The Scariest Halloween Costume of All

Where Are We with Market Valuations? What Can We Expect for the Next Decade?

October-21-2008

It is Oct. of 2008, Dow is hovering at around 9,000, about where it was 10 years ago. S&P 500 is about 10% lower. If you have been investing an S&P500 index fund, you are losing money even if you have been doing dollar cost average. Where are we with market valuations? What kind of return can we expect from the general market over the next decade?

In his Oct. 16 article on New York Times, Warren Buffett wrote. “Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.” He is much more bullish about stocks now. What are the factors that make Buffett more bullish? What returns does he mean by “a substantial degree”?

Before we can answer the question, let’s review what Warren Buffett said before and how he come up with the numbers.

Review of Buffett Speeches and Articles

In Nov. 1999, Dow was at 10,998, a few months before the burst of dotcom bubble, stock market gained 13% a year from 1981-1998, investors’ (or speculators’ rather) expectations were high. The inexperienced investors--those who had invested for less than five years--expected annual returns over the next ten years of 22.6%. Even those who had invested for more than 20 years were expecting 12.9%. Warren Buffett said in a speech to friends and business leaders, “I'd like to argue that we can't come even remotely close to that 12.9%... I think it's very hard to come up with a persuasive case that equities will over the next 17 years perform anything like--anything like--they've performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate--repeat, aggregate--would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”

We all know what happened afterwards. Two years after the Nov. 1999 article, Dow was down to 9,000, Mr. Buffett said, “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”

9 years has past since the publication of the article of Nov. 22, 1999, it has been a painful and wild ride for most investors. The good news is that Mr. Buffett is now bullish. “Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.” He wrote.

Warren Buffett’s key value-determining factors

To understand how Mr. Buffett came up with the numbers, let’s review the factors Mr. Buffett uses to determine the market valuations. His key value-determining factors are:

1. Interest rate.

Interest rates “act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.”

2. Corporate profitability in relation to GDP

“5% growth in GDP… it is a limiting factor in the returns you're going to get: You cannot expect to forever realize a 12% annual increase--much less 22%--in the valuation of American business if its profitability is growing only at 5%. The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.”

Over time, corporate profitability always reverses back to the mean relative to GDP, Warren Buffett argues. Therefore, over long term, the stock market will only gain as much as the GDP does.

3. You are an optimist

“… who believes that though investors as a whole may slog along, you yourself will be a winner.”

Good luck with that... unless you only buy good companies at under valued prices.

Where are we today with market valuations?

Based on the above assumptions, Mr. Buffett uses the market value of all publicly traded securities as a percentage of the country's business--that is, as a percentage of GNP. “The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.” Warren Buffett said.

With this in mind, we have drawn the ratio of Wilshire Total Market index with regard to GNP. The ratio is shown below. As we can see, the market is valued at the level of 1992-1994, the eve of the unprecedented bull market.






What can we expect from the general market for the next decade?

Two years after the Nov. 1999 article, Dow was down to about today’s level, Mr. Buffett said, “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”

Mr. Buffett derived his 7% number from the expected GDP growth and the stock market valuations at the time. 6 years has past, Dow is sitting about where it was 6 years ago. This country experienced a recession and maybe in one today. But still the US economy measured by GNP grew 41%. This means that the stock market valuation is sitting about 40% lower than it was when Mr. Buffett projected 7% return in the stock market. If all these numbers are true, we expect that stock market is positioned for a long term annualized return of around 10% a year.

P. S. In our back testing of 1998-2008, we found that highly predictable companies outperformed general market by about 9% a year, undervalued predictable companies beat the market by more than 16% a year. You may want to check our list of predictable companies and Buffett-Munger Screener.

Dear First Eagle Investors:

As we have written in the past, we have since the early 1980s had several credit crunches including the S&L crisis, the LTCM crisis, and the telecom bust earlier this decade. In each episode the authorities were successful in reflating the credit bubble but also perhaps engendering an accumulation of bad habits. But, as the Austrian School of economics teaches us, credit bubbles are eventually followed by credit busts. This bust seems especially painful because of the size of the bubble that preceded it due to continuous efforts over the past 30 years to interfere with the corrective process. At the end of this bubble we found ourselves looking at a mountain of debt supported by ever increasingly thin capital ratios in ever more unregulated areas of finance. This created a dangerous combination of unsustainable leverage and unmanageable risk.

Recently the deflating of the credit bubble has entered a new phase. The unwinding has suddenly become disorderly and has naturally spilled over into the equity markets as investors begin to consider the effects of the credit bust on the real economy and earnings prospects. The result is indiscriminate selling and outright panic. In hindsight, though we correctly anticipated this bust we obviously could have been better prepared. Though we judged it improper to participate in the earlier recapitalization of the financial services industry, thus saving our shareholders from permanent losses, we have not been able to escape the second-order effects in that many of our holdings were perhaps sources of liquidity to other funds being forced to liquidate.

We'll be clear that we are rather concerned with the unintended consequences of the actions taken by authorities so far. But we also believe firmly that such action will be taken--no matter what--to prevent either a '30s style depression or an extended Japan-style malaise. In that case we believe there is approximately zero chance of either scenario, while also conceding that we will face difficult economic times nonetheless. A credit bust is never painless. And the dollar may well lose its shine as the world’s reserve currency, hence our continuing position in gold.
With that said, though from a macro standpoint things look grim, the good news is that since we have some excess cash we are able to buy securities at somewhat peculiar prices--thus the spectacle of Shimano's shares trading at 8x cash-adjusted earnings after having fallen by half in three months, 3M's at 9x earnings, Pargesa's at close to our first purchase price 6 years ago, and Nitto Kohki's shares at 2x cash-adjusted earnings. As investors with a long-term perspective, equities are beginning to look attractive, even as corporate profits come under pressure.
We are focusing on the types of companies we always have--a combination of “cigar butts” (as
Warren Buffett called Benjamin Graham-type stocks) and some truly exceptional businesses trading at fire sale prices. Sometimes when investing seems most scary it's the best time to invest. This may be one of those times.

Thank you for your continued support.
- Jean-Marie Eveillard, Matt McLennan and Abhay Deshpande

Dear Investor: Please Don't Go!

The following fictitious letter, with two possible endings, is compiled largely using the exact words used by fund managers at Citadel Investment Group, Greenlight Capital, and TPG Axon, among others, in letters sent to investors in recent weeks. The alternative ending owes much to Andrew Lahde of Lahde Capital. All the words have, however, been rearranged and no longer necessarily reflect the views of these managers.

Dear Crunch Capital investors:

Our Big Absolute Return Fund (BARF) returned minus 23.4 percent net of fees in the third quarter of 2008. We are embarrassed [1] by our performance, and we remind you that we eat our own cooking as the largest investors in our funds.

Last year was a strong one for us, and the first half of 2008 was solid. In sharp contrast, the last quarter has been abysmal, and we are sorry to have let you down with the terrible performance of the portfolio.

Candidly, in hindsight we grew a bit overconfident in our ability to navigate treacherous waters. By June, we were already materially reducing risk. But midyear economic data threw markets for a loop [2]. Everything that had gone up in the past few years-equities, foreign currencies, and commodities-was dumped by investors as they fled in the other direction.

The July reversal in markets caused damage to many hedge funds, which had clearly been in "extreme agreement." As a result, investors have been unwinding trades that might otherwise make sense because 1) they are nervous about short-term losses, 2) they are reducing risks and leverage generally, and 3) they are possibly facing redemptions from their own investors.

In hindsight, our suggestion last quarter to cash out and go to the beach would have been the better option. We failed to foresee the financial disaster that was to unfold, and September was the single worst month [3], by far, in Crunch's history.

The extraordinary market conditions were combined with unpredictable financial sector rescues and with regulatory changes driven more by populism than policy. Among other things, the decision of regulators around the world to ban the short selling of equities created dislocations across many of our portfolios.

The collapse of several large financial institutions was caused by bad practices and poor risk management. The loud complaints about short selling are acts of desperation, to distract attention from the real problems, by business and government leaders who have been caught with their pants down [4].

Political risk is usually associated with developing markets, but for the moment, suddenly changing regulations-sometimes overnight-are having a large impact on U.S. markets. Still, we recognize that our job as investors is to play by the rules the policymakers set.

General release ending:

With that in mind, we have incurred a great deal of additional pain in recent weeks to reshape our portfolio, and we are optimistic about our current positions and our long-term prospects. We can't make the money back overnight, and we expect markets to continue to exhibit "manic depressive" behavior as they vacillate between fear and optimism, so we urge your patience.

Not only that, but we think the hedge-fund industry model is likely to be tested and reshaped in meaningful ways.

But we do believe the next 12 to 18 months may prove one of the best buying opportunities [5] we have ever seen. Markets are a train wreck, and there is substantial opportunity to profit handsomely.

We have never backed down when faced with a challenge, and this time will be no exception. We are immensely grateful for your support. Please don't withdraw your money!

Yours truly,

Crunch Capital

Director's cut ending:

Happily, we have been able to do that successfully in our biggest asset pool, the Global Short Fund, which gained 800 percent and provided you-and ourselves-with massive gains overall. Most of our forecasts have unfolded or are in the process of unfolding. Rather than gloating, however, we are writing to say goodbye [6].

We were in the game for the money. The low-hanging fruit-idiots whose parents paid for prep school, Yale, and then the Harvard MBA-were there for the taking as they rose to the top of companies such as American International Group, Bear Stearns, and Lehman Bros.

We will no longer manage money for other people. We have enough of our own wealth. We will let others try to amass nine-, 10-, or 11-figure net worth. We plan to throw our BlackBerrys away and enjoy life.

Please don't try to contact us. Others will handle the dissolution of the fund. Oh, and the United States should legalize marijuana.

All the best,

Crunch Capital

Calpers Looks to Shore Up Assets

The nation's largest public pension fund said it intends to tap California public employers for more money if its heavy investment losses don't reverse, a sign that more financial pain could be in store for state and local governments.

The California Public Employees' Retirement System, known as Calpers, said its assets have declined by more than 20%, or at least $48 billion, from the end of June through Oct. 10.

Unless returns improve, Calpers is poised to impose an estimated increase in employer contributions of 2% to 4% of payroll starting in July 2010 for about two-thirds of its state-employer members, and in July 2011 for the remaining third. Any decision will be made after Calpers knows its returns for the fiscal year.

The average employer contribution rate for public agencies including cities and counties is 13% of payroll in the current fiscal year, Calpers said.

A Calpers rate increase would add to a fiscal mess in California, where falling sales-tax and income-tax revenue and a tanking real-estate market have affected government agencies across the state. With budget cuts for state and local governments projected in coming years, an increase from Calpers would be one more burden.

The news "bodes very badly for us," said Lori Ordway-Peck, assistant superintendent of business services for Burbank Unified School District, which serves about 15,000 students near Los Angeles. "Something would have to give to find that money.

Joe DeAnda, a spokesman for California Treasurer Bill Lockyer, said "the most obvious impact is going to be on taxpayers, who will have to fund any additional increases" to Calpers contributions, though he added that the treasurer is maintaining hope that a market recovery will minimize, if not eliminate, any additional burden. H.D. Palmer, a spokesman for the California Department of Finance, declined to comment, as Calpers hasn't yet decided whether to enact the increase.

With most economists forecasting a recession in the U.S., and at least a slowdown abroad, analysts see a tough road ahead for corporate earnings, and expectations for the stock market are low.

For the fiscal year ended in June, Calpers lost 2.4%; Merrill Lynch recently estimated the average public pension fund's return as negative 5.1% for that period. Regardless of whether Calpers beats its peers, losses make it more difficult for the fund to fulfill its job of delivering pension payments to 1.6 million beneficiaries -- retirees and others.

Between Oct. 31, 2007, when Calpers assets peaked at $260.4 billion, and Oct. 20 of this year, when assets stood at $192.7 billion, the fund lost about $67.7 billion. The giant fund has tried to steer through the recent market turmoil while searching for new leadership, as its chief executive officer and chief investment officer both stepped down midyear.

While Calpers may end up among the first public pension funds to pass on the costs of investment losses to employer members, it may not be the last. Almost every public pension fund is grappling with losses in stock markets, where funds hold on average 58% of their assets, said Keith Brainard, research director at the National Association of State Retirement Administrators. "Sooner or later the money coming in has to equal the money going out," he said.

The increase in contributions to Calpers could be greater than 4% if the fund's assets decline further by the end of the fiscal year in June 2009. The increases would be smaller, or potentially not occur, if the fund reverses those losses.

A Calpers spokeswoman said that because of strong returns over the four years through June 2007, the fund has put aside 14% of its assets to serve as a cushion during bad times. As a result, the potential increases in employer contributions would be less than increases imposed during previous downturns.

The declines could take a toll on Calpers's funding status, which is the fund's assets divided by its liabilities. That status would be 68% by the end of June 2009, based on the market value of its assets and if the current 20% decline holds.

The ratio for healthy pension funds should be at least 80%, according to Mr. Brainard. At the end of the 2008 fiscal year, Calpers was 92% funded. It was 102% funded at the end of June 2007.

While Calpers has the ability to increase employer contributions, most public funds can't impose any contribution increase unless it is approved by the state legislature. And given economic woes, other state legislatures may be loath to impose more burdens.

Mr. Brainard said that while pension funds could allow their unfunded liabilities to grow in the short term, they will eventually have to dig themselves out of a hole to meet their obligations to beneficiaries.

Roger Mialocq, a partner with Harvey M. Rose Associates who serves as audit manager for Santa Clara County, says the county is struggling financially, and balanced its budget this year "only by using very large amounts of reserves." Santa Clara County includes much of Silicon Valley.

Mr. Mialocq said finance officials at Santa Clara and other counties have been bristling at Calpers rates since 2005, when the fund increased its contribution requirements to make up for losses from the dot-com bust. For Santa Clara, Mr. Mialocq said, the rate the county was paying for most employees jumped to about 13 cents for each dollar of salary from about eight cents.

Mr. Mialocq says that for the current fiscal year, the county is paying $176 million to Calpers for its 15,000 employees, and is projecting a $320 million shortfall for the next budget year. The kind of increase Calpers is projecting, which wouldn't start until 2011 for Santa Clara, could mean a bump of $20 million or more for the county, he estimates.

A Calpers spokeswoman said the formula for calculating the raise for an employer member relies on many factors, including the size of the payroll and the rate of retirement. "The true picture will only emerge as we get closer to the date," the spokeswoman said.

Rep. George Miller

Meanwhile, on Wednesday, the U.S. House of Representatives' Education and Labor Committee, headed by Rep. George Miller, a California Democrat, said the U.S. Pension Benefit Guaranty Corp. lost $3.1 billion in stock investments in the 11 months through August. The PBGC is a government agency that insures private pension plans, takes over failed pension plans, and pays benefits to workers in those plans.

On Sept. 30, 2007, the value of PBGC's total investments was about $63 billion, according to the agency's Web site. Jeffrey Speicher, a spokesman for the PBGC, said the agency now has $68 billion in assets and has "sufficient funds to cover our obligations for years and years into the future."

The Worst Year Ever: S&P 500's Worst Declines

With a 38.9% decline year to date, 2008 is shaping up to be the S&P 500's worst year ever. At this point in the year, the next closest years in terms of declines were 1931 and 1937. In both of these years, the S&P 500 was down 31% through October 22nd.

Since its peak in October 2007, the S&P has now declined by 42.3%. On a historical basis, this is the sixth worst decline in the S&P 500 without a rally of 20% or more. As shown in the list below, outside of the Great Depression, the only period where the S&P 500 had a greater decline was during the bear market of 1973/1974. Historically, it hasn't been much worse.

Platinum Almost The Same Price As Gold

Men everywhere holding out to buy that platinum engagement ring can rejoice in the fact that the metal has declined from a high of $2,276/ounce in March to just $793/ounce today. But what's really crazy is how close platinum is trading to gold. Even though platinum is 30x rarer than gold, it is currently trading at just an 11% premium. Earlier in the year, there was a $1,300/ounce price difference between the two metals, but that difference is now just $83. The charts below highlight the historical premium between platinum and gold, and while it's hard to believe the two could be trading at similar price levels now, it did occur quite often in the early 90s. What is shocking is how fast the premium has declined in recent months. Instead of buying gold coins, maybe now is the time to buy platinum ones.

S&P 500: Which Way Will It Break?

As the S&P 500 falls another 5% today, the index is now trading at the low end of its recent triangle formation. Investors with a technical bias will be watching to see if this level holds in order to determine whether today's decline is a successful test or the beginning of another leg down.

Are swaps forecasting a huge equity rally?

I've always been drawn to swap spreads as a leading indicator of other things (e.g., credit spreads, generic financial conditions, fear, health of the economy), so when I put together this chart I told myself to not get too excited, because it suggests that the big selloff in equity markets was just a temporary thing that will soon be almost entirely reversed. Wouldn't that be exciting?

The Best Have Been The Worst, The Worst Have Been The Best

We recently calculated the performance of stocks since the S&P 500 made a short-term bottom on October 10th based on how they performed from the 9/19 peak to 10/10. As shown below, the decile (50 stocks in each decile) of stocks that held up the best from 9/19 to 10/10 are up just 3.43% since then, while the decile of stocks that performed the worst during the big selloff are up a whopping 26.23%. Clearly there has been a lot of bottom fishing going on.

US Dollar: A Nice Move, But A Long Way To Go

The US Dollar index is now up 16.5% since it bottomed earlier this year, which is a significant rally for a currency that many had begun to jokingly call the US Peso. The Dollar is currently in a very nice short-term uptrend, trading 5.5% above its 50-day moving average and 11% above its 200-day. However, it's important to remember that the currency has a long, long way to go to get back to levels seen in the earlier part of this decade. As shown in the chart below, we need about 5 times the rally we've seen over the past couple of months to get back to 2000 levels. But the Dollar has historically had very long bull and bear market cycles, and once it gets going in one direction, it usually stays on track for quite some time.

SPREADING SKYWARD

The biggest challenge in strategic-minded investing lies within. The high-yield bond market of late offers a telling example.

Trailing yields on junk bonds have soared recently, as our chart below shows. The risk premium on junk over 10-year Treasury Notes exploded skyward to close yesterday at nearly 15%. That's the highest since the early 1990s and, one could argue, it looks enticing.

The human mind, meanwhile, is a complicated organ. What looks like far better values today relative to, say, June 12, 2007 isn't necessarily obvious or compelling to homo economicus. We cite June 12 of last year because that was the trough for the junk/Treasury yield spread, as per Citigroup High Yield Index.

Not long after, we remained suspicious that the spread was sufficiently high to compensate for the risks ahead, as per our post in late summer 2007. As it turned out, we weren't wary enough, not by a long shot. We did, however, say that even though the risk premium had risen to a bit over 4% in August 2007, "we're not yet convinced that strategic opportunities are convincing in the highest-risk spectrum of assets." In fact, we should have told everyone to run for the hills and put everything in cash. Hindsight, as always, tells us exactly what we should have done.

As it turned out, the crowd had other ideas, which is to say bullish ideas. Indeed, the late summer of 2007 was a strong period for the junk bond market. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), for instance, had a run higher in August and September of that year, reaching an all-time high of $104.70 on September 25, 2007. The ETF closed yesterday at $71.40.

Having been crushed, the high-yield bond market now offers its highest trailing yield in a generation. We're guessing, but it seems as though there are few takers, if any. Yes, there's reason to shun junk bonds, starting with the high odds that a painful and lengthy recession awaits. If so, defaults on junk will rise. Understandably, that scares off the bulls. And for all we know, staying scared may be the only logical decision at this point. An economy that takes a beating will treat the lower-grade tier of securities harshly, even after the harsh treatment to date.

In fact, there are always convincing reasons to shun those asset classes when they've fallen on hard times. The process works in reverse too, as so there's always a bullish rationale for buying more even though the valuations look thin and the assets are priced for perfection.

High-yields bonds are but one example of this ebb and flow of greed and fear. Granted, junk offers one of the more extreme cases of boom turned bust. Yet all the asset classes suffer this back and forth, albeit in varying degrees.

No, we don't know if high-yield bonds are about to soar in price, run flat for many years, or dive deeper into the hole. All we know is what's passed and the prices currently offered by Mr. Market. By that standard, the prices look a lot better now than they did on June 12, 2007 for junk. What does that imply for the future? We can't say for sure, but we have our suspicions.

Keep in mind that we've made a number of comments this year that the junk spread looked relatively compelling, i.e., it had risen. We now know that we were early in making such comments. We may still be early, and in fact that seems probable. Rest assured we have limited, if any skill in short-term market timing, and it's debatable if we're any better on a long-term basis. As such, we favor diversifying by asset class and trying to exploit seemingly compelling valuations over time.

Junk bonds should never represent more than a tiny slice of a strategically diversified portfolio, in part because the market capitalization of such bonds relative to everything else is tiny. But there's a case for upping the allocation to this corner of fixed-income a touch these days, given the sharp rise in yield premium. Then again, there'll probably be an even stronger case for upping the allocation a month or a year from now. So it goes when mere mortals such as your editor attempt to divine the future by analyzing the present.

At some point the junk spread will top out, just as it bottomed out back in June 2007. We'll always miss the absolute tops and bottoms. But if you have a long-term view, you can't afford to miss a major turn in a cycle, and in fact you don't have to, at least not completely. But there's a catch: being wrong at times. Sometimes you have to be willing to lose a few battles to win the war.

Hedge funds should rue the day that the term “absolute returns” was coined

Despite begin caught with their hands in the beta cookie jar last quarter, hedge funds had one of the best relative performances ever in Q3 - beating equity indices by a country mile. Most industry participants acknowledge that various “alternative betas” and even, as we have recently seen, traditional betas have found their way into hedge fund returns. And some now attribute hedge funds’ returns since 2003 as simply repackaging beta and selling it at alpha prices. While countless reports of abysmal hedge fund performance have included the caveat that they have still beaten the S&P 500 handily this year, the industry remains in the cross hairs of the mainstream media for what it alleges was “promising absolute returns in good times and bad”.

Despite the marketing power of the “absolute return” moniker, its adoption by the hedge fund industry is now coming back to haunt it. Although we know very few hedge funds naive enough to make such promises, the tacit endorsement of the term by the industry at large has obscured the benefits of old-fashioned relative performance.

Institutional investors have largely adopted hedge funds not because of their performance, but because of their diversification properties - as indicated by their low market correlation.

A survey conducted last year by French business school Edhec shows that virtually all performance measures used by European institutional investors are essentially relative, not absolute.

The simplest measure cited by respondents was the average outperformance vs. the benchmark. The Information Ratio goes a step further by measuring the benchmark outperformance relative to the standard deviation of that out performance. But just in case a fund simply levers-up the benchmark index in an “up” year (thus producing a high information ratio), Jensen’s alpha accounts for the correlation between the fund and the index (the lower the correlation, the higher the alpha ceteris paribus).

While varying in their sophistication, all three of these measures are essentially relative. And all three are used by institutional investors to measure the performance of hedge funds as well as traditional long-only strategies.

Edhec’s survey also explores the methods used by institutions to calculate alpha. Writes Edhec:

“One of the most commonly cited performance measures in investment management is of course alpha. Judging from the financial press, the quest for alpha is still very much predominant in the industry. Obviously one cannot talk about alpha if one does not know how to measure it.”

As the chart below from their report shows, a popular back-of-the-envelope metric is performance vs. peer group. While not technically alpha, normalizing for the investment strategy does remove the ability of a manager to win accolades simply because she was in the right place at the right time.

More accurate techniques for calculating alpha (from multi-factor models, market models and returns-based style analysis) implicitly measure fund performance relative to a benchmark (the market or some other model).

Of course, the market benchmark is a blunt instrument that could easily suggest a manager produces alpha when they simply pursued a strategy that did well. So institutional investors use customized benchmarks that more accurately reflect the manager’s strategy. Still, Edhec found that a large portion of investors still measured their managers relative to broad market indices.

Since they are free to shift their strategies, hedge funds tend to have time-varying correations to markets, making relative performance very difficult to calculate (i.e. relative performance to what?). But the fact remains, hedge funds - like all other investments - are measured by institutions on a relative basis, not an absolute basis. While early investors into the asset class (family offices, private banks) may have been more enamoured with the promise of “absolute” returns, many of the new investors have a more methodical (and realistic) view of hedge funds. This may not stem the short term outflows from the industry, but the institutional investors we’ve talked to have been more disappointed with what they see as a high market correlation (low alpha) than the recent drawdowns.

Bears Are Turning To Bulls All Over

Let's count some market bears recently turned bullish. Granted, not all the bears are of the perma- variant, and their bullishness is considerably more nuanced than the fevered pom-pom shaking you hear from the perma-bull side. Nevertheless, here are a few notable market bears that have turned bullish in the last two weeks or so:

• Jeremy Grantham
• Doug Kass
• Barry Ritholtz

No sign of Peter Schiff, David Tice, Michael Panzner, etc., but that admittedly may require considerably more than a mere 40+% year-over-year decline, plus a few major banks and brokers going down, etc.

Feel free to add to the list.

Absence of IPOs Hits 10 Weeks

It's official: The U.S. IPO market has seized up completely, with a record-setting stretch of inactivity that began in August.

It's been 10 weeks since a company has held an initial public offering in the U.S., the longest period on record since Thomson Reuters began tracking deals in 1980. The last deal occurred on Aug. 8, when Rackspace Hosting Inc. made its debut on the New York Stock Exchange.

If the vacuum continues throughout October, it will mark the first consecutive two-month period without an IPO in the U.S. since Thomson Reuters began keeping track. ...

Libor-OIS, TED Spread Improving…

Libor-OIS: 293 bp (previous 331)
TED Spread: 327 bp (previous 399)
Rates used:
Libor: 406 (previous 442)
OIS: 113 (previous 111)
T-bills: 79 (previous 43)

Why Warren Buffett is Right (and Why Nobody Cares)

Why Warren Buffett is Right (and Why Nobody Cares)

John P. Hussman, Ph.D.

The best way to begin this comment is to reiterate that U.S. stocks are now undervalued. I realize how unusual that might sound, given my persistent assertions during the past decade that stocks were strenuously overvalued (with a brief exception in 2003). Still, it is important to understand that a price decline of over 40% (and even more in some indices) completely changes the game. Last week, we also observed early indications of an improvement in the quality of market action, and an easing of the upward pressure on risk premiums.

In 2000, we could confidently assert that stocks would most probably deliver negative total returns over the following 10-year period. Today, we can comfortably expect 8-10% total returns even without assuming any material increase in price-to-normalized-earnings multiples. Given a modest expansion in multiples, a passive investment in the S&P 500 can be expected to achieve total returns well in excess of 10% annually.

None of this is an argument that the market has necessarily registered either a near-term or a final bear market low. Regardless of whether or not the market has established a short-term trough, one would generally expect that a decline of the magnitude we've observed would be followed several months later by a secondary decline (which may or may not take stocks to lower levels). It is also not an argument for establishing an aggressive investment stance. We continue to hold index put option coverage under about 90% of our stockholdings, though primarily as a “stop loss” against any major continuation, rather than a defense against moderate declines. What is clear, however, is that after more than a decade of strenuous overvaluation, stocks are finally priced to deliver acceptably high long-term returns.

While it's true that the market established even deeper valuation troughs in 1974 and 1982 (near 7 times prior peak earnings, compared with the current multiple of about 11), it is important to remember that long-term Treasury yields were 8% in 1974, and 14% in 1982, compared with about 4% at present. While I've frequently argued that stock and bond yields are not related in anything near the 1-to-1 manner that the “Fed Model” suggests, it is already clear that a long-term investment in stocks here is likely to substantially outperform a long-term investment in Treasury securities over time. Even with very little adjustment for risk, U.S. stocks are likely to provide stronger long-term returns than the yields available on most corporate bonds as well.

This point is so important that I am again presenting our 10-year total return projections for the S&P 500 Index ( standard methodology ). The heavy line tracks actual 10-year total returns since 1950 (that line ends a decade ago for obvious reasons). The green, orange, yellow, and red lines represent the projected total returns for the S&P 500 assuming terminal valuation multiples of 20, 14 (average), 11 (median) and 7 times normalized earnings.

The reason we use a variety of methods to “normalize” earnings is that reported earnings are actually more volatile than stock prices themselves. In recessions, both earnings and stock prices decline, but stock prices nearly always bottom first. Year-over-year changes in reported earnings have virtually no correlation with year-over-year changes in stock prices. Despite all of that earnings volatility, long-term S&P 500 earnings can be nicely contained by a 6% growth trend connecting earnings peaks across economic cycles as far back as you care to look. Interestingly, even the enormous short-run variation in U.S. inflation rates over time has had very little impact on that long-term dynamic.

As for individual stocks (at least the stable, quality businesses), you don't liquidate just because a recession may depress earnings next quarter, or even for a few years. The main use of quarterly earnings reports is as an information signal for businesses whose future can't be adequately assessed otherwise. The better the business, the less attention you place on quarter-to-quarter earnings.

Why Warren Buffett is right, and why nobody cares

On Friday, Warren Buffett published an editorial in the New York Times titled “Buy American. I Am.” In that piece, Buffett noted “ I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities. Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky's advice: ‘I skate to where the puck is going to be, not to where it has been.'”

The most interesting thing about that op-ed piece wasn't Buffett's opinion about stock valuations. He's absolutely right, in my view. Rather, it was fascinating how quick many investors were to dismiss Buffett's advice, saying either that he didn't understand how bad the economy was going to get, that he preferred to “get in early,” or that he was “talking his book” and trying to bid up the value of his own investments.

Look. Buffett doesn't need the money. Virtually everything he has is now or will ultimately be committed to philanthropy. My impression is that Buffett honestly doesn't like to see investors making decisions that will damage their financial security over time. Also, a good part of his own self-concept centers on being a good allocator of capital. If he didn't like his investment positions, he wouldn't try to talk them up. He would liquidate them. If he thought he could postpone his purchases without a high probability of missed returns from waiting, he would have waited. My guess is that Buffett is very excited about the values he has been buying up, but doesn't get wrapped up in the day-to-day fluctuations that weaken the judgment of less disciplined investors.

The most expensive resource on Wall Street is short-term comfort. Investors who constantly seek comfort over the short-term ultimately give up a fortune over the long-term. In a market economy, the most reliable source of long-term gains is to provide scarce and useful resources to others when those resources are most in demand. At present, the most probable source of long-term returns is the willingness to provide liquidity (holding out willing bids at depressed prices in a panicked market), risk-bearing (taking on the market risk being liquidated by fearful or distressed sellers), and information (through the proper assessment of value). In my view, Buffett's willingness (and our own) to accept market risk here does all three.

Though Buffett doesn't easily show his hand regarding individual purchases or the details of his calculations, he has always been very clear about what drives his assessment of value: stocks should be valued as if you were purchasing the whole business. The way you (properly) value a business is to weigh the price against the long-term stream of cash flows that you expect that business to deliver into your hands over time.

I'll say that again. The real object of interest is the long-term stream of cash flows that the company will deliver into the hands of shareholders over time (beware of companies that quietly dispose of their reported earnings through grants of stock and options to management and employees). Nearly all of the value of a stock is loaded into the “tail” of that stream – 5, 10, 20 years out and beyond. As Buffett notes “fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.”

The rush to dismiss Buffett's advice underscores the extreme level of bearishness among investors here. According to Investors Intelligence, just 22.4% of investment advisors are presently bullish. This matches the lowest extremes we've seen in decades. Extreme negativity of investors has generally been a useful contrary indicator of stock market prospects. That doesn't ensure that stocks have registered their final lows, but it contributes to a set of historically favorable conditions here.

At present, we observe not only undervaluation coupled with negative sentiment, but also extreme volatility that has historically accompanied important market troughs. Similar spikes in actual (e.g. 44-day) volatility were observed in July 1962, June 1970, October 1974, December 1982, December 1987, October 1998, and September 2002, all which were associated with important market lows.

The argument for gradually increasing our stock market exposure in the past couple of weeks is not that some flag has gone up that provides certainty about a bottom. Rather, our investment discipline is to gradually increase our investment exposure in proportion to the expected return/risk profile associated with prevailing conditions of valuation and market action. Scaling our positions in proportion to the market's expected return/risk profile, based on prevailing conditions (rather than trying to forecast market turns), is the essential practice.

Buffett notes, “Let me be clear on one point: I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

I have no idea whether the market will be higher or lower a month or a year from now either, but I think I differ from Buffett on the reasons for this. Buffett's reason is that he largely disregards short-term fluctuations, understanding that the market will improve before visible fundamentals do. My reason is that our market allocation is proportionate to the favorable expected return/risk profile of the prevailing Market Climate, and I have no way of knowing when that Climate will shift. When it does, we'll change our allocation. As I've said before, you don't have to forecast the future direction of the wind – you just need to regularly adjust the sails as the evidence changes.

Early measures of market action turn favorable

Notably, last week we observed a measurable reversal in risk premium pressures, coupled with a clear “breadth reversal” across a wide range of industries. As I've stated frequently over the years, the most important feature of market action is not the extent or duration of market movements, but their quality and uniformity. These measures can change very quickly, and long before “trend following” signals such as moving-average crossings occur. Last week, our most sensitive measures of market action clearly reversed to a favorable condition. These don't “whipsaw” very often because they come into consideration only when market action is unusually compressed. Presently, in addition to undervaluation and extreme sentiment, we already have the beginnings of favorable market action.

That said, we don't yet have enough evidence to simply remove our hedges. The prevailing evidence is consistent with a high expected return/risk profile for stocks, but the still “early” improvement in market action and the unusual nature of the current downturn suggest that we maintain something of a “stop loss” in the form of continued put option coverage, with strike prices within a few percent below current levels. That is the position that we have established here.

The recent panic is frequently described as the “worst” since the Great Depression, but this does not imply that the outlook is similar. One of the clearest contributors to the Depression was the failure of the monetary base to expand at anywhere near the demand for base money. At present, governments have made a concerted effort to put the world awash in base money.

Neither the crisis in financials or the current recession are surprising, but Depression talk is hyperbole. About the only surprise in recent weeks was that the broad recognition of a U.S. recession emerged at the same time as the peak of the financial crisis. That compressed what should have been two separate down-legs of a bear market into a single swan-dive. This downturn is certainly extreme, but the conditions that amplified the downward spiral in the Great Depression are largely absent here. Both at market peaks and at market troughs, investors allow their imaginations to run, almost always to their detriment.

I'll repeat what I wrote during the 2000-2002 bear market: at meaningful market lows, "the tenor of news reports has always been something to the effect that 'conditions are bad, expected to get worse, and there is no end in sight.' When the news reports are uncontroversial in reporting that the U.S. is in recession, when they suggest that there is worse news ahead, and when they indicate that nothing seems to be helping, that is when the market is likely to register its low."

This is also a good time to reiterate our standard “anti-marketing” message: The Strategic Growth Fund is not a “market timing” fund. Nor is it a “bear” fund or a “market neutral” fund. Strategic Growth is a risk-managed growth fund that is intended to accept exposure to U.S. stocks over the full market cycle, but with smaller periodic losses than a passive buy-and-hold approach. We gradually scale our investment exposure in proportion to the average return/risk profile that stocks have provided under similar conditions (primarily defined by valuation and market action). We make no attempt to track short-term market fluctuations. We leave “buy signals” and attempts to forecast short-term market direction to other investors, preferring to align our investment positions with the prevailing evidence about the Market Climate.

My opinion is that while there is still risk that the market will decline even further, investors may be underestimating the potential for a rapid 20-25% spike higher in U.S. stocks as risk aversion collapses. That opinion doesn't drive our investment stance. Rather, both my opinion and our investment stance are driven by the objective evidence we have in hand about valuations and market action. At present, the evidence indicates that it is appropriate to accept market risk, but with something of a “stop” in the form of put option coverage close to (or a few percent below) current levels.

I won't sugar-coat the fact that we are accepting some amount of market risk here, and that this exposes us to some amount of potential loss if the market continues lower. Again, however, we continue to have a put option defense below about 90% of our stock holdings with strike prices within a few percent of current levels, which should relieve any concern about unacceptably large downside exposure. Equally important, in the event that stocks were to decline from here, I expect that there would be a strong likelihood of recovering at least to current levels on a subsequent advance. From that perspective, I expect that whatever downside we might experience as a result of a further market selloff would probably be temporary.

With the Strategic Growth Fund less than 10% below its record high, we now observe a loss of 40% or more in the major indices, extreme bearish sentiment and volatility consistent with important market lows, and a clear though still “early” improvement in our measures of market internals. It is impossible to be a successful equity investor without the willingness to accept some amount of market risk when conditions appear frightening. If anything should be clear from the bubbles of recent years, the greatest risks are not when prices are depressed, the economy is weak, and investors are frightened, but rather when prices are elevated and an unendingly positive outlook for technology, or housing, or global growth, or private equity, or emerging markets, or commodities seems all but certain.

Treasury gets it right

Last week, the Treasury finally got it right, announcing that it would directly provide capital to troubled financial institutions by purchasing senior preferred equity stakes. As I argued in An Open Letter to Congress Regarding the Current Financial Crisis and You Can't Rescue the Financial System if You Can't Read a Balance Sheet, this is exactly the right approach, since it operates on the liability (capital) side of the balance sheet, which is where the trouble has been. I would have preferred the Treasury to follow Bagehot's Rule (lend freely but at a high rate of interest) as opposed to the “favorable” terms that were offered. This would have encouraged these financial companies to get off of the public's dime as soon as possible. Even so, as long as the yield on the preferred is higher than the Treasury's funding costs, the favorable terms will represent an insufficient risk premium but not a loss to the public.

Still, some amount of patience is needed, lest investors frighten themselves that this capital infusion is not working. As I wrote in a note to shareholders in the Fund News section of the website on October 15, “Investors appear frantic to observe a reduction in LIBOR and other measures of credit strain, but such impatience is not reasonable given that the Treasury has not yet actually executed the announced transactions to provide capital to U.S. financials. Sellers at these levels may find themselves scrambling to repurchase stock as that occurs, particularly in view of current valuations (even adjusted for the impact of an ongoing recession). On nearly every measure - sentiment, valuation, volatility, oversold conditions, and others, we are observing extremes associated with strong expected return/risk profiles, on average.”

With respect to the economy as a whole, I continue to believe that allowing what I've called a “property appreciation right” (PAR) would be the single best legislative change to decouple the mortgage crisis from the broader economy:

Congress can efficiently mute the impact of the mortgage crisis on “Main Street” by allowing a small change in foreclosure law. Specifically, in foreclosure proceedings, judges should have the ability to reduce the amount of principal on a mortgage loan, provided that the original mortgage lender receives a “Property Appreciation Right” or “PAR” from the homeowner. The PAR would be an obligation to repay the mortgage lender out of future appreciation on the home (including property subsequently purchased, until the obligation was relieved). Payment would occur either when the home was sold, or through an equity-extraction refinancing at some later date. In that way, homeowners would surrender some amount of future appreciation in return for an equivalent reduction in the mortgage principal. This would result in an immediate lowering of mortgage payments, yet the original mortgage lender would still stand to be made whole. To account for time-value, the amount of the PAR obligation could be allowed to increase at a small rate of interest. The homeowner would be able to keep the house. Importantly, there would be no need to continue major write-downs on mortgage securities, since only the character of the payments, not the value of the mortgage obligation itself, would change.

(Readers who believe this approach should be included in discussion are encouraged to forward the above paragraph to their representatives in Congress.)

Market Climate

As of last week, the Market Climate for stocks was characterized by favorable valuations and early evidence of favorable market action. The improved character of market action is not evident from standard “trend following” evidence such as moving-average crossings and so forth. Rather, last week we observed a very broad reversal in breadth and risk premiums. When this has occurred in the context of favorable valuations, compressed price trends, and bearish sentiment, such early reversals have often resulted in double-digit market gains over a period of weeks. At the same time, we are maintaining something of a “stop loss” a few percent below current levels in the form of put option coverage for about 90% of our stock holdings. In doing so, we are balancing the improvement in our quantitative measures, as well as our qualitative analysis, against our tolerance for risk (we prefer investment positions that allow us to be dead wrong about everything and still not experience intolerable losses). I expect that we'll maintain some amount of put coverage at least until we observe confirming evidence from high trading volume and improvement of more conventional market internals.

Generally speaking, an intolerable loss is one that requires a heroic recovery simply to break even. From my perspective, the S&P 500 has experienced an intolerable loss, since a 42% loss requires a 70% gain just to recover. The typical market loss of about 32% in an average bear market requires a 47% gain in order to break even, leaving only bull market returns beyond that amount to contribute toward long-term progress. Downside risk should always be assessed in relation to upside potential: a 10% loss is recovered by an 11% gain, a 15% loss is recovered by an 18% gain, and a painful 20% loss is recovered by a 25% gain. Such losses in say, a short-term money market fund, would be cause for panic because gains of 18%-25% are indeed heroic propositions. In the equity markets - particularly for strategies that can be partially or fully exposed to market fluctuations - such recoveries are reasonable and even commonplace (within a matter of weeks or months) once the market has become deeply depressed.

In bonds, the fear about Depression gripping the markets had a striking result last week, as investors priced inflation-protected bonds as if the rate of inflation would be essentially zero for the next 5 years or more. Now, from the standpoint of immediate inflation risk, I have long argued that widening credit spreads have a very strong effect in suppressing inflation. At the same time, however, the enormous increase in government liabilities stemming from an ongoing budget deficit and huge financial rescue efforts is likely to result in normal if not elevated levels of inflation as the economy recovers.

As investors suddenly adopted a “deflation mindset,” they dumped their inflation-protected securities with little regard to price or longer-term inflation prospects. TIPS yields soared to over 3%. From a historical perspective, it has been rare for U.S. Treasury securities to provide real yields much over about 2% annually. In the Strategic Total Return Fund, we shifted about 25% of the Fund into Treasury Inflation Protected Securities with a variety of maturities. We may accumulate more if real yields press even higher. As always, you scale in proportionately as the expected return/risk profile becomes favorable.

Back in April, when commodities were still advancing to new highs, I noted that “at the point where real interest rates become positive and trend higher, we may observe a softening in commodities. Presently, we don't observe that, but it is important to keep in mind that the strength in commodities largely mirrors a persistent decline in U.S. real interest rates, and in the value of the U.S. dollar. As the downward pressure on real interest rates abates, so most probably will the upward pressure on commodity prices.” Having closed our TIPS positions when real interest rates fell to negative levels, we closed the bulk of our precious metals positions shortly thereafter when gold soared over $1000 an ounce. It is not typical for the Fund to have the majority of its assets in Treasury bills, but that was the case through much of the summer.

The weakness in commodities now having largely played itself out, the entire analysis above could now be reversed. Specifically, at the point where real interest rates stabilize or trend lower, we may observe a strengthening in commodities. The weakness in commodities we've seen lately mirrors the surge in U.S. real interest rates and in the value of the U.S. dollar. As that upward pressure on real interest rates abates, so most probably will the downward pressure on commodity prices (as well as the upward pressure on the U.S. dollar). In addition to the Total Return Fund's positions in TIPS and short-dated Treasury securities, the Fund continues to hold about 30% of assets in a diversified group of precious metals shares, utility shares, and foreign currencies. With these markets sharply down from their highs, I believe it is appropriate for the Strategic Total Return Fund to again hold a moderate, diversified portfolio of TIPS, short-dated Treasury securities (awaiting higher real or nominal yields to invest in longer-dated securities), precious metals shares, utilities, and foreign currencies.

The Incredibly Shrinking Hedge Fund Industry

Recent weeks for hedge-fund managers have been ug-lee.

And, as companies that track the industry scramble to put out estimates quantifying the value of the damage there is no consensus on just how much hedge funds have lost, but the trend is crystal clear.

Some of the latest come from Eurekahedge, a hedge-fund research company and consultancy. According to its preliminary estimates, hedge-fund losses totaled roughly $79 billion in September, including $44.5 billion of investment losses and $34.5 billion of investor withdrawals. That was only partially offset by about $10.5 billion of new money flowing into the more successful strategies, Eurekahedge figures.

The financial turmoil has caused steep declines across a number of markets, triggering widespread losses across the hedge-fund industry. Many hedge funds now are down as much as 30% or more for the year–and some 60% or worse. Even many of the biggest names in the hedge fund industry have suffered hefty declines, including Ken Griffin’s Citadel Investment Group and Tim Barakett’s Atticus Capital.

That is causing already skittish investors to take out money and park it in less risky places, such as cash. And, some of the industry’s largest investors–the fund-of-fund groups that invest in pools of hedge funds–have had hefty withdrawals from their own investors, forcing them to take out more money from hedge-fund managers.

In the third quarter, hedge-fund assets shrank by a record $210 billion, or more than 10%, estimates Hedge Fund Research. To put that in perspective, the decline in assets for the quarter exceeded the entire amount of money that flowed into the industry in 2007, which was a record $194 billion.

Of those third-quarter declines, more than $31 billion was attributed to investors taking out their money, the largest net capital redemptions on record, says Hedge Fund Research. That left total hedge-fund assets at $1.72 trillion, down from $1.93 trillion at the end of the second quarter.

As a group, they were down almost 5.5% in September alone and down more than 10% for the year so far, according to Hedge Fund Research. To be sure, that is still better performance than the broader stock market.

And, the contraction is expected to continue, with many industry insiders predicting that by year end hedge-fund assets will have shrunk by a quarter or more. Already a number of hedge funds have shut their doors and many more are expected to follow suit. Credit Suisse estimates 30% of the roughly 8,000 hedge funds will close in the next few years.

Andrew Lahde bows out in style

Say what you will about Andrew Lahde, but the man knows how to write a letter.

Last month, the famed-for-betting-against-subprime hedge fund manager shuttered his operations, citing unacceptable levels of counterparty risk.

His goodbye missive is impressive not just for its length, but for its clearly-articulated (and somewhat apocalyptic) closing arguments.

Verbatim:

“Today I write not to gloat. Given the pain that nearly everyone is experiencing, that would be entirely inappropriate. Nor am I writing to make further predictions, as most of my forecasts in previous letters have unfolded or are in the process of unfolding. Instead, I am writing to say goodbye.

Recently, on the front page of Section C of the Wall Street Journal, a hedge fund manager who was also closing up shop (a $300 million fund), was quoted as saying, “What I have learned about the hedge fund business is that I hate it.” I could not agree more with that statement. I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

There are far too many people for me to sincerely thank for my success. However, I do not want to sound like a Hollywood actor accepting an award. The money was reward enough. Furthermore, the endless list those deserving thanks know who they are.

I will no longer manage money for other people or institutions. I have enough of my own wealth to manage. Some people, who think they have arrived at a reasonable estimate of my net worth, might be surprised that I would call it quits with such a small war chest. That is fine; I am content with my rewards. Moreover, I will let others try to amass nine, ten or eleven figure net worths. Meanwhile, their lives suck. Appointments back to back, booked solid for the next three months, they look forward to their two week vacation in January during which they will likely be glued to their Blackberries or other such devices. What is the point? They will all be forgotten in fifty years anyway. Steve Balmer, Steven Cohen, and Larry Ellison will all be forgotten. I do not understand the legacy thing. Nearly everyone will be forgotten. Give up on leaving your mark. Throw the Blackberry away and enjoy life.

So this is it. With all due respect, I am dropping out. Please do not expect any type of reply to emails or voicemails within normal time frames or at all. Andy Springer and his company will be handling the dissolution of the fund. And don’t worry about my employees, they were always employed by Mr. Springer’s company and only one (who has been well-rewarded) will lose his job.

I have no interest in any deals in which anyone would like me to participate. I truly do not have a strong opinion about any market right now, other than to say that things will continue to get worse for some time, probably years. I am content sitting on the sidelines and waiting. After all, sitting and waiting is how we made money from the subprime debacle. I now have time to repair my health, which was destroyed by the stress I layered onto myself over the past two years, as well as my entire life — where I had to compete for spaces in universities and graduate schools, jobs and assets under management — with those who had all the advantages (rich parents) that I did not. May meritocracy be part of a new form of government, which needs to be established.

On the issue of the U.S. Government, I would like to make a modest proposal. First, I point out the obvious flaws, whereby legislation was repeatedly brought forth to Congress over the past eight years, which would have reigned in the predatory lending practices of now mostly defunct institutions. These institutions regularly filled the coffers of both parties in return for voting down all of this legislation designed to protect the common citizen. This is an outrage, yet no one seems to know or care about it. Since Thomas Jefferson and Adam Smith passed, I would argue that there has been a dearth of worthy philosophers in this country, at least ones focused on improving government. Capitalism worked for two hundred years, but times change, and systems become corrupt. George Soros, a man of staggering wealth, has stated that he would like to be remembered as a philosopher. My suggestion is that this great man start and sponsor a forum for great minds to come together to create a new system of government that truly represents the common man’s interest, while at the same time creating rewards great enough to attract the best and brightest minds to serve in government roles without having to rely on corruption to further their interests or lifestyles. This forum could be similar to the one used to create the operating system, Linux, which competes with Microsoft’s near monopoly. I believe there is an answer, but for now the system is clearly broken.

Lastly, while I still have an audience, I would like to bring attention to an alternative food and energy source. You won’t see it included in BP’s, “Feel good. We are working on sustainable solutions,” television commercials, nor is it mentioned in ADM’s similar commercials. But hemp has been used for at least 5,000 years for cloth and food, as well as just about everything that is produced from petroleum products. Hemp is not marijuana and vice versa. Hemp is the male plant and it grows like a weed, hence the slang term. The original American flag was made of hemp fiber and our Constitution was printed on paper made of hemp. It was used as recently as World War II by the U.S. Government, and then promptly made illegal after the war was won. At a time when rhetoric is flying about becoming more self-sufficient in terms of energy, why is it illegal to grow this plant in this country? Ah, the female. The evil female plant — marijuana. It gets you high, it makes you laugh, it does not produce a hangover. Unlike alcohol, it does not result in bar fights or wife beating. So, why is this innocuous plant illegal? Is it a gateway drug? No, that would be alcohol, which is so heavily advertised in this country. My only conclusion as to why it is illegal, is that Corporate America, which owns Congress, would rather sell you Paxil, Zoloft, Xanax and other additive drugs, than allow you to grow a plant in your home without some of the profits going into their coffers. This policy is ludicrous. It has surely contributed to our dependency on foreign energy sources. Our policies have other countries literally laughing at our stupidity, most notably Canada, as well as several European nations (both Eastern and Western). You would not know this by paying attention to U.S. media sources though, as they tend not to elaborate on who is laughing at the United States this week. Please people, let’s stop the rhetoric and start thinking about how we can truly become self-sufficient.

With that I say good-bye and good luck.

All the best,

Andrew Lahde”

Bear Market Cartoons