Imbalance in S&P 500 Seeding Pessimism: Chart of the Day

By David Wilson - Jul 24, 2012

Smaller U.S. companies are trailing larger ones badly enough to help explain why stock investors are increasingly pessimistic, according toPierre Lapointe, a global macro strategist at Brockhouse & Cooper Inc.

The CHART OF THE DAY displays a ratio of the Standard & Poor’s 500 Equal-Weighted Index, which doesn’t take into account each company’s market value, to the S&P 500, which does.

The ratio peaked in May 2011 and has fallen 6.2 percent since then. Yesterday’s reading was the lowest since February 2010, which showed the equal-weighted index failed to keep up with a 22 percent gain for the S&P 500.

“Individual investors do not feel as rich” as the S&P 500’s performance would indicate, Lapointe and two colleagues wrote in a July 20 report. This would have given investors a reason for concern last week even though the index climbed to a two-month high, the report said.

Only 22.2 percent of the respondents were bullish in the latest weekly survey by the American Association of Individual Investors. The percentage, reflecting the outlook for the next six months, was the lowest since August 2010.

Consumers “starting to feel the pinch” of a slumping U.S. economy may have even more to do with the prevailing view, the Montreal-based strategist wrote. Growth slowed to a 1.4 percent annual rate last quarter from the 1.9 percent pace three months earlier, according to the average estimate of economists in a Bloomberg survey.

Another All or Nothing Day

MONDAY, JULY 23, 2012 AT 11:41AM

While there is still plenty of time left in the trading day, the S&P 500 is currently on pace for its 20th all or nothing day of the year.  We consider all or nothing days in the market to be days where the net daily A/D reading in the S&P 500 exceeds plus or minus 400.  

After a slow start to the year, the pace of all or nothing days for the equity market has picked up moderately in recent weeks.  At the current pace, the S&P 500 would see 36 all or nothing days in 2012.  At this rate, it would be the fewest amount of all or nothing days since 2007, but the fifth most since 1990.

Seth Klarman: The Oracle of Boston

A hedge-fund manager with a low profile and a big following

Jul 7th 2012 | Boston | from the print edition

HEDGE-FUND bosses rarely double as cult authors. But an out-of-print book by Seth Klarman, the boss of the Baupost Group, sells for as much as $2,499 on Amazon. A scanned version of “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” has been circulating around trading floors. One hedgie likens Mr Klarman’s book to the movie “Casablanca”: it has become a classic.

Why are Wall Street traders such avid readers of Mr Klarman? Baupost, which manages $25 billion, is the ninth-largest hedge fund in the world. Since 2007 its assets have more than tripled, as other funds have wobbled. Baupost has had only two negative years (in 1998 and 2008) since it launched in 1982, and is among the five most successful funds in terms of lifetime returns (see chart), a particularly striking record given its risk aversion. Long closed to new investors, Baupost counts elite endowments like those of Yale, Harvard and Stanford among its clients.
Soft-spoken and based in Boston, a safe distance from the Wall Street mêlée, Mr Klarman keeps a low profile and rarely speaks at industry shindigs. He is probably the most successful long-term performer in the hedge-fund industry who has managed to stay out of the spotlight.
Mr Klarman is a devotee of “value investing”, a discipline forged by Benjamin Graham (see article) and popularised by Warren Buffett, which involves buying stocks at a discount to their intrinsic value. He will look beyond equities for bargains—a good example is Lehman Brothers, which at the end of last year was Baupost’s largest distressed-debt position. But in every investment he insists on a “margin of safety”, the buffer between what investors pay for the stock and what they think it is worth, so they are protected against unforeseen events or miscalculations.
Mr Klarman first became an acolyte of value investing when he worked at Mutual Shares, a value-investing mutual fund, as an intern and again after he finished Harvard Business School. One of his former Harvard professors then recruited him to run a family office for him and three other families, with an investment pot of $27m (Baupost is an acronym for these families’ surnames). Although the fund is significantly larger today, Mr Klarman still runs Baupost like a family office. He is extremely risk averse; his primary goal is not stellar returns but preservation of capital.
In other ways, too, Baupost is not a typical hedge fund. It uses no leverage, which is partly why Mr Klarman is not famous for one stunningly profitable trade, like George Soros’s bet against sterling or John Paulson’s against the housing bubble. Baupost has few short positions and often holds its positions for years, rather than days or months. Mr Klarman is patient and confident enough to do nothing. He currently has around 30%—and has been known to have as much as 50%—of his portfolio in cash. In 2008 Baupost was one of the few firms that had the scale and the available capital to buy up lots of assets from distressed sellers. “The ability to be one-stop shopping for an urgent seller is very advantageous,” he says.
Given Baupost’s allure, it could easily make a killing on fees. But Mr Klarman eschews the generous “2 and 20” compensation structure typical of most hedge funds, which take 2% of capital as a management fee and 20% of gains. Instead, old investors pay “1 and 20”, and newer ones (he has let them in twice, in the early 2000s and 2008) no more than “1.5% and 20”.
That is not the only way Mr Klarman has positioned Baupost in contrast to other funds. He thinks one of investors’ greatest mistakes is chasing short-term performance and obsessively comparing returns with those of competitors and with benchmarks. In the year to April, Baupost was up by around 2%, trailing the S&P 500 (which was up by 11.9%) and the average hedge fund (4.4%). He is probably the only hedge-fund manager ever to tell investors that he does not want to be their best-performing fund in a given year, as he did in a recent letter. He has deliberately maintained a sticky investor base composed almost entirely of endowments, foundations and families, which understand his investment philosophy and will not redeem after a few negative quarters.
Some have nonetheless expressed concern about Baupost becoming a behemoth. The bigger a hedge fund, the more its investments become restricted to bigger companies and the harder it is to generate profits. Returns could flag. “He’s pretty damn big. That doesn’t excite me,” says the chief investment officer of a large American endowment with money in Baupost. Mr Klarman himself says he remains “convinced that unlimited size is a bad idea.” Two-thirds of the firm’s approximately $17.6 billion in growth over the past five years comes from compounded profits, as opposed to new money coming in. In 2010 Baupost returned 5% of investors’ capital, because he did not think there were enough ways to put it to work.
Hedge funds are notoriously monotheistic and usually suffer if the founder leaves. Mr Klarman, who is 55, has already started working with his team on succession planning. Last year he promoted someone to serve alongside him as manager of the portfolio. Mr Klarman has also hired coaches to work with him and some of his team on devising strategy and maintaining the firm’s culture.
In 2011 Baupost opened a London office, its first outside Boston in its 30-year history, to buy assets as European banks deleverage. That has happened more slowly than expected. Mr Klarman has been critical of governments propping up markets through stimulus and keeping interest rates low, all of which has perverted markets. But this is the type of environment where bargains will eventually surface. “Whatever investment success we achieve will take place against a troubled backdrop,” he wrote in January. Last year “felt like we were playing a great hand of cards in the basement of a condemned building filled with explosives during an earthquake.” He did not get where he is now by being an optimist.

Gold Can't Catch a Break

If you think it has been a tough few months for equities, it pales in comparison to the recent performance of gold.  After hitting its high for the year in February, gold has been in a relentless downtrend for the last four months.  In fact, since the February peak alone there have been eight different periods where gold attempted a rally, only to see the advance run out of gas before the commodity could even make a higher high.

The Smartest Man is a Firedancer

07/02/2012

The Smartest Man is a Firedancer

When the New Democracy party in Greece defeated the anti-bailout Syriza, I was anxious to learn what The Smartest Man in Europe thought of it all.  The next day I flew across the Atlantic to meet him and we had a long discussion about the world financial outlook.  Many of you remember The Smartest Man from earlier essays; I have been writing about him annually for more than a decade.  He has been a friend for thirty years, and during that period he has shown an almost uncanny ability to see major events affecting the financial markets before other observers.  Among these were the fall of Japan as an economic power in the 1980s, the economic changes in China and their significance the early 1990s, and the serious consequences of excessive borrowing in the developed world in the last decade. 

His DNA endowed him with a certain amount of business acumen.  His ancestors operated canteens along the Silk Road, selling food, weather protection and supplies to travelers to India and China.  He apprenticed in finance in New York, but returned to Europe to take advantage of opportunities created during the post-war recovery there.  Along the way he has acquired the ABC’s of European wealth – an airplane, a Bentley and a house on a Cap in the French Riviera.  The depth and breadth of his art collection is impressive, but material things are not what gives him a high.  He gets his thrills from identifying a problem, thinking it through and being right in determining how it gets resolved.  In his ninth decade, he is an inspiration to me.

He started out by saying he had done some preparation for our visit.  “I think the title of your essay should be ‘Dancing around the Fire of Hell.’  For years I’ve been telling you that the accumulation of debt was going to be the ending of the developed world and for years you have been telling me my views are too extreme.  The problem is you are an optimist and I am a realist.  You go around with a smile on your face thinking that there are serious problems facing us, but that everything will turn out favorably because the policy makers will do what they have to do to avoid disaster, and so far you have been right.  The developed economies and their stock markets have plodded along and investors haven’t made or lost much money in spite of the challenges.  At a certain point, however, the temporary measures that the policy makers put in place to avoid financial catastrophe prove insufficient and that’s where we are now.  I’m not saying that it will happen tomorrow but events are falling into place that will take the smile off your face.

“The problem is that most investors think incrementally.  They don’t step back and look at the whole landscape, which includes how we got here and where we might end up.  In democracies the people always want the government to do more for them, but they don’t want to pay higher taxes.  Politicians get elected by promising benefits, not by raising the revenues necessary to avoid increasing debt.  In a developed economy real growth should equal the population increase plus productivity.  For Europe and the United States that’s about 2%, but people there want their economies to grow more than that so the government provides the stimulus to create faster growth and takes on the debt necessary to do it.  Everything is fine as long as the cost of ten-year debt doesn’t exceed the nominal growth rate, but when it does the cost of servicing the debt becomes an unsustainable burden, and that’s where Spain and Italy are.  The United States isn’t quite there yet.

“When governments finally get around to recognizing they are in trouble, what do they do?  They accept the fact that they cannot produce more growth by providing fiscal stimulus because that would only increase the debt problem, and they can’t take the risk of a recession that might clean out the legacy debt obligations because that would prevent future borrowing, so they do the only thing they can do: they print money.  That’s what the Federal Reserve did in 2008 when they increased the Fed balance sheet from $1 trillion, virtually all in the U.S. Treasurys, to $2.5 trillion, with the increase mostly in mortgage-backed securities.  That’s what the European Central Bank (ECB) did in 2011 when the sovereign debt problems of the weaker countries became severe.  The balance sheet of the ECB increased from €2.0 trillion to €3.0 trillion, and the increase was mostly made up of the sovereign debt of the weaker countries.

“This may go on for a while, but it can’t go on forever.  In Europe’s case Germany will stop backing the monetary expansion and the U.S. Fed will get uneasy as well.  As Milton Friedman persistently argued, inflation is always and everywhere a monetary phenomenon.  So far, however, inflation has remained tame because house prices and wages haven’t risen in most places in Europe and the United States (except real estate in London and New York, where foreign capital has flowed in).  At some point, however, inflation will become a factor.

“Right now we’re witnessing a kind of convergence.  The standard of living in the developed world is declining and the standard of living in the developing world is increasing.  Debt to Gross Domestic Product (GDP) ratios in the developed world are about 100%, where, as Ken Rogoff and Carmen Reinhart have pointed out in This Time Is Different, growth becomes modest.  In the developing world debt to GDP is only about 35%, so these countries have a long way to go. 

“When you think about it, there are a lot more people producing things these days than there were thirty years ago.  Up until 1980 the United States was a major manufacturer and accounted for the dominant share of world GDP, about twice as much as it does now.  By 1980 Europe was producing goods for export and Japan was selling cars, cameras and consumer electronics to everyone.  Now China is the second largest economy in the world and is a major manufacturer, having come from nowhere in the 1970s.  With so many places producing so much and some doing it at relatively low cost, is it any wonder that a lot of people in higher labor cost areas like Europe and the United States are out of work?  The U.S. today is primarily a service economy with a trade deficit.  Germany is a manufacturing economy with a trade surplus.  Do you have to ask why one is doing well and the other isn’t?

“Going back to the Greek election, I think it will prove to be a non-event.  Antonis Samaras will agree to adhere to the austerity program the previous government signed in March in exchange for financial relief, but it will be hard for him to deliver as required.  The Greek people won’t tolerate the pain they will be forced to endure.  They are hot-blooded and want to see results quickly.  There are only two ways to solve the problems of the weaker countries:  austerity, which would mean a 10% contraction in GDP (and Greece is already doing worse than that) or default, which is the route that Russia and Argentina took to get back on track.  Ireland is a good example of a country that successfully took the austerity route.

“Before we experience widespread defaults the authorities will pull out every trick in the book to prevent catastrophe.  That’s because there is a general belief that the European Union was a good idea.  In order to compete against the United States and Asia, the European countries had to hang together.  It was as much a geopolitical decision as an economic one.  There needs to be more cooperation among the European leaders.  The first step is to create a coordinated banking system to prevent a run on the banks.  Deposit insurance won’t do the job.  It’s too much to expect the various governments to agree to a political union at this time, but there could be a banking union to prevent the European banking system from collapsing. 

“The next step will be for every central bank in the world to keep printing money.  Ultimately this will bring on a higher level of inflation, but I think the world is ready to accept that.  World leaders will agree that growth should be their objective and inflation will be the price they will have to pay for it.  This may result in some instability among currencies.  Before this happens there will have to be more suffering.  Spain and Greece will default.  There won’t be outright financial disaster because by the time the defaults take place the banks will have sold most of the troubled sovereign debt on their balance sheets to the European Central Bank.  France’s deficit will get worse as Hollande implements some of the programs he talked about in his campaign.  Human beings and governments have an unlimited imagination and they will use it to delay the day of reckoning.  In the longer term the crisis may turn out to be a good thing because the pain of what we are about to go through will prevent it from ever happening again.

“In the short term interest rates should keep rising because debt is increasing faster than GDP.  This should be true in the United States also, but capital is moving there for perceived safety reasons.  After the defaults occur, there will be slow growth.  The defaults will ultimately create a banking crisis, and that will result in a World Economic Conference where the leaders will agree on an objective of 7% nominal growth made up of the 2% real growth and 5% inflation.

“The Federal Reserve has to keep printing money to prevent a recession.  Europe is already in a recession and the ECB will keep printing money, but the Fed may be more aggressive and that could weaken the dollar further.  What we are experiencing is an accumulation of bad decisions.  The worldwide banking system was able to work together effectively to deal with the financial crisis of 2008 but hasn’t done so well since then.  The banks need more capital.  Their loans are being written down.  Their government bond holdings are declining in value.  On top of this, Basel III is imposing additional capital requirements.  How does that make sense?  It’s impossible.  I don’t know whether a default or an economic conference comes first, but in democracies, a crisis usually causes a conference.  In the meantime, capital in Europe will continue to flee to Germany, Finland and the Netherlands.

“So what am I doing with my money?  It is hard to hide in stocks.  Even Danone is reporting disappointing earnings; people are so worried they aren’t even buying yogurt.  The French auto companies are in trouble.  I think gold is going much higher.  I am buying energy stocks because I want to own something real.  Preserving capital is my focus now, not making money, but I like IBM and Apple.  Also some Swiss multi-nationals.  If Obama wins in November the market will go down.  A Romney victory will create a rally, but once he gets into office he will find there is not much he can do to make things better.”

I left The Smartest Man’s office somewhat dazed.  My optimism was clearly diminished by what he had to say, but I still believe that somehow disaster has a way of usually not happening.  It seems clear that world leaders are going to do everything possible to avert a financial catastrophe and I think they have the resources to accomplish that goal.  It does seem, however, that the developed world has to resign itself to a prolonged period of slow growth.

Two bonds that DoubleLine bought over $1.7bil of last month

While people tend to flock to the DoubleLine Capital conference calls, I’ve always been more interested in tracking the bonds that they buy from month to month.  After all, with AUM in the Total Return Fund now exceeding $27bil, they need to be buying a TON of bonds.  Where do they see value? How does that fit in with housing and macro views?

In retrospect, the fund has changed a lot over the past two plus years.  When the fund opened in March of 2010 the 10yr was over 3.5%, and non-agency MBS prices were generally much lower across the board.  With rivals fretting about “who will buy all of those treasuries”, DoubleLine prudently bought a large amount of duration in the form of last cash flow Z CMO’s at deep discounts.  The key rate duration of these type of bonds were tied to the 10-30yr part of the UST curve, and they obviously rallied tremendously as the 10 & 30yr now sit at 1.66% and 2.75% respectively.  Today’s rate environment is very different and so are the opportunities in fixed income.

The relatively stable loss-adjusted yields produced by non-agency MBS are still available, but they’ve come in with the overall yield chase.  Furthermore, with billions going into the total return fund each month it becomes more difficult to source as attractive bonds as it was when the asset base was a fraction of today’s size.

What are they buying today with these massive inflows?
After reviewing the fund holdings of DBLTX as of May 31st, 2012, a few purchases were notable.  DoubleLine added over $1bil of newly issued 20yr 3.5% pools and nearly $700mil of 30yr 4% jumbo pools.  The 3.5% pools are borrowers with a rate of ~4%.  Looking at total issuance for May, it appears DoubleLine bought about 1/3rd of the total issuance of these bonds.  This collateral has been pretty slow with prepays generally under 10c.  Not a super sexy bond, as it will likely yield somewhere in the 2.30%-2.60% range with a spread of ~1.35% over USTs, but the bond would be a strong performer if rates continue to fall and/or QE3 comes around.

Grantham: ho hum 7 yrs

Jeremy Grantham has attracted a cultlike following to his quarterly investment letters. For good reason: The chief investment strategist at Boston asset manager GMO warned of dismal returns ahead for U.S. stocks in the 2000s and predicted the bursting of both the technology and housing bubbles.
Lest you get the impression Grantham is a permabear (a label he hates), in his March 2009 letter he advised snapping up U.S. stocks just as they were plunging to their nadir in the financial crisis. Those who bought profited from one of the most powerful market rallies ever. N

These days Grantham, 73, is downbeat about the prospects for most, but not all, stocks. A student of history, he has much to say about why markets get out of whack, and why we may be entering a period in which resource scarcity is again an issue for society -- and an opportunity for investors.


How do you go about finding the best opportunities?
The great opportunities are much more likely to come at the broader asset class level than from individual stocks.
Asset classes -- stocks, bonds, commodities -- get very badly mispriced. That's because they come with enormous career risks for institutional investors. As a professional, you can afford to pick some stocks and be wrong about a few of them. To keep your job, you cannot take the risk of being seen to be wrong about the "big picture" for very long.

How did the price/earnings ratio of the S&P 500 get to 35 in 2000, compared with the long-run average of 15?
You had a massively mispriced market, and it was talked about all over the place. But no one would step aside. Institutions couldn't bring themselves to do that because they would have been skinned alive for their conservatism.
So asset allocation is an enormous opportunity, but only if you're willing to take considerable career risks. Playing against the tech bubble was unbelievably painful for us for two years, and then eventually, of course, it paid off handsomely.

How do you avoid getting sucked into bubbles yet still get some benefit from rising prices? 
Remember that history always repeats itself. Every great bubble in history has broken. There are no exceptions.
At GMO, we have a database of 35 bubbles. Of the 33 that have ended, every one broke all the way back -- not halfway back -- to the trend before the bubble started.

Remember also that stocks are kind enough to wear a price tag. In 2000 the price tag said "Ouch!" It implied a return of negative 3% a year for 10 years. In March 2009 the price tag for the S&P 500 was 13 times earnings. That said you were going to make about 10% a year plus inflation for seven years.

Is a bubble forming in the U.S. bond market? 
Fixed income has had a big run for two reasons. One is manipulation by the Federal Reserve to keep rates artificially low. The other is the substantial degree of nervousness in the system due to the weak economy, Europe's problems, and the recency of the great crash. So you have in fixed income what I would call an anti-bubble. It's there because people are still frightened of the stock market.
The next giant move in bonds will be bad for long-term-bond holders. The normal return would be 3% plus inflation. So if inflation is around 2.5%, you'd expect 5.5% from a government bond. That's a long, long way from where we are.

What is the long-term effect of the Federal Reserve keeping interest rates low?
[Fed chairman Ben] Bernanke is making sure that we don't get a decent risk-free return. It's brutally unfair to retirees. He's doing this because if he keeps rates ugly enough for long enough, we will reluctantly filter our money into equities. A higher stock market induces more consumption and is helpful short term to the economy.
The bad news is every penny of that gets given back. It's like a pact with the devil: You make your money by pushing stocks up, but then inevitably the market must go back to fair value. When it does, it creates an anti-wealth effect, usually at the worst possible time.

What is your long-term outlook for stocks? 
Returns over the next seven years will likely be ho-hum. On a global portfolio, that means maybe 4% after inflation, compared with 6.1% historically.

What area of the world do you see as a focus for investment over the next few years?
Foreign markets are decidedly more reasonable than the U.S., so we advise a bigger than normal emphasis on developed and emerging countries. They're priced to return about 5.1% a year, above inflation, over seven years.
Within the U.S., 100% of our equities are in high-quality blue chips. If you concentrate on the great franchise companies, you should get a real return of around 3.9% over seven years. So you'll feel not too bad.
Our seven-year numbers say that you should stay away from low-quality U.S. equities completely.

If you're underweight U.S. stocks, is it because you see another bubble there?
It doesn't feel to me that we're in the late stages of a bubble. The U.S. seems overpriced -- and if you take out the blue chips, it seems substantially overpriced. But it doesn't have the usual signs of group-think.
If the S&P 500 were to build up from about 1300 today to 1500 later this year or early next, then you'd want to run for cover and keep your head down.

Are commodities the next bubble? -
We used to live in a world where the price of resources came down steadily, and now the world has changed. You have a great mismatch between finite resources and exponential population growth.
China uses 46% of all the world's coal, for heaven's sake! The global population has surged from 6 billion to 7 billion in 12 years, and is now on its way to 9 billion. You'd better expect prices to rise.

So how would you advise investing in commodities?
I wouldn't touch futures; it's complicated and too unprofitable. Buy the guys who own stuff in the ground. Metal, oil, even natural gas, which is cheap now but will eventually pick up.

Our biggest problem as a planet will be our inability to feed more than 9 billion people in 30 years' time. We have to address this. It's much more important than any stock market problems.
When it comes to portfolios, my personal advice is for anyone who can, put money into forestry or farmland. Long term, you would probably never come near their returns in the stock market. In the world that I see, land is golden.

How will the stock market react to the upcoming election? 
On one hand you've still got Bernanke promising to keep rates low. On the other hand, you've entered a new political world. The Republicans will want to show much more fiscal responsibility. And even if the Democrats are back, they will attempt to illustrate that they are also aware of the long-term problems of debt accumulation. My guess is that it's a tougher environment for the market starting next year.

Mutual Fund Performance Persistence

Do top-performing mutual funds reliably continue to be top performers. In their June 2012 semiannual report entitled “Does Past Performance Matter? S&P Persistence Scorecard”, Standard and Poor’s summarizes performance persistence statistics for U.S. mutual funds overall and for funds grouped by capitalization focus of holdings. They measure persistence of the top 25% (quartile) and top half of funds across multiple subsequent years and frequency of migration of all performance quartiles from one multi-year interval to the next. Using annual performance data for a broad sample of U.S. mutual funds during March 2002 through March 2012, they find that:

• Only 4.05% (19.6%) of mutual funds in the top performance quartile (half) as of March 2010 persist in the top quartile (half) for both of the next two years, compared to 6.25% (25%) for random expectations.
• Only 0.93% (5.22%) of mutual funds in the top performance quartile (half) as of March 2008 persist in the top quartile (half) for all of the next four years, compared to 0.39% (6.25%) for random expectations.
• There is some tendency toward reversal of fortune of the best and worst funds across consecutive, non-overlapping three-year and five-year performance intervals (see the chart below).
• Results are generally consistent across groups of funds segmented by stock capitalization focus (size style).

The following chart, constructed from data in the summary, summarizes migration of mutual funds from three-year performance quartiles ending March 2009 to performance quartiles for the next three years. Each quartile contains 493 funds. Funds in the top (bottom) quartile during the first three-year interval are most likely to be in the bottom (top) quartile during the subsequent three-year interval. However, funds in the bottom quartile during the first interval are most likely to disappear during the next interval.


In summary, evidence casts doubt on the existence of U.S. mutual fund manager skill and indicates that fund performance is more likely to reverse than persist.
Cautions regarding findings include:

• Since the report does not address factors related to performance persistence, findings do not obviously translate into a fund switching strategy.
• Performance measurements address size of holdings but not other factors commonly applied to alpha (book-to-market and momentum).

unconstrained

So-called “unconstrained” bond funds got very hot a while ago, so it’s time to check in on how they’ve done.

For background, you can read a couple of postings from April 2011.  One from Josh Brown looked at the popularity of the vehicles at the time, while David Merkel examined them in a historical context and pointed out some important issues for investors.  The remainder of the year included weak performance from most of them, the crux of a December piece from Bloomberg.

The three mutual funds shown above were featured in that Bloomberg story.  They are JPMorgan Strategic Income Opportunities (JSOAX), PIMCO Unconstrained Bond (PUBAX), and Eaton Vance Global Macro Absolute Return (EAGMX).  Pictured too is the iShares Barclays Aggregate Bond ETF (AGG), which has easily beaten all of them since the start of 2011.  This longer chart begins in 2009.

Eric Sprott on the Recent Volatility in Gold

Seeing how gold has seen volatility as of late and numerous top hedge funds hold physical gold, we thought it would be prudent to check in with one of the most outspoken gold advocates: Eric Sprott of Sprott Asset Management.

After all, gold is one of Dan Loeb's top holdings at Third Point.  David Einhorn of Greenlight Capital has long held physical gold as a top stake.  And we highlighted in April how John Burbank's Passport Capital had been buying gold.


So what do investors make of the latest volatility?  Eric Sprott and Shree Kargutkar put out an interesting note on the precious metal on June 8th:

Sprott on Gold

"There have been key devel­op­ments in the phys­i­cal gold mar­ket over the last few weeks which we feel are worth highlighting:

1) The Chi­nese gold imports from Hong Kong in April, 2012 surged almost 1300% on a YoY basis. Total gross imports for the month of April were 103.6 tonnes and the net imports were 66.3 tonnes1. It is not the data for April alone which has caught our eye. There has been a stun­ning increase of gold imports through Hong Kong for export into China over the past 2 years. Between May 2010 and April 2011, China imported a net 66 tonnes of phys­i­cal gold through Hong Kong. Between May 2011 and April 2012, that num­ber jumped to 489 tonnes. This rep­re­sents an increase of 640%. 

2) Cen­tral banks from around the world bought over 70 tonnes of gold in April, 2012. Data from the IMF showed devel­op­ing coun­tries such as the Philip­pines, Turkey, Mex­ico and Sri Lanka were sig­nif­i­cant buy­ers of gold as prices dipped.

3) Iran pur­chased $1.2B worth of gold in April, 2012 through Turkey. As the devel­oped nations con­tinue devalu­ing their cur­rency at the expense of devel­op­ing nations, coun­tries such as Iran, China and Mex­ico are forced to look at alter­na­tive stores of value.

4) After twenty years of lack­lus­ter returns and stag­nant bond yields, Japan­ese pen­sion funds have finally dis­cov­ered the value of invest­ing in gold. The $500M Okayama Metal and Machin­ery pen­sion fund placed 1.5% of its assets into gold bullion-backed ETFs in April in order to "escape sov­er­eign risk"4.

5) Bill Gross writes, "Soar­ing debt/GDP ratios in pre­vi­ously sacro­sanct AAA coun­tries have made low cost fund­ing increas­ingly a func­tion of cen­tral banks as opposed to pri­vate mar­ket investors. Both the lower qual­ity and lower yields of pre­vi­ously sacro­sanct debt there­fore rep­re­sent a poten­tial break­ing point in our now 40-year-old global mon­e­tary sys­tem. […] As they (investors) ques­tion the value of much of the $200 tril­lion which com­prises our cur­rent sys­tem, they move mar­gin­ally else­where — to real assets such as land, gold and tan­gi­ble things, or to cash and a fig­u­ra­tive mat­tress where at least their money is read­ily acces­si­ble". Is the bond king rec­om­mend­ing gold? YES, YES YES!

6) The Gold Min­ing ETF, GDX, has seen strong inflows in the past 3 months. The num­ber of units out­stand­ing have increased from 162.5M to roughly 187M between March 1, 2012 and May 31, 2012. This rep­re­sents an increase in assets of almost $1.2B in a span of 3 months. It is worth point­ing out that for a major­ity of this three months period, GDX, and by exten­sion the gold min­ing com­pa­nies were expe­ri­enc­ing sig­nif­i­cant declines in their mar­ket values.


We believe there has been a mate­r­ial change in the gold invest­ing land­scape. The HUI, which is the Gold Bugs Index, is now up over 20% from its lows since May 16th, 2012. The slide in gold equi­ties seems to be sub­sid­ing as a foun­da­tion for a strong move upwards is set. New buy­ers, rep­re­sented by the Chi­nese, cen­tral banks, Japan­ese pen­sion funds and the Ira­ni­ans, bought almost 140 tonnes of gold in April alone. To put this into per­spec­tive, the annual gold pro­duc­tion is approx­i­mately 2600 tonnes. China and Rus­sia pro­duce around 500 tonnes of gold annu­ally, which never makes it to the open mar­ket. This leaves about 2100 tonnes of gold pro­duc­tion annu­ally for the rest of the world.


When buy­ers rep­re­sent­ing 140 tonnes of new demand enter a mar­ket which only has 175 tonnes of monthly sup­ply, we are left won­der­ing about two things:

1) In a bal­anced mar­ket, where is the source of sup­ply to the new buy­ers going to come from?

2) How can a new buyer of size get into the gold mar­ket, which is already bal­anced, with­out sig­nif­i­cantly impact­ing the price of gold? The answer is fairly obvi­ous. When demand out­strips sup­ply, prices move higher. These sig­nif­i­cant macro changes in the sup­ply­de­mand dynamic of the gold mar­ket should pro­pel the price of gold to new highs."  


For more from this fund manager, we've also highlighted Sprott's previous commentary on how 2012 is the year of the central bank.

The Hunch, the Pounce and the Kill

BOAZ WEINSTEIN didn’t know it, but he had just hooked the London Whale.

It was last November, and Mr. Weinstein, a wunderkind of the New York hedge fund world, had spied something strange across the Atlantic. In an obscure corner of the financial markets, prices seemed out of whack. It didn’t make sense.

Mr. Weinstein pounced.

As the financial world now knows, what was out of whack was JPMorgan Chase & Company. One its traders, Bruno Iksil, the man later nicknamed the London Whale for his outsize trades, was about to blow a multibillion-dollar hole in the mighty House of Morgan.

But the resulting uproar, in Washington and on Wall Street, has largely obscured a simple truth of the marketplace. Yes, Morgan lost big — but, as Mitt Romney has pointed out, someone else won. And that someone or, rather, those someones, turn out to be Boaz Weinstein and a wolf pack of like-minded hedge fund managers.

In the London Whale, these traders saw a rich opportunity, and they seized it with both hands. That, after all, is the way hedge funds roll. His cool calculus has made Mr. Weinstein a very rich man: he is in talks to buy the Fifth Avenue co-op of a reclusive heiress, Huguette Clark, for $24 million.

It might seem remarkable that someone like Mr. Weinstein, a man virtually unknown outside of financial circles, could deal such a stinging blow to one of the world’s largest, most respected banks. Jamie Dimon, the chairman and chief executive of JPMorgan and a face of the banking establishment, is struggling to contain the damage from what he has called a “terrible, egregious mistake.” The loss — JPMorgan put it at $2 billion, but it may turn out to be $3 billion or more — has renewed calls for stronger financial regulation.

Given the secretive nature of the business, few on Wall Street, including Mr. Weinstein, were willing to speak publicly about how the hedge funds harpooned the London Whale. But interviews with more than a dozen hedge fund managers, investors and traders pull back the curtain on the ways of this band of traders, and on what really happened.

One thing is sure: Mr. Weinstein, 38, played a central role in this, one of the biggest trading blowups since the financial crisis of 2008. Mr. Iksil and his colleagues in the chief investment office at JPMorgan may have lighted the fire, but Mr. Weinstein and his cohorts fanned the flames. In the hedge fund game, a business in which ruthlessness is prized and money is the ultimate measure, Mr. Weinstein is what is known as a “monster” — an aggressive trader with a preternatural appetite for risk and a take-no-prisoners style. He is a chess master, as well as a high-roller on the velvet-topped tables of Las Vegas. He has been banned from the Bellagio for counting cards.

From offices on the 58th floor of the Chrysler Building in Midtown Manhattan, Mr. Weinstein runs a $5.5 billion hedge fund firm called Saba Capital Management. (“Saba” is Hebrew for “grandfatherly wisdom,” a nod to his Israeli roots.) It was there, last autumn, that he noticed an aberration in the market for credit derivatives. He knew from experience what it was like to lose a lot of money at a big bank. Before starting Saba, he was responsible for a team that lost nearly $2 billion, in the depths of the financial crisis, at Deutsche Bank. Others lost even more. Last November, however, he saw that a certain index seemed to be trading out of line with the market it was supposed to track. He and his team pored through reams of data, trying to make sense of it.

Finally, as Mr. Iksil, the London Whale, kept selling, Mr. Weinstein began buying.

At the time, traders in London had no real idea that JPMorgan was behind the trades that were skewing the market in credit derivatives. In fact, they weren’t even sure that it was a single bank or trader. But soon the City of London, Europe’s financial hub, was buzzing. Whoever the mysterious trader was, he or she kept selling derivatives intended to rise in value in the event that certain corporate bonds became riskier. The volume of trades was off the charts. Who could possibly sell so much? And, what if the trade reversed, as it inevitably would?

And so the battle lines were drawn. On one side was JPMorgan, the American banking giant that had weathered the financial crisis far better than so many of its peers. On the other were hedge fund managers, including Mr. Weinstein at Saba.

Such standoffs are not uncommon on Wall Street. An aggressive trader makes a wrongheaded bet, then doubles down to scare off competitors on the other side of the trade. Market rivals often get slapped down, unwilling to keep buying as the other side is selling, or vice versa. For traders with the backing of a major bank, like JPMorgan, the task is much easier.

But not always. Sometimes, the other side sits tight, then hits back in force. And it does so in numbers.  

By January of this year, the trade against the London Whale was not going well for the hedge funds. The price of the index, as well as others, was still falling, and the losses were mounting for Mr. Weinstein and the others. But by February, it was clear that a single, big player was behind the selling. On trading desks in London and New York, everyone was talking.

It had to be JPMorgan.

BOAZ WEINSTEIN has always played the wild card in the markets. He grew up on the Upper West Side of Manhattan, in relatively modest surroundings, the son of an automobile insurance salesman and a translator, both regular watchers of “Wall Street Week.” As a student at Stuyvesant High School in Manhattan, he entered a contest to see who could pick the best stocks. He won — by selecting an assortment of the fastest-growing stocks he could find from newspaper charts. He studied philosophy at the University of Michigan — he was partial to Hume and Camus — but today favors behavioral finance, particularly the work of his friend Dan Ariely, a professor at Duke. Mr. Weinstein is married to Tali Farhadian Weinstein, a rising lawyer in the Justice Department.

Last February, at a conference organized by another hedge fund manager, his friend William A. Ackman, Mr. Weinstein was hailed as one of the savviest credit traders in the business.

The February conference was held, ironically, in JPMorgan’s offices on Madison Avenue. Workers at the bank milled about as Mr. Weinstein and others offered  investment tips.

Dressed in a sharp blue suit, Mr. Weinstein stepped up to the microphone and opened with a joke that only a financial wonk would appreciate. He showed a slide comparing the cost of credit default swaps on various government debt to the percentage of young men in those countries who live with their parents. The slide titled “Mamma Mia!” suggested that, by that measure, Greece, Portugal and Italy were in trouble.

But what really got people’s attention was his second-to-last slide. It was his pick for the “best” investment idea of the moment. Mr. Weinstein recommended buying the Investment Grade Series 9 10-year Index CDS — the same index that Mr. Iksil was shorting.

The crowd, 300 or so investment professionals, began buzzing.

“Once he came out in that meeting and was so specific, others jumped in,” one hedge fund manager said.

But the London Whale was so big that, for months, the hedge funds betting against him simply got steamrolled. One of Mr. Weinstein’s funds at Saba was down 20 percent heading into May.

Then the tables began to turn, as news reports about Mr. Iksil, fed by the hedge funds, began to surface on both sides of the Atlantic. Suddenly, everyone was checking out the obscure index that Mr. Weinstein and others had seized upon.

By May, when fears over Europe’s debt crisis again came to the fore, the trade reversed. The London Whale was losing. And Mr. Weinstein began to make back all of his losses — and then some — in a matter of weeks.

Other hedge funds were also big winners. Blue Mountain Capital and BlueCrest Capital, both created by former JPMorgan traders, were among those winners. Lucidus Capital Partners, CQS and a fund called III came out ahead, too.

INSIDE the hedge fund world, some joked that Mr. Weinstein had been able to spot the London Whale because he himself had been a whale once, too.

Mr. Weinstein was a pioneer in complex credit derivatives, latching onto them early in his tenure at Deutsche Bank, before they became the financial weapons of mass destruction that worsened the financial crisis. He was a profit machine at the bank, notching earnings in 10 of his 11 years trading there. At 27, he became one of the youngest managing directors in the bank’s history. Before his book blew up, Mr. Weinstein was reportedly pulling down about $40 million a year. He exploited price discrepancies and piled leverage into his trades.

Then his team at Deutsche Bank lost $1.8 billion during the 2008 financial crisis. The trading losses ruined bonuses throughout the bank, and ruffled more than a few feathers.

He would later leave the bank and, along with 12 of his colleagues, set up Saba. Mr. Weinstein started it with $140 million — a pittance by hedge fund standards. In the intervening years, he has outperformed his peers and managed to vacuum up assets at a time when most growing hedge funds have been struggling to hold on to what they’ve got. He now controls more than $5.5 billion.

 The similarities between Mr. Weinstein and Mr. Iksil still resonate in the market.

“It was one whale versus another whale,” one hedge fund manager said.

Those who have traded against Mr. Weinstein describe him as an aggressive trader who bets big and moves fast. He values a deal more than old-fashioned etiquette. Traders tell tales of losing money to him because of split-second price differences he picked up faster than they did. While that kind of behavior doesn’t win a lot of friends on Wall Street, these traders concede that Mr. Weinstein is too big and powerful to ignore.

At a lot of large hedge funds, the top dogs bark orders to underlings, but Mr. Weinstein is almost always the one doing the trading at Saba. He calls around to the banks daily. His confidence and willingness to take on risk, however, leave some worried that he’s never too far away from another Deutsche Bank trade — from, in essence, becoming the whale.

“If you hand me a list of the top-performing guys in the space, I’d expect to see his name on it,” said one bank executive who works closely with hedge funds. “If you hand me another list of hedge funds that might blow up, I’d expect his name to be on that, too.”

Others disagree, saying that Mr. Weinstein has a long record as a steady performer.

LIKE many hedge fund traders, Mr. Weinstein is comfortable with risky pursuits, particularly those that require spot calculations and a cool head. A gambling enthusiast, he has an affinity for blackjack and poker. In 2005, Mr. Weinstein won a Maserati by competing in poker in a tournament sponsored by a unit of Warren E. Buffett’s Berkshire Hathaway. Mr. Weinstein still drives the car. He plays with celebrities like Matt Damon, too.

Not everyone is enthusiastic about Mr. Weinstein’s playing style. A few years back, on a trip to Vegas, he was banned from the opulent Bellagio casino for counting cards while playing blackjack.

Much has also been made of his prowess as a chess player. He earned the chess master designation at the age of 16, and has remained a lifelong fan, though he plays less these days. At a charity auction in 2010, he paid $10,500 to play alongside the chess legend Garry Kasparov and the young chess sensation Magnus Carlsen.

Mostly, he sneaks in quick games online, sometimes with Peter Thiel, a hedge fund manager and Silicon Valley star who was an early investor in Facebook.

Both chess and playing the markets require a mind that can see several steps ahead of the next man — a fact that has not been lost on Wall Street. Privately, Mr. Weinstein tells friends that while skill at chess is great to have, it’s hardly a requisite for being a good trader.

Whatever the case, chess helped him gain his first real shot on Wall Street. At 18, after failing to land a summer job at Goldman Sachs, Mr. Weinstein ran into a senior partner in the bathroom on his way out. The partner, David F. DeLucia, a chess expert, had played Mr. Weinstein numerous times, and quickly arranged more meetings for him.

Now Mr. Weinstein is practically a featured attraction on Wall Street. He attends galas and charity events, and is sought out to speak at big events. Pictures of him clasping a drink at last night’s party appear with regularity on business Web sites.

And, financially, the payoff has been enormous. Last year, he earned more than $90 million and, by some estimates, landed on the rich lists of the hedge fund industry. Such figures aside, he is described as someone who doesn’t flash his wealth. Before he won his Maserati, he didn’t own a car.

At another recent investor conference, Mr. Weinstein strolled among the crowd in Avery Fisher Hall at Lincoln Center. Accompanying him was his mother, Giselle, with whom he watched “Wall Street Week” as a child.

While hedge fund managers, investors and analysts mingled over cocktails, Mr. Weinstein appeared buoyant. His trade against the London Whale was finally paying off, a vindication — and a profitable one — of his hunch months earlier. That same day, news reports said Mr. Iksil, the London Whale, would soon be leaving JPMorgan.

Jeffrey Gundlach, Bond Savant

Can you spot the $34 billion fund manager? Jeffrey Gundlach (third from left), who runs DoubleLine Capital, the fastest-growing mutual fund startup in history. His mid-'80s haircut is only slightly less weird than his rise to the top

DoubleLine Capital’s new office is high up in a downtown Los Angeles skyscraper, with unobstructed views of the famous Hollywood sign. As you walk out of the elevator, a huge canvas with the firm’s logo greets you; DoubleLine founder Jeffrey Gundlach painted it himself. Pass a six-foot-tall faux terra-cotta Chinese warrior and you’ll find a conference office called the Van Gogh Room. The Van Gogh Room has no Van Goghs, though it does display a pair of landscape paintings and looks out to a reception area adorned with other paintings Gundlach won at auction. It also, on this visit, contains Gundlach, sitting at the end of the conference table in a crisp button-down shirt, with a goatee and rust-colored hair, cut short.
The idea was to interview Gundlach, whose company is the fastest-growing mutual fund startup in history, but the conversation quickly turns into a kind of test. Gundlach wants you to know he is a connoisseur of fine art. He also wants you to know you don’t know squat.
Photograph by Todd Weaver for Bloomberg BusinessweekGundlach in his new L.A. offices
“Do you know the total U.S. debt?” he asks.
Around $15 trillion?
“Right,” he says. “Do you know what percentage of national revenue comes from the income tax?”
No idea.
“You’re forgiven for not knowing that,” he says. “It’s not what you do. But if you’re managing bond money, it’s the least you should know. Was it Socrates who said, ‘It’s that I know that I don’t know everything’?” Gundlach is fond of quoting the great and ancient in the service of macro bets: A recent PowerPoint presentation on the future of bond yields started nearly every slide with a quotation from Shakespeare.
He dives into why he alone can trounce the competition in bond funds. “I can still do about 7 percent in a world of 2 percent,” he says. “You stress-test your portfolio constantly. You think about it and analyze it to death. Other people don’t know how. I wish I could teach it to somebody.”
Since DoubleLine first took investor money in April 2010, it has amassed $34 billion in assets. Even as it quadrupled in size last year, DoubleLine’s $22 billion Total Return Bond Fund (DBLTX) outperformed 99 percent of its rivals. The firm takes in $80 million to $100 million in new client dollars every day.
Unlike the reigning bond king, Bill Gross, manager of Pimco’s $259 billion Total Return Fund, DoubleLine Total Return invests primarily in mortgage-backed securities, which Gundlach says he can combine into a portfolio that posts higher returns even during economic downturns. In January, Barry Ritholtz, the New York finance blogger who helps manage $500 million in high-net-worth assets, moved all of his Pimco assets to DoubleLine. Ritholtz says that with the Federal Reserve maintaining its zero-interest rate policy and Treasury bonds yielding so little, Gundlach’s less understood mortgage market expertise was needed to get his clients higher yields without having to make a firmwide bet on interest rates. “It was a straight-up trade for me,” Ritholtz says. “Bill Gross for Jeffrey Gundlach—no player to be named later.”
DoubleLine is not only the fastest-growing mutual fund startup ever, it may also be the fund with the strangest genesis. Two and a half years ago, Gundlach was fired by his old employer, Trust Company of the West, where he and his team managed 70 percent of that firm’s $110 billion in assets. It was a messy departure that involved mass defections, a stash of porn and drug paraphernalia, and an acrimonious trial. The rival firm Gundlach founded may outgrow its ancestor.


Gundlach grew up in Buffalo. His father was a chemist at a company that made wax for bowling alleys, and his mother was a housewife. Although his uncle Robert Gundlach invented the photocopier and his grandfather Emanuel Gundlach formulated a hair tonic popular in the 1950s called Wildroot Cream-Oil, he says his family scraped to get by. “When our drying machine broke, it didn’t get fixed,” he says. “My mother would just run clotheslines all across the backyard.”
What he lacked in privilege, Gundlach says, he made up for with hard work and intelligence. “Look, I’ve never needed to network,” he says. “I was always at the top of my class, always got straight As. I got a near-perfect math SAT.” He went to Dartmouth on financial aid, graduated summa cum laude in math and philosophy in 1981, and entered Yale’s applied mathematics Ph.D. program. Two years later he dropped out and drove to California to become the drummer for a rock band called Radical Flats. He had a Flock of Seagulls pompadour and a day job at insurer Transamerica. A year later, broke and watching Lifestyles of the Rich and Famous on a little black-and-white TV, he resolved to become an investment banker.
He opened a phone book, flipped to “Investment Managers,” and talked his way into a meeting at TCW. He knew nothing about bonds, but the firm was impressed enough by his math skills to offer him a job. By the time he showed up for his first day of work as an analyst on the bond desk, he’d already mastered the math in Sidney Homer and Martin Leibowitz’s Inside the Yield Book, which lays out the field of bond analysis. “Very few people can do that,” he boasts. “Like, very few. I quickly realized I knew more than most people who worked at TCW for years.”
As he immersed himself in the bond market—duration analysis, the yield curve, prepayment risk—Gundlach quickly rose up the firm’s ranks. By 1987, as the savings and loan crisis took hold, the 28-year-old had a reputation as TCW’s mortgage wunderkind. The firm gave him $500 million to manage, and he finally quit his band, which by then was called Thinking Out Loud.


The bond market is a grinder’s playground. A big winner, like Gundlach in 2011, might deliver 9.5 percent. Gross’s Total Return Fund last year, with its more diversified strategy, earned 4.2 percent. A long-term winner might deliver annual returns of 6 percent or 7 percent. Managers can invest in Treasuries, among the safest securities on the planet, but with yields near record lows—a 10-year government bond earns 1.9 percent—it takes other vehicles to deliver a competitive return, especially after fees, taxes, and inflation. (Bond funds are chiefly measured against the Barclays Capital Aggregate Bond Index, just as equity funds aim to beat the Standard & Poor’s 500-stock index.) To increase returns, a manager can buy riskier foreign sovereign and corporate debt, but such an approach can go very wrong. That happened at Pimco last year when it avoided Treasuries just as they staged one of their best rallies in history.
Photograph by Cheryl HimmelsteinAt TCW, his former employer, in 2005
Gundlach favors mortgage-backed securities, which are themselves portfolios of home loans. There are two types: guaranteed and non-guaranteed. Guaranteed mortgages are backed by Ginnie Mae, Freddie Mac (FMCC), and Fannie Mae (FNMA), which are sponsored by the government. They’re more secure and thus have lower yields than their non-guaranteed counterparts. These bonds must still yield more than Treasuries to compensate investors for the risk of homeowners prepaying their mortgages. Like Treasuries, they increase in value when the bond market gets anxious about risk. That’s what transpired last year, amid fears of a European meltdown.
Non-guaranteed mortgage securities are directly issued by financial companies and banks not associated with the government, and come with no credit guarantee. The higher risk is reflected in higher yields. If the economy and housing do well, and investors prefer riskier assets to government bonds, non-guaranteed mortgage securities will both pay a nice yield and appreciate in value. The Gundlach theorem: A portfolio with a blend of both kinds of mortgage securities will combine credit risk and interest rate risk in a way that throws off higher returns.
Gundlach has been playing the mortgage market for decades. In 1990 he took home his first million-dollar paycheck. Over the following decade, his pay swelled into the tens of millions. At TCW Total Return, Gundlach rode through the worst of the financial crisis, from 2007 to 2009, to return 9.1 percent a year. By 2009 he was making $40 million a year, and his team was managing most of TCW’s assets.


Just after lunch on Friday, Dec. 4, 2009, Gundlach, then 50 and TCW’s chief investment officer, watched as the bond market closed on the East Coast. It had been a great year: His TCW Total Return Fund had posted more than double the average return of its peers. Morningstar (MORN) had nominated him Fixed Income Manager of the Decade, and he was on track, he says, to collect hundreds of millions in salary and bonuses over the next couple of years.
Gundlach headed upstairs for what he believed was an executive meeting. Instead, in the boardroom, he was met by TCW’s chief counsel and an attorney from Quinn Emanuel Urquhart & Sullivan. They presented him with a document alleging gross misconduct, including an attempt to steal staff and confidential client and trade information to launch his own rival firm. His 24 years with TCW were over, effective immediately. His BlackBerry was already disabled.
Gundlach kept an office on the west side of L.A., where he would work some mornings to avoid rush-hour traffic. Figuring he’d go collect his belongings, he pulled out of TCW’s garage in his Porsche and headed to Santa Monica. At that office, he recalls, he found the door broken and the desk drawers ransacked. TCW would later claim Gundlach kept in his office a stash of porn, sexual devices, and pot-smoking accessories. In a letter to DoubleLine clients, Gundlach called those items “vestiges of closed chapters” of his life. TCW spokesman Peter Viles says the office was company property that security personnel entered with a key.
Back at TCW’s trading floor, Chief Executive Officer Marc Stern informed Gundlach’s team that their boss was gone, and that TCW was acquiring rival Metropolitan West to plug the hole. The following morning, 15 senior members of Gundlach’s team repaired to his house. Gundlach’s then-wife, Nancy, made coffee. (That’s her, second from left, in the band photo at the beginning of this article.) Louis Lucido, a deputy at TCW, brought donuts.
By noon, 14 of the gang of 15 had resigned from TCW. The holdout was Philip Barach, co-manager of the TCW Total Return Fund. Surrounded by a circle of mutineers, Gundlach, who says he got misty-eyed, persuaded Barach to join them. The two men shook hands and hugged, and the reunited team applauded Barach as he thumbed out his own resignation on his BlackBerry. “It was a total leap of faith,” recalls Barach, now DoubleLine’s president. “I wasn’t poor. But this was all or nothing.” That night, he says, TCW CEO Stern drove to his house and offered him a minimum of $10 million a year over six years to stay, with an understanding that the 57-year-old could retire and collect his entire package in just three years. Barach turned down the offer.
“TCW made a multitude of miscalculations,” says Gundlach. “Even if they’d kept most of the team, the clients would have fled. They knew that I ran it.” TCW’s spokesman, Viles, responds that the acquisition of $30 billion MetWest more than made up for the loss of Gundlach.
By the following Wednesday, Gundlach had his 15 colleagues, plus 17 more who had also bolted from TCW, running around town to get the new operation running. Lucido bought 30 laptops with a personal credit card at Best Buy (BBY). Others Googled client names; TCW had seized their computers and Rolodexes. Barach and Gundlach prevailed upon Oaktree Capital, a $67 billion investment firm run by former TCW Chief Investment Officer Howard Marks, to kick in an undisclosed amount. On Dec. 14, five days after Gundlach was fired, DoubleLine put out its first press release.
On Jan. 7, 2010, TCW filed a lawsuit against Gundlach alleging conspiracy, breach of fiduciary duty, and theft of proprietary information. The suit claimed Gundlach had been planning for months to leave TCW and start a rival firm, and that his behavior was “erratic” and “increasingly and openly confrontational.” Forty-five out of 65 of Gundlach’s old TCW team had since decamped for DoubleLine.
“The day we were sued, the phones stopped ringing,” says Bonnie Baha, one of Gundlach’s crew of defectors. “Each of us had families to support. Not one of us was drawing a salary.” On Feb. 10, a month after TCW filed its suit, Gundlach put out a press release announcing a countersuit to recoup $1.25 billion in fees he says TCW owed him and his team. “I believe the facts stack up overwhelmingly on our side,” he said in the statement. “I would be delighted to see this case go to trial tomorrow, if that were feasible.”
DoubleLine in its early days, says Gundlach, faced the chicken-or-egg problem of not yet having nearly enough client assets to prove itself—which, of course, it could hope to do only with enough client assets. He says he realized his last best hope was opening DoubleLine to the masses. “If we were going to make it,” he says, “it would have to come down to mutual funds. It was like putting my record up to a popular vote.”
On April 6, 2010, with staff in and out of depositions related to the trial, DoubleLine launched its own Total Return Fund. A Merrill Lynch brokerage office immediately wired $65 million. By December 2010, the fund had crossed $7 billion in assets under management. One early adopter was broker Kurt Brouwer of the $700 million investment adviser Brouwer & Janachowski in Tiburon, Calif. “We used TCW Total Return, so we were comfortable with him,” he says. “The transition wasn’t traumatic. We just left TCW and moved over to DoubleLine. People are motivated when they start new funds. The messy, sordid details weren’t important to us.”


In September 2011, after six weeks of trial, an L.A. jury awarded Gundlach and three associates $67 million in unpaid wages. While the jury also found them liable for breaching their fiduciary duty to TCW and misusing company secrets, it didn’t deem the breach important enough to award TCW any damages. In December, before that decision was finalized, Gundlach and TCW agreed to settle their dispute; terms of the deal are confidential. As for that pleasure stash in Gundlach’s office, the presiding judge ruled in July that it was immaterial to the case. The jury never learned about it.
Gundlach says he will consider closing DoubleLine’s mortgage-backed investments to new money when they hit $50 billion in assets. “Do you realize that the week after TCW got rid of me, $30 billion in assets left the firm? That’s $150 million in annual fees,” says Gundlach. (TCW’s Viles calls those numbers “wildly inaccurate.”) Gundlach continues: “They figured that changing fund managers was no different than changing branch managers at the local bank.” He stops to tick off his achievements—a decade at the top of his category, taking DoubleLine’s assets from zero to $34 billion in three years. “Find me anyone else in this industry that did that.”

Invest in stocks? FORGET ABOUT IT

Main street hates stocks.
That is according to today’s front page of USA Today: The print edition had a center column, above the fold, screaming green headline “Invest in stocks? FORGET ABOUT IT.” That Cap and Bold headline is as it was in original. (The online version was the tamer Invest in stocks? Small players still smarting ^[1]).
It may surprise some people to learn this is both an expected and positive development. It implies eventual lower prices (over the intermediate term), but will also help to create that elusive lasting market bottom, as I will explain in a moment.
First, an excerpt:

“On Main Street these days, investing in the stock market is about as popular as watching a scary movie on a 12-inch black-and-white TV.
Wall Street’s long-running story about how stocks are the best way to build wealth seems tired, dated and less believable to many individual investors. Playing the market isn’t as sexy as it used to be. Since the 2008-09 financial crisis, the buy-now mentality has been replaced by a get-me-out, wait-and-see, bonds-are-safer line of thinking.
Stocks remain out of fashion even though the stock market has risen more than 100% since the bear market ended three years ago. It’s up 25% since October and 9% this year.”

This is no surprise — between the run of scandals in the 1990s and 2000s, the dot com implosion, analyst scandal, the 2007-09 crash, housing collapse, the flash crash, and HFT, mom and pop have taken their ball and gone home.
This is how bear markets eventually end.
Most people misunderstand what drives secular bull and bear markets, focusing on prices alone as the defining characteristics. I believe this is in error, or at very least paints an incomplete picture.
Whenever I give a market presentation at a conference, I always use the chart below. It explains in great deal how Main Street investor psychology impacts the long secular cycles of bull (green) and bear (red) markets. Note the metric at bottom, which is P/E ratio.
My definition of a Secular Bull Market: An extended period of time, typically lasting 10-20 years, driven by broad economic shifts that create an environment conducive to increasing corporate revenue and earnings. Its most dominant feature is the increasing willingness of investors to pay more and more for a dollar of earnings.
You can see this in the 1982-2000 secular bull market. Total returns were driven partly by earnings improvements, but far more by multiple expansion. This is essentially a psychological component.
A Secular Bear Market reflects the opposite: Following an extended secular bull, it is a period of time marked by increased volatility, frequent cyclical rallies and corrections, in an economically challenging environment. The dominant feature is that Investors are willing to pay less and less for that same dollar of earnings.
We see that today. Profits going up as volumes go down; investor interest ebbs and fades. Its how markets can go sideways or even rally and still see P/E ratios fall.
Ultimately, when the process generates enough investor disgust, we can form a lasting market low, typically, in the Single digit P/E ratios.
(The caveat is we don’t know how unprecedented Fed printing affects this psychological process).
>
click for ginormous chart
^[2]
Original chart, Crestmont Research (annotations added)
>
Source:
Invest in stocks? Small players still smarting ^[1]
Adam Shell
USAToday, May 8, 2012
http://www.usatoday.com/money/perfi/stocks/story/2013-01-07/fears-of-investing-in-stocks/54815608/1

---

Article printed from The Big Picture: http://www.ritholtz.com/blog
URL to article: http://www.ritholtz.com/blog/2012/05/invest-in-stocks-forget-about-it/

Benchmark obsession undermines investor returns

Sir John Templeton, the pioneering global investor, argued that the aim of investing was quite simply “maximum real returns”. Over time this simple but powerful objective has been lost. This is all the more surprising because, clearly, real returns matter to the end investor, particularly in current markets. Pensions are paid from real returns not relative ones.

So where did the concept of relative performance originate? It probably stemmed from good intentions (as do most bad ideas). Why pay active fees if the managers don’t deliver returns above a passive benchmark? However, this idea has morphed into an unhealthy obsession with pigeon-holing managers into niche buckets.

The late great value investor Bob Kirby opined: “Performance measurement is one of those basically good ideas that somehow got totally out of control. In many cases, the intense application of performance measurement techniques has actually served to impede the purpose it is supposed to serve”.
Investment committees spend an inordinate amount of time discussing decisions such as which small-cap growth manager to hire.
Yet often they fail to devote the same energy to discussing the asset classes to choose. They should spend more time selecting the asset classes. After all, the extra performance from a good manager over an asset class is unlikely to be much more than the icing on the cake.
Perhaps this neglect of the importance of asset class decisions stems from the fact that such discussions are inevitably harder than discussing the relative merits of a beauty parade of managers. Often discussions on asset classes degenerate into debates over the economic outlook.
Sadly this is largely an investment dead end. There is no evidence that anyone can read the economic tea leaves consistently well. As if that wasn’t difficult enough, even if you got the economics right, you still have to work out how the markets will react, and which assets will benefit.
Many institutional investors have their asset allocation dictated to them from asset liability studies, or simply implement a fixed ‘strategic’ asset allocation, thus abdicating responsibility for any discussion on asset classes. There is also a tendency to view ‘strategic’ as meaning static. This assumption needs challenging.
When a pensions plan appoints a manager with an investable benchmark they inadvertently create incentives to alter the manager’s behaviour.
Suddenly everything becomes relative, so the manager starts to think about relative valuation (ie is the asset I’m buying cheap relative to the benchmark?), relative risk (ie. I mustn’t deviate too far from my benchmark as I will be taking on ‘tracking error’), and, worst of all, relative return (ie. I did a good job because I only lost 30 per cent of your investment, and the benchmark was down 50 per cent). So while an investable benchmark makes measuring performance an easy task, it isn’t necessarily good for focusing the manager’s mind on generating real returns. Relative benchmarks are often employed to the detriment of real returns and the preservation of capital.
Thankfully, there is a simple, although not easy (to borrow Warren Buffett’s phrase), alternative – to use a value approach across a wide range of assets. Buy when an asset is cheap, and sell when an asset gets expensive – buy low and sell high, a sensible approach to both the preservation and growth of capital.
Valuation is the primary determinant of long-term returns, and the closest thing we have to a law of gravity in finance. For instance, buying assets when they are expensive (high price/earnings ratios in the equity space and low yields in the bond space) tends to result in low returns. In contrast, buying cheap assets generally leads to high long-term returns. So moving your assets in response to valuation signals makes sense.
Of course, there is a downside to this style of investing. In order to pursue a value-driven approach you need two key traits – patience and a willingness to be contrarian. Unfortunately these traits are in rare supply, and become almost extinct when people act in groups (such as committees).
Let’s end as we began with a quotation from Sir John Templeton: “If you buy the same securities as other people, you will have the same results as other people. It is impossible to produce a superior performance unless you do something different from the majority. To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest reward”.
James Montier is a member of GMO’s asset allocation team and the author of several books including Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance