racism was repulsive, and their anti-Semitism wasn’t too pleasant, either. But I was impressed with one aspect of their lifestyle. On a tour, they showed me a vast storeroom filled with beans. Pinto beans, lima beans, all sorts of beans, vacuum-packed in garbage-can-size vats. Three years of food, for when the revolution comes. I knew, of course, that I didn’t need three years of beans in my house, but I took the lesson: it’s not the worst thing in the world to have a couple of weeks of food and water on hand, just in case a natural or man-made emergency is more than FEMA can handle.

Lundin is not a racist; in fact, he’s an Obama supporter, and he resents the racist associations attached to survivalism. Nor does he wish for the grid to go down. He says he enjoys electricity and indoor plumbing. He tends to think, though, that civilization is a thin film, and that in times of economic distress, it’s smart to be prepared for the day when Safeway runs out of milk. “This isn’t something I hope for. But what if the illusion does really crumble, and we have to move as a society to something else?”

I asked Cody how he invests his money. “I don’t believe in the intangible economy; I believe in the tangible economy. When I have extra money, I buy tools, food, or land. I like to be able to see what I’m buying. And I really don’t like debt, so I’d rather not have certain things than be in debt to anyone. I just feel better knowing that I don’t owe money, and I feel good knowing that I can take care of myself. That’s the American way, to be able to be self-reliant.”

For the record, I don’t think the grid is buckling under the weight of consumer debt or the mistakes of AIG. But we’re in a strange moment in American history when a mouse-eating barefoot survivalist in the mountains of Arizona makes more sense than the chief investment strategist of Merrill Lynch.

“People need a plan, they need skills, and they need supplies. What would happen if the ATMs stopped working for a couple of days? People would panic. But you won’t panic if you’re prepared to ride out a disturbance.”

Even out West, he says, people in the cities are unequipped to go for more than a day or two on their own. The Mormons, who are strongly encouraged by their church to keep a year’s supply of food in their homes, are an exception. “I know some people who say that if things go to hell, they’re just going to go to some Mormon’s house and steal all his shit. But that’s not right.”

“Also, many Mormons keep guns.”

“Yeah, there’s that.”

The curious thing about listening to Cody Lundin is that in his ideas I heard echoes of ideas I’ve been hearing from people very much dependent on the financial grid. Bill Gross, the founder of Pimco, the world’s leading bond trader (and, according to a September 2008 ranking by Forbes, America’s 227th-richest person), suggested that thrift—not mouse-eating thrift, but more moderate forms of thrift—is quickly becoming the norm, as a result of society’s massive over-leveraging.

“Risk-taking went over the edge,” he told me. “We are inventing something new. We’re very afraid. We know from the Depression that people who lived through it didn’t change their mentality for the rest of their lives. They were sewing their socks. They refused to take a lot of chances. My sense is that it will take 10 or 20 years to find that spark of risk-taking in people again.”

When I told Seth Klarman, one of the country’s leading value investors, about my visit with Cody Lundin, he said, “It’s always smart to prepare for disaster. In investing, that means holding disaster insurance. In your personal life, it makes sense to have inexpensive disaster protection, so come what may, you’re ready for any eventuality. I like to store some extra bottled water in the basement, but my wife thinks it’s too much clutter. I told her I’d share my water with her anyway.”

While I’d choose Cody Lundin to serve as my off-the-grid adviser, I would choose Seth Klarman as my on-the-grid adviser, if only he were taking clients.

Klarman was hired out of Harvard Business School to manage a $27 million fund that, as of early this year, had grown to $14 billion. He is also the author of one of the more expensive books in the world, Margin of Safety. An out-of-print guide to value investing, it sells for as much as $2,500 per copy on the Web.

Klarman is an acolyte of Ben Graham, the original value investor. Value investors—Warren Buffett is the most famous—seek out distressed, underappreciated assets, buy them, and wait until the rest of the world realizes that they’re worth something.

“The overwhelming majority of people are comfortable with consensus, but successful investors tend to have a contrarian bent,” Klarman said over lunch one day in an empty Boston restaurant. “Successful investors like stocks better when they’re going down. When you go to a department store or a supermarket, you like to buy merchandise on sale, but it doesn’t work that way in the stock market. In the stock market, people panic when stocks are going down, so they like them less when they should like them more. When prices go down, you shouldn’t panic, but it’s hard to control your emotions when you’re overextended, when you see your net worth drop in half and you worry that you won’t have enough money to pay for your kids’ college.”

One theme of Margin of Safety is that people like me aren’t equipped to be investors. “No one knows what he’s doing unless he’s a full-time professional,” he said. “As in many professions, full-time experts have an enormous advantage. Investing is highly sophisticated and nuanced. The average person would have an incredibly hard time competing.”

I asked Klarman if he wasn’t working against his own financial interest by arguing that average people aren’t qualified to be investors.

“Most people on Wall Street do well enough,” he said. “It’s regrettable that anyone would want a client to take risks beyond what the client could handle.”

He agreed with Robert Soros that the financial-services industry treats the small investor not as a client but as a source of ready cash. “The average person can’t really trust anybody. They can’t trust a broker, because the broker is interested in churning commissions. They can’t trust a mutual fund, because the mutual fund is interested in gathering a lot of assets and keeping them. And now it’s even worse because even the most sophisticated people have no idea what’s going on.”

After 15 years of pabulum, I was enjoying, in a perverse sort of way, receiving straight talk from masters of finance.

“Everybody these days is a just-in-time investor. People say, ‘I’m going to leave my money in the market as long as possible, and then pull it out of the market just before I have to write the tuition check.’ But I think we’re seeing that the day you need to pull it out of the market, the market might be down 50 percent. It’s critical not to be greedy. Avoid leverage and don’t invest money that you can’t stand to lose.”

“I haven’t leveraged myself,” I said.

He asked me if I had a mortgage. Yes. He then asked me if the amount of money I had invested in the stock market was greater than the amount I owed on my mortgage—could I liquidate what remained of my portfolio to pay off my mortgage? I could.

“So you are leveraged. Why are you keeping your money in the market?”

“Because—”

“It’s because you think you’re going to make more money in the market than you’re paying in interest on your mortgage.”

“Yup.”

“Well, are you?”

“Uhh, no. But I’m getting the mortgage-interest deduction.”

“Yes, the interest is deductible. But if you had capital gains in the market, you’d pay taxes on those. In the aftermath of this financial crisis, I think everyone needs to look deep within themselves and ask how they want to live their lives. Do they want to live close to the edge, or do they want stability? In my view, people should have a year or two of living expenses in cash if possible, and they shouldn’t use leverage anywhere in their lives.”

“But if I dump my portfolio now, I make my losses real.”

“How are you going to feel if the market drops another 50 percent?”

Klarman went on, “Here’s how to know if you have the makeup to be an investor. How would you handle the following situation? Let’s say you own a Procter & Gamble in your portfolio and the stock price goes down by half. Do you like it better? If it falls in half, do you reinvest dividends? Do you take cash out of savings to buy more? If you have the confidence to do that, then you’re an investor. If you don’t, you’re not an investor, you’re a speculator, and you shouldn’t be in the stock market in the first place.”

Several years ago, I went to a party at a hedge-fund manager’s loft in Lower Manhattan. The elevator opened directly into the loft, which was as big as Mussolini’s office. An Austin Powers bed was parked to one side.

I left the party with a friend of mine, David Segal, who is now a business reporter at The New York Times. As we walked to the subway, he said, “You know, we should get one of those hedge funds.”

“Absolutely,” I said. “Where do we get one?”

“I don’t know. Maybe we can find one on the street. But we need one.”

“Yes, we do.”

When I think back on that conversation, I realize that it represents for me the apex of hedge-fund mania. Which is to say, when two reporters realize they should get into the hedge-fund business, it might be somewhat late to get into the hedge-fund business.

Seth Klarman is right. I’m not an investor. Very few people in America actually are. I never had the knowledge or the time to master the stock market. I thought I knew how to manage the danger, which is why I invested to a disproportionate degree in the Dow 30. I’ve learned, however, that it’s quite possible to ride the Dow 30 a far way along the risk curve. And I’ve learned another thing: I once believed that a buy-and-hold strategy would make me rich. This was a mistaken belief. “The economy comes in cycles,” Robert Soros said. “If you believe that the economy is not cyclical, then buy-and-hold is for you.” He taught me a Wall Street expression: “An investment is a trade gone bad.”

Though the past six months of my financial life have been marked mainly by paralysis, I have, in fact, made a couple of decisions. I’ve decided to deplete the world’s supply of gold by two ounces. (Attention all Atlantic-reading burglars: it’s not in my house.) You’ll be pleased to know that the price of gold fell $70 the week after I bought.

And my wife and I have decided to fire our Merrill Lynch financial adviser. We’re not firing him because we realized that his company couldn’t manage its own money, much less ours, and we’re not firing him for his bad advice. I was the one, after all, who pulled the trigger on the purchase of 100 shares of AIG. (It would have been good of him to warn us about what was coming, but that would have necessitated him knowing what was coming.) We’re also not firing him because his research chief wants us to elongate our already too-long time horizon. And we’re not firing him because John Thain, his former CEO, spent the fees we paid his company on a $35,000 commode. We’re firing him mainly because he fired us. He never said he was firing us. He just stopped calling. Eventually, I stopped calling him. I got the message.

Our main job now is finding someone to advise us. This is a very difficult task.

I asked Bill Gross what he thought I should do. He was somewhat dyspeptic. “The system is rigged,” he said. “It’s difficult for the average investor to even conceptualize what we’re talking about. For this reason, I think financial advisers are still worthwhile, but the average investor can no longer pay them what they felt they were worth. You should find someone who isn’t overpromising or overcharging.”

This search is made more difficult because we don’t have enough money to make ourselves interesting to most of the best advisers, and the typical adviser is not sufficiently independent-minded to be effective.

“There’s enormous pressure to provide conventional advice,” Klarman explained, “and tremendous pressure against providing unconventional advice. Advisers only recommend what’s conventionally palatable. They tend to say 60 percent stocks, 40 percent bonds, and they’re not likely to move away from that, no matter how extreme valuations are. They’re not likely to move away from it when the market is really high, or really low. A big part of the problem is that there isn’t a perfect answer to any of this. No one can tell you how to allocate your assets 100 percent of the time. The average investor is not getting Warren Buffett to look at his portfolio; he’s getting a printout from a computer model.”

Unconventionality makes me nervous, but less so than conformity. I’m finished with conformity. In picking an adviser, I’m also looking for someone who is unleveraged; someone who is putting his own money into the investments he’s recommending; and someone who can explain to me in a few sentences, in language easily understood by earthlings, his philosophy of investing.

Despite everything, I’m not overly pessimistic. I’m long on America, as my friends on Wall Street might say. I believe that equities will grow in value. I expect the Dow to return to 9,000, or 10,000, if not sooner, then later. And when it does, if I’m not already out, I might just get out. I’m not enjoying this particular ride.

I no longer expect to get rich. It makes me happy to realize this. It also makes it easier to give more money to charity. In retrospect, I can’t imagine what led all of us to believe that we could regularly expect double-digit annual returns on our money, for doing no work. Maybe this attitude will cause me to miss the next great run-up. No matter. I’ll take 3 or 4 percent gains a year, or 1 or 2, if necessary. I’ll keep more cash on hand. I’ll keep a two-week supply of meals-ready-to-eat, bottled water, and lanterns in my basement. If things get bad, I’ll take my family and drive west, to find Cody Lundin. And if the bottom truly falls out, I’ll find a Mormon and ask him, politely, if he’ll share.

Power to the Hedge Funds!

Long demonized, they may be the model firms of the future.

Michael Hirsh

Newsweek Web Exclusive

Apr 23, 2009 | Updated: 9:18 a.m. ET Apr 23, 2009

Hedge funds are evil. We all know that without being told. They're secretive clubs of filthy-rich guys whose only goal is to make each other richer so they can buy overpriced art and palatial estates in the Hamptons. We also know that as the bubble began to overheat in the last few years, our government authorities were most worried about the damage that those unregulated, mysterious hedge funds might do to the financial system. In 2007 the President's Working Group under then–Treasury Secretary Hank Paulson issued new guidelines for "private pools of capital," especially hedge funds. And after the crash last year, hedge funds came under attack for short-selling and "gating" investors (refusing redemptions). A lot of people were waiting for the hedge-fund industry—which would get no bailouts à la AIG and Citigroup—to collapse into the dustbin of history.

It never happened. Sure, plenty of hedge funds went under: a record 1,471 were liquidated in 2008, out of a total of 6,845, according to Hedge Fund Research, a Chicago-based tracking firm. The industry's total capital plunged by $600 billion to $1.33 trillion as of the end of the first quarter of 2009, during which investors yanked another $104 billion out of them, according to data released Tuesday.

But here's the key point: the fallout happened very quietly—with no systemic risk discernible. Compared to the overlong horror movie we've been watching—Night of the Living Dead Banks—what happened in the hedge-fund world sounds almost healthy and clean. After all, that's the way capitalism is supposed to work: incompetents go out of business, smart guys clean up. And overall, the hedge-fund industry has shown remarkable resiliency in the face of the catastrophe, turning in a gain of 0.53 percent in the first quarter. (In addition, a lot of the worst performance occurred in September and October, when failing banks turned off credit to the hedge funds, forcing liquidations.) Most hedge funds are way down since last fall's market crash, but as more and more pension funds and institutional investors like universities decide where to put their money in the future, they might look at the average returns.

Ken Heinz, the head of Hedge Fund Research, says that while the industry has had an astonishingly wide range of returns—from a 59 percent drop for the worst performers over 12 months to a 33 percent gain for the best—the average decline was 19 percent. That sounds bad, except that equity funds plunged about 40 percent during the same period. If you're an institutional investor, which are you going to choose? Over the longer term, some of the numbers—depending on how you slice and dice them—look even better. Compared to the 10-year Standard & Poor's average—which is at a miserable minus 26 percent—the record of the biggest hundred hedge funds averages a 100-percent-plus gain during that same 10-year period. "The hedge fund industry has frankly acquitted itself fairly well," says Dan Gertner of Grant's Interest Rate Observer. "Much better than the investment banking."

In fact, the ones who caused most of the trouble on Wall Street were not hedge-fund managers but the bumbling CEOs of big investment banks and other companies that were trying to act like hedge funds: Stanley O'Neal of Merrill. Dick Fuld of Lehman. Charles Prince of Citigroup. And most notoriously, AIG, which Federal Reserve Chairman Ben Bernanke described contemptuously as a hedge fund attached to "a large and stable insurance company." A really, really bad hedge fund.

Many of the actual hedge funds got it wrong too, but unlike AIG or Citigroup, the ones that bungled their investments have simply disappeared forever, with little disturbance to the economy. No single firm has posed a systemic risk, even with hundreds of billions of dollars at play. The days when a ridiculously overleveraged Long Term Capital Management could bet billions without putting up any margins—which almost took down the financial system in 1999—are over. The hedge-fund world's survivors, meanwhile, include some of those who were most ahead of the curve on Wall Street—like Paul Singer of Elliott Associates, who in an extraordinarily prescient analysis in September 2006 declared that the subprime mortgage securitization market was a historic scam. He correctly identified the ratings agencies as chief culprits. Singer—known for his acerbic wit—declared facetiously: "Through the ages humans have tried to spin gold from lead. To make silk purses out of sows' ears. To take dung and call it roses. But the time has finally arrived when this has been accomplished." A number of his fellow hedge-fund managers promptly bet on a downturn.

Hedge-fund managers—the good ones, that is—have often served as invaluable early-warning systems. Before Enron collapsed it was Jim Chanos, president of Kynikos Associates, that gave the story to Bethany McLean of Fortune magazine. Her story, "Is Enron Overpriced?" was the first major sign that the company was an out-and-out fraud.

Hedge funds may even point the way to the future, in a one-eyed-man-is-king-of-the-blind kind of way. The subprime-mortgage disaster holds three major lessons for what must happen to Wall Street:

• One, the pretense that risk can be sold away and "dispersed" in bundles of securities needs to be abandoned; instead risk needs to be brought back within a firm's walls and watched closely. Retail banks need to reassume the risk of their borrowers, investment banks need to keep stuff on their balance sheets, and so on.
  
• Second, and a related point: compensation needs to be structured so that every big player has his own skin in the game.
  
• Three, the structure of Wall Street needs to change dramatically. The Citigroup financial supermarket model is an abomination. (In fact, the latest signs out of Citigroup are that the promised reorganization of the giant company—in which underperforming assets were going to be placed into a "bad bank"—may end up being more cosmetic than not, a mere accounting trick.) Congress should begin considering ways to resurrect a version of Glass-Steagall, which sensibly separated retail and commercial banks from investment banks after combined versions of the two wreaked similar damage in the late 1920s. "Anything that is 'too big to fail' is now 'too big to exist'," MIT's Simon Johnson, the former chief economist at the IMF, said in congressional testimony on Tuesday.

The hedge-fund model may offer a way forward on all of these fronts. Grant's Gertner suggests that the best path toward the future may be through the past, and not just in revisiting the virtues of Glass-Steagall. Wall Street's most successful long-term model has been the partnership on the Brown Brothers Harriman (or Goldman Sachs) model, wherein the firm is always betting the owners' own capital. Such a structure ensures careful risk assessment. Similarly, a lot of hedge-fund managers have a lot of net worth invested in their funds. If there's one thing we've learned in the last couple of years, it's that very few players on Wall Street ever understood risk. The ones that did ought be entrusted with risk in the future, while those who didn't should be kept away from it with a stick. The latter group includes the big banks, which ought to act more like utilities (they already are, in fact), and investment banks, which perhaps need to go back to issuing securities and brokering and forget about proprietary trading. Maybe only the hedge funds have earned the right to be the big risk takers of the future.

The Attraction of Gold

Barry Ritholtz asked what are three things about gold that most people don't realize. Here's part of the email I sent him:

As you probably know, I’m not a big fan of gold as an investment but as a metal (ok, element), it’s endlessly fascinating.

Maybe one day some cognitive scientist will find a connection between our brains and gold. For whatever reason, gold has dazzled men for millennia.

For example, gold NEVER rusts. I mean never! You can take the gold out of an Egyptian pyramid and stick it in your cavity (though you might want to clean it first). It’s also non-toxic which helps.

Gold is incredibly soft. One ounce can be stretched for 50 miles. It can be pounded down to a few MILLIONTHS of an inch thickness.

Gold is very heavy. Despite what you see in the Treasure of the Sierra Madre (“Badges? We ain't got no badges!,” gold dust wouldn’t have blown away.

Gold has been found on every continent on earth. Gold has also had strong religious connections. It’s mentioned in the Bible more than 400 times. Marx writes of Commodity fetishism, which is meant to have a religious connotation. And I won’t even get into Freud’s talk of the psychological connection of gold to feces (no, I’m not making this up).

When Moses came down from Sinai with the Ten Suggestions, the Jews were making a golden calf to worship. God instructed Moses to overlay a sanctuary for him in pure gold. In other words, gold had its bases covered—it was on both sides!

Plato mentions the gold/silver ratio to be 12. Recent historical evidence suggests that Isaac Newton was mainly an alchemist. The other stuff he did was just playing around on the side, and was probably an offshoot of his efforts to makes gold. Pieces of his hair have traces of lead and mercury.

Newton was also Master of the Mint and inadvertently put England in the gold standard. This means that one of the greatest geniuses in human history was also a civil servant who made economic policy based on a forecast. A forecast that was dead wrong.

There’s more gold at the New York Fed, waaaay below 33 Liberty Street, than in Fort Knox. Gold is also a really good conductor. So despite its high prices, it’s used in many electronics.

Best - Eddy

I highly recommend Peter Bernstein's The Power of Gold: The History of an Obsession

Bank cutbacks aid hedge funds

Managers of some of the world’s leading hedge funds say they are reaping a benefit from the financial crisis in the form of substantially less competition from the once-mighty proprietary trading desks of investment banks.

During the boom years of this decade, proprietary trading desks at many banks began to take similar trading positions as their hedge fund clients.

This led to complaints from hedge funds they were facing direct competition – if not mimicry – from the trading arms of banks they turned to for financing.

Daniel Och, founder of publicly traded Och-Ziff Capital Management, said in an interview with the Financial Times that his company is currently seeing less competition for investments, making it easier to capitalise on opportunities.

“The proprietary trading desks at banks are substantially less active,” he said.

One sign of the improvement is that Och-Ziff’s flagship fund, which is up 4.4 per cent in the year to March, after losing 15.9 per cent in 2008, according to regulatory filings.

In all, Och-Ziff manages more than $20bn.

Another prominent hedge fund manager, Paul Touradji, of Touradji Capital Management, said the situation reminded him of his early years in the industry, when a smaller number of players pursued arbitrage opportunities.

“There was a dearth of risk capital and that is exactly what we are seeing now,” said Mr Touradji, whose company manages about $3bn.

Mr Och added that bank cutbacks were also expanding the talent pool for established hedge funds. “There is no doubt the number of incoming calls we are getting from senior people across the world has increased,” he said.

The hedge fund industry continues to suffer outflows. Investors redeemed nearly $103bn in the first quarter, according to data released on Tuesday by Hedge Fund Research.

This represents 7.3 per cent of industry assets, but remains less than the record for quarterly withdrawals set in the fourth quarter last year when investors withdrew more than $152bn from the hedge fund industry.

A report this week by Bank of New York Mellon and researcher Casey Quirk predicted that withdrawals will be reversed in the coming years and hedge fund assets will reach $2,600bn by the end of 2013, almost double estimates for global hedge fund assets under management at the end of last year.

Haircut 100

BIS Committee on the Global Financial System estimated typical haircuts on debt securities. Note CDO haircuts, April 07 v. Aug 09:

Today's Performance By Decile

The S&P 500 is currently having its worst one-day pullback since the March 9th lows, and we broke the index into deciles (50 stocks in ten groups) based on stock performance from 3/9 to last Friday to see how the best and worst performing stocks during the rally are faring. As shown below, the 50 stocks that were up the most from March 9th through April 17th are down an average of 10.4% today, while the S&P 500 itself is down 3.65%. As you go down the list of deciles from the best performers during the rally to the worst, the performance today gets better. Clearly, investors are selling the big winners over the past few weeks, while the stocks that haven't participated on the upside are down the least today.

High Yield and Corporate Credit Spreads

Below we highlight historical charts of the Merrill Lynch High Yield and Corporate Credit Spread indices since the end of 1996. These indices measure the difference between yields on comparable length Treasuries and high yield and corporate bonds. The current yield spread between corporates and comparable Treasuries is 540 basis points (bps), while the spread for high yield bonds is 1,544 bps. At their peak, high yield bonds were yielding 21.82% more than comparable Treasuries, so the spread is down 29.24% from its high. Corporate spreads are down 17.68% from their peak. While it's a great sign to see spreads come in, the charts show that they are still extremely high from a historical perspective.

NYSE chief cautious over March rally

The March stock market rally that fuelled hopes of a broader economic recovery was deceptive because “real money” investors remained on the sidelines, according to the chief executive of NYSE Euronext, the world’s largest stock exchange.

In rare comments about market movements, Duncan Niederauer said in an interview with the Financial Times that the rally was driven by short-term traders trying to take advantage of high volatility and not by large institutional or other long-term investors.

Mr Niederauer suggested the high trading volumes and gains in leading indices did not necessarily reflect any real conviction that the worst of the economic crisis was over.

He said the volumes had been concentrated in a handful of stocks.

In fact, he said volumes had held up well because of what he termed a “traders’ market” in which participants tried to take advantage of greater volatility without needing to take a view on, or believe in, the long-term prospects for recovery.

He said: “The real money investors are still waiting. I think they’re waiting, they’re watching. They want to make sure that what we saw in March is real. And I think once they are convinced you will know it. The market will have a totally different tone to it.”

He added that the rally had also been concentrated on a handful of stocks and that large institutions and long term investors were largely keeping their powder dry.

Mr Niederauer said he sensed that volumes, while relatively healthy, were below the levels which would indicate that investors had regained confidence in the fundamentals of the market. “I think we’re waiting for another rally, in my opinion, in around June and July,” he said.

He said a summer rally would be a six to nine-month leading indicator of economic recovery and that by April 2010 the global economy would look much healthier.

The benchmark S&P 500 index rose by 8.5 per cent in March, its best month since October 2002, leading some bulls to predict that the recovery had arrived.

Pirates Attack (picture)

A 'Copper Standard' for the world's currency system?

By Ambrose Evans-Pritchard

Hard money enthusiasts have long watched for signs that China is switching its foreign reserves from US Treasury bonds into gold bullion. They may have been eyeing the wrong metal.

China's State Reserves Bureau (SRB) has instead been buying copper and other industrial metals over recent months on a scale that appears to go beyond the usual rebuilding of stocks for commercial reasons.

Nobu Su, head of Taiwan's TMT group, which ships commodities to China, said Beijing is trying to extricate itself from dollar dependency as fast as it can.

"China has woken up. The West is a black hole with all this money being printed. The Chinese are buying raw materials because it is a much better way to use their $1.9 trillion of reserves. They get ten times the impact, and can cover their infrastructure for 50 years."

"The next industrial revolution is going to be led by hybrid cars, and that needs copper. You can see the subtle way that China is moving into 30 or 40 countries with resources," he said.

The SRB has also been accumulating aluminium, zinc, nickel, and rarer metals such as titanium, indium (thin-film technology), rhodium (catalytic converters) and praseodymium (glass).

While it makes sense for China to take advantage of last year's commodity crash to restock cheaply, there is clearly more behind the move. "They are definitely buying metals to diversify out of US Treasuries and dollar holdings," said Jim Lennon, head of commodities at Macquarie Bank.

John Reade, metals chief at UBS, said Beijing may have a made strategic decision to stockpile metal as an alternative to foreign bonds. "We're very surprised by Chinese demand. They are buying much more copper than they will need this year. If this is strategic, there may be no effective limit on the purchases as China's pockets are deep."

Zhou Xiaochuan, the central bank governor, piqued the interest of metal buffs last month by calling for a world currency modelled on the "Bancor", floated by John Maynard Keynes at Bretton Woods in 1944.

The Bancor was to be anchored on 30 commodities - a broader base than the Gold Standard, which had caused so much grief in the 1930s. Mr Zhou said such a currency would prevent the sort of "credit-based" excess that has brought the global finance to its knees.

If his thoughts reflect Communist Party thinking, it would explain the bizarre moves in commodity markets over recent weeks. Copper prices have surged 49pc this year to $4,925 a tonne despite estimates by the CRU copper group that world demand will fall 15pc to 20pc this year as construction wilts.

Analysts say "short covering" by funds betting on price falls has played a role. But the jump is largely due to Chinese imports, which reached a record 329,000 tonnes in February, and a further 375,000 tonnes in March. Chinese industrial demand cannot explain this. China has been badly hit by global recession. Its exports - almost half GDP - fell 17pc in March.

While Beijing's fiscal stimulus package and credit expansion has helped lift demand, China faces a property downturn of its own. One government adviser warned this week that house prices could fall 50pc.

One thing is clear: Beijing suspects that the US Federal Reserve is engineering a covert default on America's debt by printing money. Premier Wen Jiabao issued a blunt warning last month that China was tiring of US bonds. "We have lent a huge amount of money to the US, so of course we are concerned about the safety of our assets," he said.

This is slightly disingenuous. China has the world's largest reserves - $1.95 trillion, mostly in dollars - because it has been holding down the yuan to boost exports. This mercantilist strategy has reached its limits.

The beauty of recycling China's surplus into metals instead of US bonds is that it kills so many birds with one stone: it stops the yuan rising, without provoking complaints of currency manipulation by Washington; metals are easily stored in warehouses, unlike oil; the holdings are likely to rise in value over time since the earth's crust is gradually depleting its accessible ores. Above all, such a policy safeguards China's industrial revolution, while the West may one day face a supply crisis.

Beijing may yet buy gold as well, although it has not done so yet. The gold share of reserves has fallen to 1pc, far below the historic norm in Asia. But if a metal-based currency ever emerges to end the reign of fiat paper, it is just as likely to be a "Copper Standard" as a "Gold Standard".

Are Corporate Bonds the New Equity?

• April 13, 2009, 3:12 PM ET

The financial marketplace has tended to work more efficiently when companies are easily able to borrow money from both banks and from the capital markets. Bank lending has been subdued as a result of the credit crisis and subsequent recession, but since January, corporate lending markets have boomed, leading some to say that corporate bonds are, for now, serving as a substitute for the stock market.

Through April 9, more than $974 billion in corporate bonds had been issued world-wide in 2009, according to Dealogic. That outpaces the torrid pace of issuance in 2007, when $723.6 billion had been issued en route to a record $2.127 trillion in world-wide corporate bond sales. The reason is simple, according to investors: Corporate bonds are the most desired asset class right now, at least when fund managers aren’t putting money into cash.

“If you’re looking at corporates, and wondering why there’s such an appetite, it’s because going forward, they look like the new equity,” says Matthew Smith, president and CEO of Smith Affiliated Capital, which manages $2.2 billion in assets. “There is no dividend anymore, so where is the equity surrogate to replace that? It’s high quality corporates.”

The opening of the credit markets has not been easy or quick. After a year-and-a-half of deterioration in those markets, culminating in the September 2008 freeze-up as Lehman Brothers Holdings went bankrupt, spreads ballooned and issuance was nonexistent, with just $345.8 billion issued in the third quarter of 2008, the slowest pace since the fourth quarter of 2005. The yield on the average double-A corporate bond is 3.57 percentage points greater than comparable Treasurys, an improvement from the widest level in the last year, which was 4.91 percentage points. That’s far from the 1.93-percentage-point difference that represented the narrowest spread between the two, however, and it will take more time for spreads to narrow.

“I think there’s going to be a glacial repair” in these levels, says Jessica Hoversen, fixed income and forex analyst at MF Global. She believes, however, that the narrowing will come as investors continue to shift to corporate debt and away from Treasurys as world-wide government supply continues to rise.

For the moment investors remain more comfortable with higher-quality bonds. According to Dealogic, $29.4 billion in high-yield bonds have been issued globally in 2009, which is about the same pace as in 2008, when just $28.8 billion had been issued. It’s a dramatic slowing from 2007, when $93.4 billion had already been sold world-wide. That is, in part, because investors remain concerned about corporate balance sheets, and also because of the decline in fixed-income trading, which makes these markets more illiquid.

“It’s a day-to-day environment, and it’s not as liquid,” Mr. Smith says. “There may be a buyer for your Pepsi bonds today, but you don’t know if they’re going to be there tomorrow.”

A novel approach to monitoring daily HF returns when they don’t actually exist

Apr 12th, 2009 | Filed under: Today's Post

In just about every action movie and TV show these days there is at least one scene where the hero asks one of his or her techies to “sharpen” a satellite image. Suddenly, what looked like a fuzzy bunch of pixelated squares takes on the form of someone’s face, a car, or some kind of mobile rocket launcher. We’re not graphic imaging specialists. But to us, it looks kind of outlandish that someone could take a very small amount of information (a few pixels) and divine the underlying image in fantastic detail.

But in a way, that’s exactly what Daniel Li & Michael Markov (of quantitative investment software vendor Markov Processes) and Russ Wermers of the University of Maryland have done in a paper released last month called “Monitoring Daily Hedge Fund Performance When Only Monthly Data is Available.” Their trick is to leverage another kind of technology: hedge fund replication.

As we have reported extensively, “linear factor replication” aims to predict the performance of hedge funds based on a multiple regression of their historical returns on a number of variables such as equities, Fama/French factors, and several more “exotic” risk factors.

But while hedge fund replication has sought to mimic hedge fund returns in a vacuum, the application of the concept to daily returns means that theory and reality can be brought into alignment on a regular basis. In other words, the model is calibrated to match the empirical data on a regular basis. The result is that tracking error is reduced.

To prove the concept, the researchers ran their model using the monthly returns of the (daily) HFRX Equity Hedge Index (red line). Then they compared them to the actual daily returns of the HFRX Equity Hedge (green line). They ran the analysis using a traditional linear regression and “dynamic filtering technique” called Dynamic Style Analysis (DSA).

So in essence, this approach amounts to “assisted” hedge fund replication, where the linear replication model is helped along by regular infusions of real data as a reference point.

While this concept won’t provide better hedge fund replication per se, it does suggest a novel way for hedge fund investors to track monthly-reported funds on a daily basis. To see if the model could actually be used for individual funds, researchers also tested the model on 17 long/short funds.

Average tracking error was slightly higher than for the HFRX, reflecting the idiosyncratic nature of individual hedge funds. But the model stood its own.

If a hedge fund investor can approximate daily returns, then it follows that they also might be able to hedge out unwanted risk on a daily basis. As the researchers point out, this can be particularly useful when an investor is locked in to a hedge fund due to a redemption gate, but still wants to reduce their economic exposure to the fund. The green line below shows the results of buying the HFRX Equity Hedge Index and taking an off-setting position in a replica based solely on the monthly returns.

Other applications such as “Estimating Daily VaR” are mentioned in the research paper.

In what has become a somewhat over-analyzed field of hedge fund replication, this approach to divining detail where none is provided is a refreshingly straightforward and novel idea.

Buffett Watch: Kass Buys Berkshire

Doug Kass

04/09/09 - 09:25 AM EDT

This blog post originally appeared on RealMoney Silver on April 9 at 8:39 a.m. EDT.

After the close of trading, Moody's (MCO Quote) stripped away Berkshire Hathaway's (BRK.A Quote) Triple-A rating. This move, following Fitch's downgrade last month, is almost laughable in its timing. But, if nothing else, investors have become inured to untimely moves by the ratings agencies.

As to the effect on Berkshire Hathaway's balance sheet and income statement, it is negligible. Gross debt expenses will only rise slightly -- thanks to the company's still large cash hoard and given the fact that Berkshire is overcapitalized (both absolutely and vis-à-vis other insurance companies). Importantly, Berkshire has structured its derivative contracts ingenuously in the fact that it did not have to provide additional collateral when the major world stock market indices dropped precipitously; it simply recorded non-cash charges.

The irony is that the Moody's downgrade has coincided with:

1. a substantial improvement in the value of Berkshire's investment portfolio; and

2. a reversal in some of the losses from Buffett's foray into shorting puts on the major world indices.

As it relates to Berkshire's common shares, I have been conspicuously negative toward the composition of Buffett's investment portfolio and what I described as his "style drift" regarding the foray into derivatives. My concerns peaked regarding the plight of Berkshire Hathaway's shares with a column I wrote as the U.S. stock market was bottoming in early March, "Buy American? I'm Damned!"

At the same time, I qualified that view with the notion that I admired Buffett's remarkable long-term record; from my perch (and from many others'), he is the single greatest investor in modern financial history. I have often written that both Cassandras and Polyannas are attention-getters, not money-makers.

My day job is to deliver superior investment returns to my clients, and, in order to provide alpha, flexibility is a necessary reagent, so is a contrarian streak, logic of argument and strong financial dissection and analysis. When conditions change, as they appear to be doing now -- see this morning's Wells Fargo (WFC Quote) news -- opinions must change, and opportunities must be embraced. This is especially true in the case of Berkshire Hathaway as the considerations that led to my shorting of Berkshire Hathaway's shares at around $145,000 a share have now reversed, and, with the shares today trading under $90,000 a share, I have begun to accumulate a long position in Berkshire Hathaway.

My current estimate of Berkshire's investment portfolio value is now in the neighborhood of about $73,000 a share, so I am paying less than 3.5 times after-tax operating earnings for the non-investment assets of Berkshire Hathaway.

If we triangulate Buffett's own view of intrinsic value of Berkshire (in the letters to shareholders in the 1990s), the intrinsic value of today stands at about $115,000 a share , or nearly 30% higher than its share price. And, as I expect the world's stock markets to advance smartly from current levels (and for financial stocks like Wells Fargo to lead the way), the value of the company's investment portfolio and its intrinsic value will likely be much higher by midyear. (This morning's $3 premarket rise in Wells Fargo's shares equates to more than a $1 billion increase in value in Berkshire's investment portfolio.)

Moody's move yesterday was classic in it's timing; the horse has already left the barn.

GMO’s Global Macro Hedge Fund Sees Further Declines in Stocks

By Malcolm Scott

April 8 (Bloomberg) -- Global Tactical Trust, a hedge fund run out of Australia by Boston-based Grantham Mayo Van Otterloo & Co., is betting the recent rally in stocks will end, and is avoiding high-risk investments.

The hedge fund that invests based on global economic trends returned 13 percent last year, when the industry posted average declines of 19 percent, by wagering against equities and backing bonds. Managed by Jason Halliwell, the fund is long the U.S. dollar, yen, U.S. Treasuries and gold, expecting them to rise, while remaining neutral on equities.

“We do think there’s a good chance of another leg down in the market,” Halliwell, whose team manages a total of A$1 billion ($708 million), said in an interview in Sydney yesterday. If profits in the U.S. reporting season disappoint, “there’s very strong chances that this bear market rally will turn around and we’ll see new lows.”

The Standard & Poor’s 500 Index rallied almost 20 percent from its lowest in a dozen years on March 9. It slid for a second day yesterday after investors including George Soros said more declines lie ahead.

GMO, started in 1977 by Jeremy Grantham, manages about $10 billion in hedge funds. Grantham, nicknamed a “perma-bear” by colleagues because of his grim view on stocks for more than a decade, urged investors in a March 4 commentary to start moving money from cash to stocks before “rigor mortis” sets in.

Global Tactical Fund uses mathematical and statistical models to make investment decisions, then bets on widely traded derivatives to profit from calls on global equities, bonds, currencies and commodities. The fund has A$82 million in assets, according to Bloomberg data.

Profits Fall

Profits at S&P 500 companies probably fell 37 percent on average in the first quarter, according to estimates from more than 1,700 securities analysts compiled by Bloomberg. That would be the seventh straight quarter of declining earnings, the longest since at least the Great Depression, data compiled by S&P and Bloomberg show.

“There’s good long-term returns for buying risk assets like equities at the moment, but they’re not great returns, and that’s balanced against some pretty substantial risks,” Halliwell added.

Hedge funds are investment pools that can bet on falling as well as rising asset prices. Their managers gain substantially from profits on money invested.

On ambulance chasing and bottom picking

A curious little indicator as to whereabouts we are in the credit cycle this:

Bankruptcy-related M&A.

(Or in other words, shotgun mergers and acquisitions being made where one - or both - merging parties would otherwise go bankrupt.)

Note in the graph below, from ThomsonReuters, that in the last corporate default cycle, bankruptcy M&A peaked at pretty much the same point that global stock markets reached their bottom.

Obviously given that bankruptcy M&A is only really just beginning to take-off, it’s another datapoint to add to the markets-haven’t-bottomed-yet meme. Particularly instructive when taken with Moody’s latest monthly default figures.

The Depression and Now (Charts)

World Industrial Output, Now vs Then



World Stock Markets, Now vs Then



The Volume of World Trade, Now vs Then



Central Bank Discount Rates, Now vs Then (7 country average)



Money Supplies, 19 Countries, Now vs Then



Government Budget Surpluses, Now vs Then

Kass: The Little Market That Could

Doug Kass

The Little Engine That Could (also known as The Pony Engine) was a book written by Mary Jacobs in the early 1900s. It is a moralistic children's story about a stranded train who is unable to find an engine willing to take it over difficult terrain -- that is, until a little blue engine comes to its aid. And while repeating the mantra "I think I can ... I think I can," that little blue engine overcomes the seemingly impossible task of bringing the train to its destination.

The metaphor of The Little Engine That Could applies to life and to the current state of the stock market.

Early in the week of March 2, I appeared on CNBC's "The Kudlow Report," where I asserted that the U.S. stock market was within three days of bottoming for the year, and quite possibly for a generation. On Friday, March 6, following two days of further market weakness, I reaffirmed my prediction that the bottom was in.

A week later, on March 9, I reemphasized my generational low bottom call to a skeptical crew on CNBC's "Fast Money." On that show, I cited multiple valuation models I use to assess the current value of U.S. stocks, all of which made it clear to me that equities have incorporated a lot of bad news and were undervalued both absolutely and relative to fixed income:

• The risk premium, the market's earnings yield less the risk-free rate of return, is substantially above the long-term average reading.
• Using reasonably conservative assumptions (most importantly, a near 50% peak-to-trough earnings decline, which is over 3 times the drop in an average recession), the market has discounted 2009 S&P 500 earnings of about $47.
• Valuations are low vis-à-vis a decelerating (and near-zero) rate of inflation. Indeed, the current market multiple is consistent with a 6% rate of inflation.
• Stock prices as a percentage of replacement book value stand at 1 times, well below the 1.4 times long-term average.
• The market capitalization of U.S. stocks vs. stated GDP has dropped dramatically, to about 80%, now at the long-term average. Warren Buffett was recently interviewed in Fortune Magazine and observed that this ratio was evidence that stocks have become attractive.
• The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below the levels achieved in the late 1930s and mid 1970s.
• A record percentage of companies have dividend yields that are greater than the yield on the 10-year U.S. note. At 46% of the companies, that is over 4 times higher than in 2002 and compares against only 5% on average over the past 30 years.

At the time, there were few who believed that stocks were bottoming and literally no one who thought that a sustainable market rally was even remotely possible. Chicken Little had regained credibility, and the Cassandra-like messages of Nouriel "Dr. Doom" Roubini (and those of his ilk) were universally accepted by the lemmings in the media and by the tortured hedge hogs who were then dramatically underinvested in equities and assured of their pessimistic views.

In early March, nearly everyone could explain why the market had declined and why it was unlikely to rebound, but hardly anyone could find a reason to rally. In marked contrast to the past, the general and business media seemed to refuse to consider factors that could contribute to a sustained advance in stock prices, especially given the nascent signs in retail, housing and production that the bottoming process had commenced.

It is equally important to recognize that only a handful anticipated the credit and economic travail of The Great Decession (something between a garden variety recession the The Great Depression), nevertheless, the alacrity and confidence in a continued dire outcome in the land of the Chicken Littles was something for me to behold one month ago. Three years ago, cash was not king, the buying power of private equity dominated the investment landscape, and no takeover (regardless of size) was impossible. Endowments, pension plans, banks and hedge funds jumped headlong into the leveraged world of private equity. Even two years ago, mutual and hedge funds were enthusiastically invested in equities (especially materials, commodities and energy stocks) as the newest paradigm of economic decoupling gained credence.

To summarize, in early March, cash (and liquidity) was back on the throne as king, and the great unwind of debt and the liquidation of overleveraged investments gained momentum as the hedge fund industry imploded further. The extreme negative sentiment that was associated with those conditions sowed the seeds for the bountiful harvest over the past four weeks.

With the benefit of hindsight, value was being put on our doorstep, and dinner was being served four weeks ago.

The first week of March marked the "Nouriel Roubini market bottom." The advice of those Johnny-come-lately Chicken Littles in early March proved horrific, and the performance of stocks over the past month has been the singular best four-week performance since 1933, as my watch list turned progressively more directionally upbeat.

Many have now boarded the love train.

Once again in March, as has happened in prior cycles' inflection points, markets have discounted the worsening rearview mirror and have peered optimistically into the future. Importantly, it is abundantly clear that we now have enough domestic economic data to point to a bottoming of production declines. This is particularly true as it relates to an imminent recovery/stabilization in housing, which is being catalyzed by a Fed-induced reduction in mortgage rates, record gains in affordability and a more favorable economic proposition of home ownership vs. renting.

Housing markets will bring us out just as they brought us in.

My month-old S&P forecast is materially on forecast. As a reminder, it was predicted on a parallel with the conditions that existed in the 1937-1939 U.S. stock market.

If the pattern of my prediction unfolds, the market will have only another 2% to 4% upside before a two-month price consolidation takes hold.

SPDR Trust (SPY) -- Expectations Bloomberg

If the above consolidation expectation is on target, I would emphasize the message I delivered in "The Death of Buy and Hold?" -- namely, gaming the markets will likely hold the key to delivering superior investment returns, especially over the next two to three months.

Short term, the market outlook will be importantly influenced by investor psychology and the degree to which public policy translates into economic traction.

In marked contrast to early March, when we were in a bull market for pessimism, today (as evidenced anecdotally by some breathless and relatively newly minted bullish commentary from previously bearish strategists, money managers, contributors on RealMoney, the "Fast Money" crew and elsewhere) many have recently come aboard the stock market's love train and have turned more constructive:

• Sentiment surveys indicate a pickup in bullish sentiment.
• The McClellan oscillator is way overbought.
• RealMoney's Harry Schiller pointed out that the downtrend line for the S&P from the November 2008 and January 2009 highs shows resistance at 850.

Importantly, my early March variant view is no longer so.

The consequences of worshipping at the altar of price momentum can be punitive to the recently converted. One has to look no further than the recent downturn in gold shares and in the metal commodities, both of which became overowned and overbought asset classes.

Several other fundamental and technical factors could conspire to contribute to a period of market uncertainty and a healthy several months of backing and filling.

• First-quarter earnings reports will be poor and guidance mixed to bad.
• The success of the Federal Reserve programs, which seek to ring-fence toxic bank assets, will not be known for a few months.
• A still levered and "tapped out" consumer could pause in its spending (after demonstrating sequential improvement in the first three months of 2009), even despite the benefits of lower interest rates and massive fiscal stimulation. This could jeopardize GDP growth forecasts, delay the domestic economy's recovery and result in even lower-than-expected corporate profits in 2009.
• Capital raises (especially of a financial kind) may lie ahead. Already, the REIT industry has embarked upon an industrywide recapitalization.
• Interest rates are starting to rise, providing some competition to stocks.
• The always-present fear of an exogenous event.
• Volatility remains elevated.

Weighing against the near-term consolidation argument is the historically significant improvement in the market's internals and breadth of the rally, with six 90% up days in four weeks, reflecting an abrupt change from the fear of being in to the fear of being out and left behind.

Regardless of whether a near-term consolidation is in the offing, volatility will remain heightened, and my formerly implausible S&P forecast now seems plausible.

Similar to The Little Engine That Could, the U.S. stock market appears positioned for further progress, and my mid- to late-summer destination of S&P 1,050 remains on target.

I think it can ... I think it can.

Exposing The Utter Hypocrisy Of The FDIC, And How Andy Beal Is Making A Killing Off It

Posted by Tyler Durden at 12:07 PM

For all those who feel like punching their monitor or TV every time the administration says that the legacy loan program is fair and equitable at a transaction price in the 80-90 cent ballpark, we have some news for you (that will likely make the half life of said monitor or TV even shorter).

But first, there has been a lot of speculation about where banks have marked their commercial loan portfolios. Zero Hedge had previously discovered and disclosed interpretative data from Goldman, which concluded that the major banks were still stuck in a fairytale world where these loans were marked in the 90+ ballpark, a far, far cry from where comparable loans would clear in the market. Of course, FDIC's head Sheila Bair (who many WaMu shareholders lately do not feel too hot about) had some interpretative voodoo of her own, claiming the bid offer disconnect is purely due to a lack of liquidity and access to financing:

"It has been clear for some time that troubled loans and securities have depressed market perceptions of banks and impeded new lending. Difficult market conditions have complicated efforts to sell these troubled assets because potential buyers have not had access to financing. The Legacy Loans Program aligns the interests of the government with private investors to provide financing and market-based pricing, and is a critical step forward in the process of restoring clarity to the markets. While there are inherent challenges to implementing a program of this magnitude quickly, the framework announced today provides the foundation upon which the FDIC will begin to build immediately."

So it came as a big surprise that none other than the FDIC keeps a track of where commercial loans clear in its own internal auctions. In a relatively obscure part of the FDIC's website, there lies a little gem of disclosure, which exposes all the rhetoric by Sheila Bair and by other members of the administration as hypocrisy on steroids. We bring you: FDIC's closed loan sales database. Zero Hedge took the liberty of compiling some of the data for the benefit of our readers: we picked a data sort of all closed commercial loan auctions from January 1, 2009 to February 28, 2009, to see just at what level these would close. Of course, we highly recommend our readers recreate these results.
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The results: 43 commercial loan auctions, of which 39 were for exclusively performing (so not non-performing, or lower quality auctions, and by implication free cash generating), consisting of 331 total loans, representing $206 million in face value, ended up clearing for a $103 million price, a 49.3% discount, or a 50.7% clearing price! That's right, the FDIC itself clears performing commercial loans at 50 cents on the dollar on average in its own regulated, orderly auctions. One would assume the chairman of the very agency that conducts these loan auctions would be aware of them and would at least reference or mention these results in her numerous public appearances.



Curiously, the FDIC also discloses the winning bidders. The surprising recurring result: a little known (but deserving much greater attention) company known as Beal Bank (and its LNV Corporation subsidiary). In the first two months of the year alone, Beal Bank, and more specifically its owner Andy Beal, has won $73 million face value of auctions, for a price of $43 million- a clearing price of 59%. Another way of looking at it is that Beal accounts for 35% of all FDIC auctions.

Just who is Andy Beal, aside from a prolific and profitable poker-playing, college-dropout of course? A great question, which Forbes goes into great detail answering this weekend. We paraphrase the key points from Forbes:

Standing outside the glass-domed headquarters of his Plano, Texas, bank in March, D. Andrew Beal presses a cellphone to his ear. He's discussing a deal to buy mortgage securities. In just a few minutes, the deal's done: His Beal Bank will buy $15 million of face value for $5 million. A few hours earlier he reviewed details on a $500 million loan his bank is making to a company heading into bankruptcy--the biggest he's ever done. A few floors above, workers are bent over computer screens preparing bids for chunks of $600 million in assets dumped by two imploded financial firms. In the last 15 months, Beal has purchased $800 million of loans from failed banks, probably more than anyone else.

It is amusing that Beal Bank, which is not large enough to qualify for the FDIC's zombie bank life-support program known as TLGP, is beating the FDIC at its own game, gobbling up assets (at fair market prices, which is what auction outcomes are by definition). Beal is such a non-mainstream individual that Project Zero will hold a honorary bunk in his favor, (he will have to decide who gets top with Chuck Bowsher) until such time as he decides to stand outside ZH headquarters for 24 hours to gain admission:

It's hard to imagine Beal fitting in at a bankers' convention. He walked into the Las Vegas Bellagio in 2001 and challenged the world's best poker players to games with $2 million pots--the highest stakes ever. Donning large sunglasses and earphones, Beal held his own against the poker stars, once winning $11 million in a single day, although he shrugs that he lost more than he won. At the track he'll drive one of his nine race cars (costing as much as $100,000 each) at 150 mph. On city streets he cruises in a huge Ford Excursion, the vehicle that has made him feel safe since a drunk driver punctured his lungs in 2000.

However, the main reason why Beal is prophetic beyond his years is the following:

He thinks the government is going to be "disappointed" by its various programs to revive lending. He says Treasury Secretary Timothy Geithner's new plan to guarantee loans to buyers of toxic assets won't lead to many sales because the problem isn't liquidity but price. They are not low enough. Half the country's banks--4,000 in all--would be bust, he says, if they marked their loans to what the loans would fetch in an auction. He says banks are fooling themselves by refusing to mark busted assets down.

"Banks are on a prayer mission that somehow prices will come back and they won't have to face reality," Beal says. And that reality, according to Beal, is going to get a lot worse. "Unemployment is going over 10%, commercial real estate hasn't even begun collapsing and corporate credit defaults are just getting started," he says. His prediction: depression, without bread lines this time, thanks to the government safety net, but with equal cost to society.

It is a fitting conclusion that Beal himself is the winning bidder in FDIC's commercial loan auctions (which no other major bank with a $ trillion+ balance sheet has any interest in participating in - why is this if the loans are worth 90 cents as Citi et al have them market internally?), and thus the true market test of what all these toxic legacy loans are really worth. Zero Hedge wholeheartedly agrees with Beal that the CRE situation is headed for a cliff at 120 mph, and that no matter how much hypocritical posturing and rhetoric the administration spouts, or how many more trillions in debt the U.S. incurs to revive the financial zombie on the morgue dissection table, there is nothing at this point that can be done to change the final outcome.

Pimco Mortgage Fund: No Wonder It’s Slow Going

Yesterday we wrote that Pacific Investment Management Company, or Pimco, has raised $224.2 million for its secondary distressed mortgage fund. The target is $3 billion. It launched fundraising about 7 months ago, which means that the effort isn’t exactly moving at a breakneck pace. But then again, I thought, who’s is these days?

Well, today I obtained year-end results for the first distressed mortgage fund, and it gives me a pretty good idea as to why the fundraising is so slow. The fund, called PIMCO Distressed Mortgage Fund I LP, had a total of $2.8 billion in commitments.

Since it’s inception on Oct. 31, 2007, the fund has earned a -34.05 return after fees. It was down 25% in the fourth quarter alone. The firm’s explanation for the loss:

Although the market expected continued weakness in housing, the weakness of the general economy, underscored by substantial increases in the unemployment rate, was not as widely anticipated. This led to significantly wider risk premiums in non-Agency MBS of 4-6% over the quarter. Investor uncertainty has been increased further due to prospective legislation, including bankruptcy reform and aggressive streamlined loan modifications. The policies are particularly concerning because they include principal forgiveness.

Said our source: “They must be so embarrassed about what they have done that they took no public questions on their last investor conference call.”

Here are a few key data points from the docs:

Tough to market a second fund when your first fund’s results are that ugly…

S&P 500 Near Overbought Levels

At its peak yesterday, the S&P 500 briefly traded more than one standard deviation above its 50-day moving average before closing slightly below this overbought threshold. Since the S&P 500 peaked in October 2007, prior occurrences where the index has closed at overbought levels have been relatively rare and brief. Following prior instances, the S&P 500 has quickly reversed and headed lower. Overbought levels can be worked off either with sideways trading over time or by falling prices. Therefore, how the market reacts if we hit overbought levels in this rally will help to determine whether or not this is just another bear market rally (lower prices) or something more sustainable (sideways trading).