Friday, October 31, 2008

Does the market bottom in 1Q/2Q 2009?

Did anyone sit out October?

I wrote in early October that Mebane Faber had done a study indicating that equities could see positive returns in November and December because of the horrible month that stocks saw in September. Faber followed up with a further study entitled What happens after two bad months that point to median gains of 7% for the rest of the year if history were to be any guide. VIX and more came to a similar conclusion on market direction by comparing the current period in the US to Japan:
Japan's "lost decade" does bear some resemblance to the problems in the U.S. Looking at the historical record with a global perspective, it is tempting to conclude that the current situation ripe for another volatility bounce of at least two months.

Waiting for the retest of the lows
Without a doubt, last week’s market was a bottom fishers’ paradise. In addition to running my recent screen of beaten up financials, I ran other deep value screens and found all sorts of companies that were worth more dead than alive. There were 14 stocks trading below net cash (cash – total debt) that were profitable and therefore in at low risk of bankruptcy. There were also 42 stocks trading below net-net working capital (current assets – all liabilities) and were profitable. These are all indications of extreme cheapness that bottom-up value investors are fond of.

However, my sources tell me that many hedge funds have moved to cash and called it quits for the rest of the year (SAC Capital is just one well-known example). Any rally that we may see in the stock market for November and December cannot be regarded as enduring until it can be confirmed in January when hedge funds return to the market.

What bothered me was that a lot of individual investors have been too eager to jump on this rally. I wrote that sentiment was too bullish for this to be a durable bottom. However, sentiment models are not great at timing markets in the very short term. Come January, my guess is that the overly optimistic sentiment chickens will come home to roost and this market will retreat again to test the October lows.


Market undergoing a bottoming process
This market action points to the scenario of the stock market undergoing a bottoming process. Consider this NY Times chart of previous bear markets. While the depth of this bear is comparable to other Great Bears, this bear has been remarkably short so far compared to the others.

What's more, most bear market bottoms have been formed by two or three tests of the lows before the bulls take control. I went back and looked at previous bear market bottoms since the 1970s. The table below shows the time between the first and last tests of the market lows. In most cases, it takes 3-6 months before a low is established and proven to be durable.

Previous Bears: Time between first and last market low
2002 7-8 months
1991 3-4 months
1987 1 ½ months
1982 6 months
1974 3 months


Recession to bottom out in the Spring?
This market analysis is consistent with a study from Bespoke indicating that the recession would likely bottom out in the Spring:
The average length of US recessions is 14.4 months. Using the assumption that the recession began at the start of 2008 (using Industrial Production and Employment statistics), if the current period ends up just as an average contraction, we could expect the economy to bottom some time next spring.
The shape of the yield curve is also pointing to a growth revival in 2009. Now, some may say that all these financial problems are going to create an incredible drag on the economy and the US is not likely to emerge from recession any time soon. However, the historical evidence shows that while recessions induced by financial stress tend to be deeper, they don’t seem to any longer.

For investors trying to time the market bottom, Northern Trust put out a study that showed the S&P 500 generally bottomed out 2-5 months before the actual economic bottom. If we were to accept Bepsoke’s forecast of a recessionary bottom in the Spring, then this would also suggest a market bottom in early 2009.


Base case: The market bottoms in early 2009
In summary, the technical and economic analysis both point to the same conclusion. The market is likely to rally for a couple of months into year-end. Then expect a decline and re-test of the October lows in the January-April timeframe and that test would mark the bottom of this bear market. At that point, I would be getting ready and orienting my portfolio to take advantage of a Phoenix effect.

The greatest risk to this forecast is that the world’s financial system is extremely fragile and future events are highly dependent on policy response. Given that the US is facing an election and we will likely not see the economic team until early next year, anything can happen.

Tuesday, October 28, 2008

What actually happens in the long run?

I recently posted that bottom-up and value-oriented investors tend to be bullish on the US equities but noted that top-down investors continued to be concerned about the macro environment.

There are exceptions. Here is a top-down analysis that concluded that equities are cheap. Based on Jeremy Siegel’s observation that stocks have historically returned about 7% a year, the authors of this study showed that currently equities are trading well below the 7% trendline and concluded that stocks are cheap.

This is an example of an analysis whose data suffers from a severe problem of survivorship bias.


Survivorship bias colors the data
What if your family had managed to save the equivalent of $100 at the time of Augustus Caesar (give or take 2,000 years ago) and put it into equities or an equivalent investment? At 7% a year, the value of your family’s $100 original investment would now have 60 zeros behind it. Your family could finance TARP and the bailout by the world’s central banks from the chump change derived one day’s interest.

What happened?

What happened was in the intervening 2,000 years, there were many upheavals that destroyed wealth. Empires fell, starting with the Roman Empire, barbarians sacked cities and a lot of people died in very unpleasant ways.

We don’t have to go back 2,000 years to look at survivorship bias or wealth destruction. Going back 100 years, people mainly invested in bonds and equities did not represent a liquid asset class. Supposing we were to look at the bond markets 100 years ago, the “developed” market consisted of Britain, France and Germany. The “emerging” markets were America, Argentina, Canada and Russia. (Please forgive me if I have forgotten a market or two.)

Any analysis of the capital markets today that focuses on the principal survivor markets (US and UK) would have missed a number of markets that tanked horribly during that 100 year investment interval. Any care for some Argentinean railway bonds from 100 years ago? Russian ones? How about some “safer” German bonds? After all, it was a developed market - which subsequently went through one world war, subsequent hyperinflation and then the physical devastation of its infrastructure after another world war.


War and revolution the risk
Today, people are cranky and getting crankier. The risks of political turmoil are front and center. The gentlest example I have is a chart of the electoral map before and after the Great Depression. We could very well see the trend favoring open markets and the free flow of capital and ideas reverse itself. War is a possibility.


Think about your assumptions
This is a warning for quants and other modelers. Think about your assumptions to avoid making fundamental errors in judgment.

Bottom-up investors are finding bargains today. Top-down investors continue to be worried about the macro risk of a sea change that may devastate their wealth just as some of the events in the past hundred years have destroyed wealth. Were it not for those very real concerns, equity prices would probably be a lot higher than they are today.

Sunday, October 26, 2008

The kid in the candy store

Top-down oriented investors seems to have significant concerns about the macroeconomic backdrop right now. On the other hand, many value and bottom-up oriented investors who were previously cautious on the market have either become more constructive on stocks or turned outright bullish. The list goes on: Warren Buffett, Jeremy Grantham, Ken Heebner, John Hussman, John Neff and return estimates based on the ValueLine Survey.

Putting on my bottom-up investor’s hat on, I can sympathize with the bullish assessment. Just for fun I ran a quick screen of low-priced beaten up financials with heavy insider buying and came up with a moderately sized list, which is shown below. It’s easy to see how some of the bottom-up managers are behaving like kids in a candy store. You don't see these kinds of values every day. The P/Es of these financials are low and they have had significant insider buying in the last six months and no insider sales, which is an indication of management confidence. In addition, other deep value screens are also showing long lists of stocks with good upside potential with solid asset value support.

Click for larger image

However, my inner top-down investor remains concerned that there is too much macro downside risk. The market is too dependent on policy response for me to sound the all-clear for the bulls.

Disclaimer: I don’t have a position in any of these stocks. You should not consider this as a recommendation to trade any of them. You are responsible for your own portfolio and you should do your own homework.

Thursday, October 23, 2008

A barbell portfolio for a fork in the road

Whew! The official intervention in the last few weeks seems to be finally taking effect. Credit markets are finally starting to normalize as we see that LIBOR starting to edge down.

Now that the panic seems to be starting to end, I began to muse the implications of the events of the past few weeks and months on investment policy. Note to traders: investment policy isn’t about what happens in the next day or next week, but orienting the portfolio for the next 3-5 years (or more).


Inflation or deflation?
I have written before that future events depend much on the policy response to the crisis. Much of the investment outlook for the next 5-10 years depends on how the authorities and market participants behave in the next few months.

The world is in a fork in the road. Down one path is the specter of Weimar Republic style hyperinflation. Already the Treasury yield curve has steepened as the bond market starts to wonder how the authorities are going to pay for this bailout. There are two key risks. First, all this liquidity doesn’t or can’t get drained from the system after risk premiums retreat to normal levels. Former Fed Chairman Paul Volcker summarized the second risk of this massive intervention succinctly: “Those banks have been nationalized, overtly or not overtly, which is something that hasn't happened before in the history of developed countries. How to wean them from government support? That is the challenge of the future.

On the other hand, down the other road is the terror of deflation and Depression. If America’s lenders (China, Japan, Middle East states, etc.) decide that enough is enough and it’s time to put the US on a diet. We could witness a Brady-like debt restructuring plan, most likely with draconian adjustments in the manner of IMF prescriptions (here's an example).


Serial bubbles: The Greenspan put becomes the G-7 put
The inflationary case is easy to make. Politicians of all stripes loath to make unpopular decisions and would rather pay the piper later. With one in six homes in the US showing negative equity and the pain spreading on Main Street, the political pressure for further relief is intense. A plethora of measures have been enacted that indicate that the government is well down this path. For instance, the Fed has written a blank check to G-7 central banks for USD assets (emphasis mine):
The BoE, ECB, and SNB will conduct tenders of U.S. dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction. Accordingly, sizes of the reciprocal currency arrangements (swap lines) between the Federal Reserve and the BoE, the ECB, and the SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded.
This week we have news of the Money Market Investor Fund Facility (MMIFF), a Federal Reserve facility of up to $540 billion to help money market funds. This is the latest in the alphabet soup of rescue packages from the Fed and Treasury.

Other examples of excesses abound. TARP is already spawning moral hazard at the individual level. High sounding principles of corporate governance, first espoused at the initiation of the bailout, are being watered down. The suspension of mark to market accounting is already laying the groundwork for the next bubble. Companies like AIG are acting like nothing has happened and business goes on as usual, even after becoming the recipient of the Fed’s largesse (see this, this and this).

Foreigners may be already reacting to this heightened inflation risk. Robert Mundell, the father of the euro and an advisor to the Chinese government, was reported quoted as saying that China should purchase all of the IMF’s gold if it came up for sale. While I would somewhat discount this report as it originates with GATA (Gold Anti-Trust Action Committee), which many scoff at as being part of the tinfoil hat brigade, it does represents another piece of the puzzle in a mosaic that indicates we are well down the path of the next bubble. As they say: just because you are paranoid doesn’t mean people aren’t out to get you.


The deflation case: Where is the growth?
Right now, emerging markets (notably China) is the main source of world growth but emerging market growth is teetering. If the emerging markets falter, then the world would descend into a serious synchronized global recession. Brad Setser speculated that the current crisis may mark the end of Bretton Woods 2:

The Bretton Woods 2 system – where China and then the oil-exporters provided (subsidized) financing to the US to sustain their exports – will come close to ending, at least temporarily. If the US and Europe are not importing much, the rest of the world won’t be exporting much.
China cannot plausibly hold up the entire world. Emerging market economies are more fragile than we think. Already we can see Korea as an example of a country having difficult with getting access to USD liquidity in their banking system. The list of emerging economies in trouble or is seeking IMF help is growing daily (Argentina, Belarus, Hungary, Pakistan, etc.).


Paul Volcker: No serial bubbles
According to the latest polls and Intrade, Barack Obama is a virtual shoo-in to win the presidency in November. Paul Volcker is known to be one of his principal economic advisors and the Obama campaign reportedly consults Volcker on virtually all economic issues. Therefore, it wouldn’t be a huge surprise to see Volcker appointed as Treasury Secretary should Obama become president. While Volcker may not accept the appointment because of his advanced age of 81, he would undoubtedly be an influential voice in an Obama Administration.

With that in mind, let’s look at two recent interviews that Paul Volcker had with Charlie Rose (here and here. Warning – the interview videos are long). A summary of his comments follows:
  • The Fed and Treasury have the tools to fix this crisis and they are now doing the right things.
  • Japan and China will (have no choice) but to continue to finance the US. In other words, Bretton Woods 2 is not dead.
  • The US economy is fundamentally sound (similar to my previous comment that if the US were a company, it could be best described as right business model but bad balance sheet.), Volcker’s comment was “we need more electrical and chemical engineers and fewer financial engineers”.
  • When the dust settles, he would favor policies that 1) create more financial regulation and oversight; and 2) encourage savings and less spending.
  • Beware of inflation: “Inflation is the ultimate destructive result.”

The last point is particularly important about “inflation is the ultimate destructive result”. There would be no serial bubbles with Paul Volcker in charge. He would likely advise the new president to take the pain now and prepare the groundwork for a sustainable recovery. Should Volcker become Treasury Secretary, we can expect a couple years of pain in the form of restructuring, debt destruction and deflation.

A barbell portfolio for uncertain times
Given these two disparate outcomes, both of which are very real, what does an investor do?

Under a scenario of rising inflation and possibly hyperinflation, hard assets are the best hedge. The equities of emerging markets, the most likely source of growth, would likely lead any rebound should the world reflate relatively quickly from this crisis.

On the other hand, hard assets and emerging market stocks will not fare well in a deflationary scenario where defaults abound and investors seek safety. Cash, in the form of default-free paper, would perform best in that environment.

Given the risks involved, perhaps the most prudent course of action to create a barbell portfolio. Split the portfolio between inflation hedge vehicles and cash, preferably in the form of T-Bills. As I have no idea what anyone’s investment objectives and risk tolerances, the weights and how you pick the inflation hedge vehicles is up to you.

Monday, October 20, 2008

Where are the equity bears?

After one of the biggest equity market declines we’ve seen in recent memory and a looming worldwide recession, investors should be worried and bearish, right?

It seems not. Maybe this all stems from Warren Buffett's clarion call to buy US equities last week. Readings from sentiment models indicate that either investors are not bearish enough or plain outright bullish on the market, which makes me concerned that there is more downside to come.


AAII survey not bearish enough
The chart below shows the AAII sentiment survey. After the recent freefall in the stock market, it is amazing to me that sentiment readings are less bearish than they were at the last short term market bottom:



Hulbert indicators confirm lack of bearishness
We also have several confirmations of this lack of bearishness. Mark Hulbert recently wrote that the newsletter writers who advise buy-and-hold strategies haven’t thrown in the towel yet and moved to market timing:
Historically, buy-and-hold tends to reach its peak of popularity at market tops, just as market timing becomes most out of favor. The inverse tends to be the case at market bottoms.
On Thursday October 16, Peter Brimelow also confirmed that newsletter writers’ sentiment wasn’t bearish enough:
The Hulbert Stock Newsletter Sentiment Index, which reflects the average recommended stock-market exposure among a subset of short-term stock market-timing newsletters tracked by the Hulbert Financial Digest, stood on Wednesday night at negative 12.8%. That's sharply higher than last week, when it was at negative 33.5%, although the Dow was 1,400 points higher and Mark Hulbert was already worried for contrary opinion reasons.



Bloggers are wildly bullish, individuals not panicked
What’s more, I was shocked to learn that there isn’t a single bear in the recent TickerSense’s blogger sentiment survey.

My own private conversations with individual investment advisors indicate that their clients are not panicked and some have even been buying. While these advisors mostly advocate asset allocation and buy-and-hold strategies, the lack of panic among individual investors is a huge concern for bulls.

On the other hand, there is a pervasive sense of doom on the economic front. The lack of doom among equity investors, however, point to more downside for the stock market.

Wednesday, October 15, 2008

Advice for the hedgie walking wounded

As the list on the Hedge Fund Implode-O-Meter grows, my sources show that the average diversified hedge funds were down about 16% YTD (to early October) and they were exhibiting current drawdown of about 17%. Convertible Arbitrage, Equity Long/Short and Event Driven strategies were the worst performing strategies with average current drawdowns of over 20% each. Moreover, there have also been stories floating around that even some large brand name hedge funds are down 10-15% YTD.


Living to fight another day
If you are one of those walking wounded hedge fund managers who survived, congratulations! Periods of negative returns are useful for reflection and analysis of your investment process. If you are undergoing such a review, here is some free simple advice on how to put together a strategy and portfolio:
  • Diversify, diversify, diversify your factors! As any baby quant knows, combining uncorrelated factors to put together a strategy makes for more stable results.
  • Distill your bets and focus on what you are good at. In other words, don't forget risk control.

I show two examples of these principles below.


Factor diversification
I have written about the benefits of factor diversification before. Here is another example. This was a strategy that I was heavily involved in developing for an equity market neutral portfolio. The chart below shows the out of sample returns of two stock selection models.

Model A is a bottom-up derived multi-factor model with an average holding period of 1-2 months. Even though the process was bottom-up oriented, it acquired decided top-down trend following like characteristics (which was extremely powerful during the backtest period). My solution was to complement Model A with Model B, a short-term price reversal model with an average holding period of 4-5 days. The portfolio returns, which consist of a 67% weight in Model A and 33% in Model B, are less volatile.

The chart below shows the rolling correlation of the two models. Intuitively, one would expect that the trend following/momentum Model A and the price reverting Model B to have a correlation of close to -1. In fact, their rolling correlations have fluctuated around the zero line over the out of sample period.
The bottom line: The combination of Model A and B made for a far more stable stock selection model, as shown by its positive (though somewhat volatile) returns during a difficult period for hedge funds. The results were updated to 14 Oct 2008. Portfolio returns were stable in the panic market selloff last week and subsequent rally on Monday.


Distilling your bets
I have my reservations about the blind application of Grinold’s Fundamental Law of Active Management. Nevertheless, the ideas behind his principles remain true:


In so many words, Grinold said to size your bet according to your skill. If you have no skill, the solution is to eliminate or minimize that bet.

A case in point. About a year ago, I was involved in a risk-control project for a long/short equity manager. He had shown very good returns over the years but results were volatile.

The manager had an eclectic top-down rotation investment process. At any one time, he may latch onto one or more interesting investment themes, e.g. biotech, emerging markets, etc., and make a big bet on any one of those themes. The result was a long/short equity portfolio with a decidedly long bias.

Unfortunately, the portfolio was taking on excessive and unnecessary market risk. While long term returns were excellent, the fund suffered large draw-downs in bear markets. Our solution was to sizably reduce market and common factor risk in the portfolio, as the manager admittedly didn’t have any market timing ability. We used standard risk models, from Barra and from Northfield, to estimate the factor exposures of the portfolio in order to form a hedge and overlay on top of the actual portfolio. The chart below shows the returns of the original portfolio and a portfolio hedged using ETFs, such as ETFs on the S&P 500, Russell 2000, as well as country and sector ETFs.

The table below shows the returns of the simulation. The returns of the hedged portfolio over the simulation period outperformed the original unhedged portfolio by 3%. The hedged portfolio avoided much of the drawdown experienced by the unhedged portfolio and outperformed both the S&P 500 and the HFR Equity Hedge Index. In addition, the hedged portfolio had superior risk characteristics as it avoided much of the drawdown in the bear market after the Tech Bubble top of 2000.







The moral of this story: Figure out what you are good at, stick to it and eliminate/minimize the other bets in your portfolio.

Monday, October 13, 2008

Data problem = commodity rally?

The Baltic Dry Index has been falling for the last three months and in free fall for the last month. I had originally interpreted that as slackening world demand and particularly by China indicating a worldwide economic slowdown. Now a report from Naked Capitalism suggests that shipping volumes have seized up because of the financial crisis:
I spoke to another friend of mine this afternoon, whose father has been in the shipping business forever. Pristine credit rating, rock solid balance sheet. He says if he takes his BNP Paribas letter of credit to Citi today for short term funding for his vessels, they won't give it to him. That means he can't ship goods, which means that within the next 2 weeks, physical shortages of commodities begins to show up.

Readjust growth expectations?
If this condition of inability to ship because of problems in inter-bank credit market is widespread, then we have a case of analysts getting fooled by the data. The steps taken by the authorities to ease these conditions could then spark an enormous rally in the markets, in equities and especially in commodities.

Friday, October 10, 2008

How long and deep the slowdown?

There is little doubt that the US is entering a recession. The IMF's latest report also forecast that the world is entering a major downturn. The bigger questions are:
  • How long and how deep is the US slowdown?
  • Most importantly, will the US slowdown drag down the rest of the world?

As for the depth question, we have a good idea. Econobrowser pointed to a study that indicate the presence of financial stress is indicative of deeper recessions. How long it lasts and the its effects on the world depends on the policy response.


What’s the policy response?
In Charlie Rose’s interview with Warren Buffett, Buffett stated that the depth of the slowdown is dependent on the policy response:


Unemployment is going to go up under any circumstances. The 6.1 is going to go higher. But whether it goes and quits at seven or whether it quits at ten or 11 or 12 depends on, among other things, the wisdom of Congress and then the wisdom of - in terms of carrying out the plan that Congress authorizes.

Best and worst case scenarios
As the financial markets went into cardiac arrest in the last few weeks, many observers began to compare the current period in the US to either the Great Depression of the 1930s or Japan’s Lost Decade in the 1990s.

I beg to differ. I have constructed best and worst case scenarios that may be better analogies for today's situation.


Best case: German reunification
When the Berlin Wall came down, West Germany made the political choice to exchange West German Marks for East German Marks at a 1:1 ratio. The decision shocked the financial markets. I recall describing it at the time as a giant LBO of unproductive Soviet era assets which would create a drag on the German economy. The world began to slow down because of this macro shock and the Iraqi invasion of Kuwait toppled the world over into recession.

Yet the adjustment period was surprisingly mild. Germany underwent a couple of years of tough adjustments, followed by a period of anemic growth in the mid-90s (see analysis here). The former East continues to have problems, but overall Germany, Europe and the rest of the world were not dragged down by the macro shock in 1990. Germany has the reputation as an engineering powerhouse, whose principal export is its intellectual property.

The US parallels are obvious. Like Germany, the US is being weigh down by unproductive assets. Like Germany, much of US exports is intellectual property. It has an open economy, people from all over the world flock to its universities and its intellectual property exports have enabled it to re-invent itself periodically. I lived in Boston for nearly a decade and has seen it first hand. Research on radar was done in Boston during the Second World War. Over the successive decades, companies based in the area have demonstrated that Boston is a center of innovation. Examples include Digital Equipment, Lotus Development, the dot-coms during the tech bubble. The biotechs that dot the landscape today are a testament to the brainpower that is the source of intellectual property exports and America’s competitive advantage.

If the US were a company, it could be best described as right business model but bad balance sheet. The solution to such cases is to re-capitalize the balance sheet so that the enterprise could continue. In his interview, Buffett opined that:

[W]e've got the same plants out there we had two years ago. We got the houses. We've got people that are more productive than they've ever been in the history of this country. We've got a wonderful economic formula in this country. But right now it is being - it's been brought to a halt by …the de-leveraging that's going on right now that has caused the credit crisis…

I think confidence will come back. I will tell you this, this country is going - will be living better ten years from now than it is now. It will be living better 20 years from now then ten years from now. The ingredients that made this country, the miracle of the world. We had a seven for one improvement in the average American's standard of living in the 20th Century.
If the German reunification analogy holds true, then the United States will likely suffer a deep recession for 1-2 years but the rest of the world will recover relatively quickly.


Worst case: Depression of 1870s
There have been some in the blogosphere that have suggested a better analogy for the current times is the Depression of 1870s, which lasted for about a decade:

The parallels are striking—it started with a housing bubble which popped and generated a mortgage crisis. Financial markets fell apart when investors, relying on complex financial instruments, did not consider counter-party risk.
The financial troubles began initially in Europe but eventually spread to America, culminating in the Panic of 1873. Such episodes of booms and busts no doubt heavily influences works of later economists such as John Maynard Keynes as he sought out policy responses to smooth out these periods of volatility.

While a decade long depression is possible, it is less likely and represents the worst case apocalyptic scenario imaginable. The authorities did not have the policy levers that are available today, however flawed they may be. Bernanke is known to have studied the Great Depression of the 1930s and he is no doubt determined to avoid such an outcome.


Policy response is key to resolving the crisis
Surprisingly, policy response so far has been relatively ineffective. I have written before that the overwhelming issue is solvency in the banking system and not liquidity. So far the economic consensus concurs with that view. A partial list include the following: BCA Research, John Cochrane, Paul Krugman, Greg Mankiw, Nouriel Roubini, and Luigi Zingales and Diamond et al. Warren Buffett also agrees with the approach:

So there is - there are two things needed in the system. The one that's needed overwhelmingly is liquidity. When people are trying to de-leverage, there has to be somebody there to buy. And they don't have to buy at fancy prices, but to buy.

And then there's also a capital problem with some of the institutions. We have provided capital here with a couple institutions recently. The federal government did that in the '30s for the RFC and I think there could well be a proper role for government in that.
The UK is partially nationalizing its banking system and Gordon Brown urged the world to follow suit. The New York Times reported that the US Treasury is considering similar steps and the WSJ reported that it may insure all bank depts. Hank Paulson is quoted as saying: “We will use all the tools we’ve been given to maximum effectiveness, including strengthening the capitalization of financial institutions of every size.”

Former Fed Chairman Paul Volcker wrote in the WSJ indicating that we have the tools to fix the problem, we just need the leadership. In other words, all is not lost.

Wednesday, October 8, 2008

Signs of a panic bottom?

This week I have had several calls and emails from friends, acquaintances and former colleagues to discuss the state of the market. Mrs. Humble Student of the Markets also got this "joke email" from one of her friends.

The Treasury Department is putting out a new Dollar bill...


Bespoke also reports that the S&P 500 is 26% below its 200 day moving average, which is an extremely rare event.

While I continue to have concerns about the market, the combination of this level of panic and more reasonable valuations is highly suggestive that a tradable bottom is in place.

Tuesday, October 7, 2008

Some voices of calm in a maelstrom

With Europe in turmoil and US equity markets continuing its free fall, virtually every investment professional that I know is seriously worried. However, there are a couple of voices of calm and hope in this maelstrom.

John Hussman, the portfolio manager of Hussman Funds, has been cautious throughout the market runup the last couple of years is now sounding somewhat more positive in his latest weekly commentary [emphasis mine]:
With the S&P 500 trading below 1100, the U.S. stock market is now in the upper range of what I consider to be reasonable valuations. Stocks are certainly not "cheap" or undervalued overall, but they are no longer priced to deliver unacceptably poor long-term returns. I have no strong belief that stocks have reached a bottom. Although there is an increasing likelihood of a sustained "bear market rally," I believe there is a good chance that valuations will eventually move lower still before a durable cyclical low is established. Still, investors should recognize that normalized valuations are now the best they've been since 1995. That may not be saying much, since the total return on the S&P 500 since 1995 has averaged only about 7% annually, but it is what we might call "the beginning of wisdom."
He continued [emphasis mine]:

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 more likely to register its low.

My assertion is not that we are necessarily at such a low yet, but the present sentiment of panic is typically one that presents useful opportunities for gradually scaling into market exposure, as uncomfortable as it might feel over the short term. This is what good investors get paid to do - not always immediately, but over time.
Charlie Rose did an interview with Warren Buffett last week. Buffett is also beginning to see some value:
ROSE: Cash is said to be king now. Are you sitting on a lot of cash so that this is the time for Berkshire Hathaway and Warren Buffett to look carefully at a lot of opportunities?

BUFFETT: Yes. We want to use cash. The reason we haven't used our cash, two years ago, we just didn't find things that were that attractive. But when people talk about cash being king, it's not king if it just sits there and never does anything. There are times when cash buys more than other times, and this is one of the times when it buys a fair amount more. And so we use it.

ROSE: There's a time accumulate and a time to spend.

BUFFETT: Absolutely. You want to be greedy when others are fearful. You want to be fearful when others are greedy. It's that simple.

Warren Buffett is focused on long-term value oriented and he will admit that he is not good a short-term timing. None of this indicates that the equity markets around the world will make a bottom this week or this month. They can continue to go down. However, these comments are powerful rays of hope for shell-shocked bulls.

Buffett went on and talked about a lot more other issues surrounding the current crisis. More on that later in a future post...

Friday, October 3, 2008

Bailout 1.1 passes! Will we need 2.0?

So the bailout bill finally passed. No doubt all those amendments helped convince Congress to give the nod to the legislation. While others get all excited over such proposal like the one to suspend mark to market accounting, my favorite amendment is:
SEC. 503. EXEMPTION FROM EXCISE TAX FOR CERTAIN WOODEN ARROWS DESIGNED FOR USE BY CHILDREN.
For investors the key question is whether the authorities will have to come back to the well again later. To evaluate any solution, here are the issues to consider:
  • Does it give the system solvency? or just liquidity?
  • Who finances the rescue?
  • How does it affect the US consumer?


Does it make the system solvent?
I have written before about the solvency and liquidity. The scale of the Fed’s liquidity injections into the financial systems has been off the charts. The latest report states:

Banks' discount window borrowings averaged $367.80 billion per day in the week ended October 1, nearly double the previous record daily average of $187.75 billion last week, Federal Reserve data released on Thursday showed.

Liquidity isn’t the problem. Solvency is. What price does the Treasury pay for these toxic assets and will it make the system solvent? I keep repeating Brad Setser’s comments but it’s worthwhile to keep them in mind:

If [the US Treasury] pays a high price for various dud assets, it won’t move nearly as much off the banks’ balance sheet — which may leave residual questions about the health of key institutions. On the other hand, if the Treasury pays a low price, it may leave a lot of banks in trouble and in desperate need of new equity.

If the bailout doesn’t create sufficient solvency in the system, then we may need another bailout. Jonathan Weil has suggested direct equity injections [read: nationalization] into the banks would be a lot more efficient way of spending $700 billion.


Who finances the bailout?
The question of who finances the bailout has profound investment implications. If it’s financed by the printing press it will be highly inflationary. On the other hand, if the majority of the burden is borne by foreigners (China, Japan, Middle East states, etc.) then the results are likely to be deflationary.

If foreigners have to finance the bailout, then what do they want? Over in his blog, Fabius Maximus proposed a Brady bond like solution for the US:

The Master Settlement of 2009

I. The US receives $1.5 trillion in new lending in 2009 and 2010, with smaller loans in the following five years. New lending under this agreement ends in 2015.

II. Existing US government and agency bonds held by foreign central banks are rescheduled. Principal or interest payments begin in 2016, amortized over the following 30 years at low fixed interest rates.

III. The bonds are denominated in an index of currencies, weighted by the debt held by each nation. We lose the ability to inflate the debt away by printing money.

IV. The US dollar is immediately devalued by some fixed amount (perhaps 20%). The lower dollar will reduce our imports, as they become more expensive. Our exports again become competitive on world markets, so we can earn the money to pay our debts.

V. Our creditors will demand (and receive) consensions [sic]. We can only guess what those might be. China will certainly ask for a sphere of influence that includes Taiwan.


How does this affect the US public?
Lastly, the reaction of the US public may be as relevant as Argentineans demonstrating in the streets in the last crisis in Argentina. Nevertheless, Macro Man was right when he noted that Americans are at serious risk of class warfare:

[The chart] shows a surge in corporate profits (at the apparent expense of wages) as a share of national income. It is the divergent fortunes of these two series that has fueled Main Street anger and turned "no" voting Congressmen into class warriors.

Stories of giant CEO severance packages also didn’t help matters.


Inflation or deflation?
For investors, we come back to the key question of inflation or deflation.

How does the solution, however it is implemented, affect the balance sheet and spending power of the US consumer? What happens ultimately affects earnings and growth, which is what the equity markets are all about.

Given all the turmoil, it may be wise to sit out October and wait for the dust to settle.

Wednesday, October 1, 2008

Wait for Halloween?

In light of the recent volatility and the ongoing debate about the meltdown and proposed solutions, one important question comes to mind for investors. What do we do about equity positions?

While the VIX spiking up to 50 on the Monday sell-off has the classic signs of a capitulation bottom, near term movements are highly dependent on news flow. In the short term, investors aren’t bearish enough for the market to make an intermediate term bottom. Mark Hulbert's analysis shows that there is too much complacency out there.

Mebane Faber did an interesting study indicating that there is some potential for excess returns. After a really bad month (yes, September certainly qualifies), wait a month and buy the market for a two month hold (November and December), you can expect an average return of 3.1% for the S&P 500 and 3.8% for EAFE.

In light of the current market volatility and this study, perhaps it would be best to wait until Halloween (Oct 31) before buying again.

Liquidity or Solvency?

The equity markets sold off hard on Monday on the news of the collapse of the bailout deal. No doubt the authorities will try to cobble together another rescue package soon.

There is no shortage of suggested solutions. For me, the key issue of evaluating the next deal is how the power shifts between investors, bankers and taxpayers.


Fed and other central banks desperately injecting liquidity
Right now, the credit markets have seized up. In response, the world’s major central banks are desperately trying to inject liquidity into the financial system.

Is it enough? Some have even suggested that a bailout isn't needed.


...but the system is insolvent
Brad Setser summarized the issues best in when he questioned whether $700b is enough. The issue is what price any bailout fund pays for the distressed securities, book value or market value (however you define it):


If [the US Treasury] pays a high price for various dud assets, it won’t move nearly as much off the banks’ balance sheet — which may leave residual questions about the health of key institutions. On the other hand, if the Treasury pays a low price, it may leave a lot of banks in trouble and in desperate need of new equity.

Paying a high price (likely book value) for the toxic paper bails out investors and bankers, but does little for taxpayers. Paying discounted market value is favorable for taxpayers but leaves the financial system insolvent.


Book or market value for the toxic paper?
I heard that the calls, emails and faxes to Congress were running at about 200 to 1 against the defeated deal. The predominant feeling among the electorate was that it wasn’t fair for taxpayers to be bailing out big investors and investment bankers. With an election not that far away, Congress listened.

Many have suggested that the key component of any deal be the payment of a highly discounted value for the toxic paper clogging up the system. If that is done, then the financials would have take massive writedowns which would render them insolvent (see John Hussman’s analysis here). John Berry has suggested that this would be the granddaddy of all carry trades. Buy high yielding assets (at 10-12%) and finance it at 3-4%. The key issue, in that case, is what is the “hurdle” default rate that makes the Treasury money?


How will foreigners react?
I have indicated before that many of the components of the failed deal, which seemed to favor investors, was quite likely the result of Chinese pressure. Yu Yongding, a former advisor to the Chinese central bank, recently acknowledged the pressures on China and on the US by stating that Asia needs a deal to prevent panic selling of U.S. debt. However, China wants something in return:

Yu said China is helping the U.S. ``in a very big way'' and added that it should get something in return. The U.S. should avoid labeling it an unfair trader and a currency manipulator and not politicize other issues, he said.

``It is not fair that we are doing this in good faith and are prepared to bear serious consequences and you are still labeling China this and that, accusing China of this and that,'' he said. ``China knows what to do. We don't need your
intervention.''
He also indicated that this may be a tectonic shift in China’s future policies:

``Our export-growth strategy has run its natural course,'' he said. ``We should change course.''

China should stop intervening in the foreign currency markets and thus allow rapid appreciation of the yuan, he said. While this would cause pain for exporters, China could ease the transition by using its strong fiscal position to aid those who lose their jobs. It also should stimulate domestic demand to offset lower income from overseas sales.

Without yuan appreciation, China will continue to accumulate foreign reserves, which means further accumulating ``IOUs from the U.S.,'' said Yu. ``This is paper and it may default and it will not increase China's national welfare.''
In other words, China stands ready to help the US through this crisis. However, there is a political price to be paid. Moreover, this may signal the beginning of the end of the US Dollar as the premier reserve currency in the world.


Not just Big Bad China making waves
Before anyone jumps on Big Bad China, understand that China has been the most vocal of the foreign lenders. No doubt others, such as the oil producing states in the Middle East that are big holders of USD paper, are thinking along the same lines. For instance, Germany's Finance Minister Peer Steinbr├╝ck was quoted in Der Spiegel as saying:

There will be shifts in terms of the importance and status of New York and London as the two main financial centers. State-owned banks and funds, as well as commercial banks from Europe, China, Russia and the Arab world will close the gaps, creating new centers of power in the financial world.
In addition, the Washington Post recently reported that:

Ibuki, the Finance Minister, said Friday that Japan would consider funding the International Monetary Fund or other international lending agencies to help with bad debt.
IMF mandated adjustments would be extremely painful for America. Note that these last two comments were from America's closest allies. In addition, an opinion piece in the Telegraph in the UK notes that a default by the US government is no longer unthinkable.

Years ago when I managed international equity portfolios, our international and emerging markets teams used to irk our US colleagues with the comment that the US is only 1 of 50 markets. That comment is now coming true in more ways than one.