Tuesday, December 30, 2008

Why a gold standard is a bad idea

Inflation is coming...
For as long as I can remember, Jim Grant has never been a cheerful fellow. In fact, there was a standing joke in my office that after reading Grant you could cheer up by reading King Lear. The thinking in Grant’s latest missive in the WSJ runs parallel to my recent post Giving inflation chance that with the massive fiscal and monetary stimulus coming down the pipe, inflation is inevitable. Jim wryly notes that “Frostbite victims tend not to dwell on the summertime perils of heatstroke.” He continued:

Prescience is rare enough in the private sector. It is almost unheard of in Washington. The credit troubles took the Fed unawares. So, likely, will the outbreak of the next inflation. Already the stars are aligned for a doozy. Not only the Fed, but also the other leading central banks are frantically ramping up money production…It is far less certain that, once the cycle turns, the central banks will punctually tighten.

A return to the gold standard would be disastrous
Given the enormity of the recent crisis, there have been calls for radical solutions. The hard money crowd, for example, has called for the return of the gold standard. However, a return to the gold standard would be disastrous. It would be a prelude to an global downturn of unprecedented proportions and doom future generations to heightened economic volatility.

First, a history lesson: Many years ago, people decided on the use of gold as a monetary standard. It turned out that gold has many nice properties that could be used as a store of value. Throughout human history, money has been predominantly based on gold but not always. It has also been based on other commodities. Peter Bernstein’s book The Power of Gold details the history of gold and commodity based monetary standards throughout history, from salt to large stones, some of which lay at the bottom of the sea.

As time went on, people found that gold, along with other commodity based monetary standards, was hard to carry around. Used in coinage, they could be difficult to divide and this division problem was a hindrance to commerce.

Then came the financial innovation called banking. You could deposit your gold in a bank. The bank would issue you a receipt and you could use that paper receipt for trade and commerce. The bank would lend out your deposit of gold to others. This was credit creation, which expanded the money supply. For every ducat lent out, that ducat would usually wind back up in the banking system, creating another ducat available to be lent out. Even with the imposition of reserve requirements that constraine the amount of loans they could make based on their deposit base, this form of fractional bank lending expanded credit and created enormous number of jobs and raised prosperity.

When kings and political rulers got into financial trouble, there was always a temptation to debase the currency. The current episode of paper money debasement began in earnest when Richard Nixon took the U.S. off the gold standard and the world went to a Dollar standard for monetary reserves. The trouble was, the U.S. Dollar wasn’t based on anything, other than the good name of the U.S. government.

Today we stand on the edge of a precipice. America is in recession but deeply in debt. It is about to print money to try to climb out of its hole. This consensus has been supported by pretty much all of the central banks and governments around the world. Some analysts have argued that the imposition of a gold standard would create the discipline on the monetary authorities from debasing the currency in this manner.

What does a gold standard really mean?
Let’s think this through – what does a gold standard really mean? Does the hard money crowd want us to go back to carrying around pieces of gold coinage around? In that case, how do we facilitate global trade?

Do we just want to revive a gold backing for money? There isn’t enough gold around in the world to support a gold standard at current gold prices. Rough back of the envelope calculations show that the Fed’s holdings of gold, assuming that it is unencumbered and not lent out, is worth around $200 billion at current prices. Remember that the U.S. Federal Reserve is one of the larger central bank holders of gold in the world. While that change might satisfy the gold bugs, it wouldn’t help the vast majority of the population around the world.

One of the assumptions of a gold standard is that the currency is backed by gold at a fixed rate. Anyone could turn in their Dollars, euros, Yens, Pound Sterling and so on, to the appropriate central bank and get gold at a fixed gold price. Such a monetary regime also implies a fixed exchange rate arrangement like Bretton Woods. Instead of allowing the market to determine currency prices, the world would return to fixed exchange rates and periodic exchange rate revaluations. Is that really the regime that we want to return to?

A gold standard also creates economic volatility in the economy. Monetary theory is based on the elegant formula MV = PQ. Holding V (monetary velocity) constant, changes in money supply directly changes the GDP level. Under a gold standard, money supply is restricted by the supply of gold, based on world mine output. National gold supply could shrink because of shocks. As an example, the Roman empire was subjected to credit crunches during wartime when hostile forces captured Roman gold and territory.

The problem of fractional lending remains under a gold standard. The banking system could still create credit. Under such a regime, if everyone decided to redeem their paper currency for gold, the money supply would collapse and the result would be another Depression. Do we want to get rid of the banking system?

If we were to take the radical step of eliminating fractional lending, going to a gold standard would mean a drastic shrinking of world GDP given the amount of money sloshing around the world today.

Culling the herd?
This is financial Armageddon. The result would be the financial equivalent of mandatory infection of the population with the Ebola virus. Maybe we could get Disney to lend a PR hand as we play “The Circle of Life” while we infect everybody with Ebola so people would be persuaded to sacrifice themselves for the Common Good.

The end of the Dollar as THE Reserve Currency
Let's face it, the days of the USD as the principal reserve currency are numbered. Roger Ehrenberg over at Information Arbitrage believes that the US is at a strategic inflection point and the start of a downward spiral and I would tend to agree. The long term path of the Dollar and US influence is downward. Investors should prepare themselves for that eventuality.

Friday, December 26, 2008

Hedge fund operational due diligence

In light of the Madoff scandal, I thought that rather than add my own snark I would ask Cox Owen to guest blog on the issue of operational diligence. Cox has worked with and consulted for hedge funds, prime brokers, fund administrators and others for almost eight years in numerous capacities. While in the hedge fund business he has worked as an operations manager, trader, project manager, consultant and more. Cox's experience of launching his own fund and consulting for other start up funds has allowed him to gain an in-depth understanding of the operational due diligence process.

You can respond to him directly at coxowen1 at yahoo.com

The Operational Due Diligence Process
Operational Due Diligence within the hedge fund world typically is done to verify that the fund is doing what they say they are doing and to ensure that the fund is following industry regulations and best practices.

As long as we continue to allow the financial executives to “creatively” spin their ideas of fraud into alpha generation we will continue to see crisis after crisis. Unfortunately our regulators come up with solutions like SOX and FAS 157 after the damage is done. The regulators in our industry need to be proactive and not reactive to these types of double dealings.

With that being said, let me first say how sorry I am to all of the people who have been affected by the actions of the executives in the financial firms that have put us in this hellish situation. It seems that in executive speak - marketing is synonymous with lying and retention payment is synonymous with bonus. Since or current regulatory environment allows the Madoffs of the world to make fools of the fund of funds, hedge funds and other asset managers it seems that this is a good time to discuss operational due diligence.

I am not blaming the regulatory agencies for the losses we have seen in this mess. I am saying they could have done a lot to help prevent to current situation if we had rigorous regulation in the certain markets, specifically the swaps market. Unfortunately since there is no accountability for the Wall Street executives we will continue to see these firms grossly mismanaged again and again with bailout after bailout until we hold the executives and board members are held accountable or until it drags our country into a depression. Given all of the financial events that have occurred since 9/15/2008 (the day Lehman filed bankruptcy) through today, we are going to have to rely on ourselves for longevity. We will achieve this only through extensive operational due diligence within our industry.

Let's first discuss Mr. Madoff. It is exceptionally difficult to find any sympathy for the financial institutions that invested with Mr. Madoff. These financial institutions are supposed to verify numerous operational components of any type of investment vehicle they invest in. No one is sure what due diligence was done by these firms, we are only sure that it was offensively inadequate. They only logical explanation that I can see is that these firms were impressed with his background as Chairman of the NASDAQ and other moving accolades. There is certainly a place in my heart for all of the non-sophisticated investors (even though they might be classified as sophisticated because of income or net worth) who did not have the staff or knowledge to look into this Ponzi scheme.

I was recently asked to draft an operational due diligence manual to show the complete depth of OPDD. As I pondered the task I quickly came to the conclusion that each manual would be different. Conducting OPDD on a trend following CTA would be entirely different from a distressed debt shop, convertible arbitrage, market neutral and every other type of strategy. Of course you would have plenty of similarity in the basic questions, number of employees, who are the principals, what sectors do you trade, etc. I clearly understand the reason for secrecy in the hedge fund world. OPDD is not about getting the recipe to the secret sauce used in McDonalds hamburgers, rather it is to verify that there is a sauce, a hamburger, customers, and all of the other components that make a successful transaction in today’s markets. After almost 40 pages into my 1st manual for one strategy it became clear that this project could grow to about 150 pages. So not to bore you with all of the details I will try to provide you with a very high level overview of OPDD. So here we go, Before examining the core aspects of any operational components of a hedge fund we should look at the fundamental characteristics that will give us a better feel for the overall evaluation of the fund in question. Due Diligence starts before the front door, understand the prospect and their strategy before having in-depth conversations. Request offering documents and marketing literature.
  1. Articles – There are many media circulations (Hedge Fund Alert, Infovest 21, MAR Hedge, Finalternatives.com, hedgefund.net, etc) that can provide general information about the individuals and their backgrounds. These articles can be a great starting point, but the information found in them should not be taken as gospel. The characteristic to look for: If the hedge fund tabloids find a launch story to be news worthy there may be some credibility to given to the fund managers. The sword cuts both ways, often you can find articles that take a negative spin. Read as many articles as you can and ask questions about the article as you can. Often you will get valuable information that you were not even looking for.
  2. People – a) Who are they?
    b) Are they known among credible peers or unknown?
    c) What is their pedigree?
    d) What type of significant investment experience do they possess?
    e) What were the key elements in the inception of the fund?
    f) Education?
  3. The Story – tell us how you got started in finance and what has lead you to this point. (Take notes)
    a) You want to make sure the story makes sense.
    b) You are checking the story for consistency as you will discuss
    their story more detail later.
    c) The story gives you the opportunity to take your discussion in any direction.
  4. The Strategy – Generally speaking, strong managers can articulate a robust and compelling strategy. (Most successful managers will offer significant amounts of information about their strategy because they know how difficult it is to replicate and to find the people to do it, successful managers usually will leave out small amounts of key information that constitute trader secret information)
    a) Being vague is a red flag.
    b) Managers who are unwilling or unable to discuss the strategy,
    are often amateurs or hobbyists.
    c) The manager should be an expert in the strategy and should
    be able to answer any question. d) What is the capacity of the strategy?
  5. Performance History (absolute and relative)- Performance history is subjective since it is correlated with risk. Example: A fund with a 2 yr track record that shows a +10% return at the end of both years might not be a good fit if it was riding 40 % drawdowns during the return period. Generally speaking, a minimum of a 2 consecutive year double digit positive return would be acceptable to move forward. As we discussed, this area is subjective for numerous reasons. Is the performance audited or verifiable in any way?
  6. Risk Management – After the Amaranth Advisors debacle and other financial disasters, it is critical to insure that risk managers are reporting and explaining all risk exposure to fund managers and others.
    a) Does the Manager use Incremental Var?
    b) Does the Manager use Marginal Var?
    c) Does the Manager use stress tests?
    d) Does the Manager apply its risk management methodology into its back testing?
  7. Traded Instruments and Liquidity – Illiquid markets can be difficult to enter
    and exit.
    a) What is the trading ability of the manager to execute trades in the described markets?
  8. Service Providers – Weaker managers will often use unknown service
    providers to reduce cost whilst sacrificing on proper service. More well
    known service providers arrange an on boarding team that will help new
    managers with many of the launching pitfalls?
    a) What law firm represents the manager?
    b) Who is the Auditor?
    c) Who is the Fund Administrator?
    d) Who is the Prime Broker?
  9. Transparency – Transparency is critical to investors today so they can see a
    day by day actual P&L.
    a) What types of transparency does the manager offer?
    b) What internal controls is the manager willing to share with the investor?
    c) What is the policy on trading errors?
    d) Does the fund have an error account?
    e) Does the manager offer managed accounts?

The offering document
The offering documentation structure can be different for every hedge fund and is almost completely different in context. The legal documentation of a hedge fund defines how the business and the fund will operate. Since every hedge fund is different (generally) and there are many good law firms with many good lawyers (each have a different flair for creating documentation). The general structure(an LLC is the GP of the LPA) is the same. The list of documents below will provide you with a general description and how they apply to the organizational and operational structure of the fund.

  • Operating Agreement – The operating agreement of an LLC defines how the business will operate. They are usually contain dissolution strategies (in the event of partnership disputes), allocations, distributions, capital commitments, management, fiscal matters, transfer of interest and more.
  • Private Placement Memorandum (PPM) – also known as the private offering memorandum. This memorandum specifies that this is a private offering that contains information about the investment process, management, ERISA and other regulatory issues, subscriptions, tax considerations, and more.
  • Limited Partnership Agreement (LPA)– This agreement defines the responsibilities and liabilities of the limited partners and the general partner. The LPA will discuss issues about key man risk, liquidation of assets and will also contain much of the same information contained in the PPM and the operating agreement.
  • Subscription Agreement – The subscription agreement allows the subscriber to identify what type of investor they are. (HNW, QEP, Foundation, Family Office, Institutional Investor, etc.)
  • Risk Disclosure Document – Often called a “D-Doc”, this document is designed to talk about the types in investing and the risks associated.
  • Business Plan – The Business Plan is a guide that the business follows in order to grow it’s business. They often detail the expenses for the first 2 yrs, number of employees, at what stage with assets under management will more employees be hired and more.
  • Marketing Document – This document will define how the fund and the managers are different from others. This document will also explain the investment philosophy and the key personnel involved.

You should keep in mind that you will see redundant information in theses documents. You are looking for inconsistencies within these documents and the DDQ that you will review later. Compare the DDQ to the notes that you have gather from the onsite visit (done later) along with the notes you have taken during your phone conversations.

Other documents that you could find along with the listed offering documents:
Investment Management Agreement
Investment Management Fees
Acknowledgement of Receipt
Trading Authorization
Arbitration Agreement
Form of Notional Funds Letter
Give-Up Agreement
Payment Authorization

The few topic we discussed are the tip of the iceberg. If you are interested in reading more about OPDD please post a response or email me directly. Or fell free to tell me to keep my trap shut and my opinions to myself.

Thank you for reading.

Sunday, December 21, 2008

Yes, but will this get by Compliance?

Blogging will be light until the end of the year. In the meantime, let me leave you with this Seasons Greetings (which hopefully gets through Compliance):

Please accept with no obligation, implied or implicit my best wishes for an environmentally conscious, socially responsible, low stress, non-addictive, gender neutral, celebration of the winter solstice holiday, practiced within the most enjoyable traditions of the religious persuasion of your choice, or secular practices of your choice, with respect for the religious/secular traditions at all…and a fiscally successful, personally fulfilling and medically uncomplicated recognition of the onset accepted calendar year 2009, but without due respect for the calendars of choice of others, and without regard to the race, creed, color, age, physical ability, religious faith, or sexual orientation of the wishee.

By accepting this greeting, you are accepting these terms:

This greeting is subject to clarification or withdrawal. It is freely transferable with no alteration to the original greeting. It implies no promise by the wisher to actually implement any of the wishes for him/herself or others and is void where prohibited by law and is revocable at the sole discretion of the wisher. This wish is warranted to perform as expected within the usual application of good tidings for a period of one year, or until the issuance of a subsequent holiday greeting, whichever comes first and warranty is limited to replacement of this wish or the issuance of a new wish at the sole discretion of the wisher.


Thursday, December 18, 2008

Beware the Ides of February

According to the Roman calendar, the ides of the month correspond to the 13th for February, or the day of the full moon in the month, which is the 10th in 2009.

As the S&P 500 seems to be mired in the current resistance zone of 900-920, I continue to believe that we are in for a short-term rally to be followed by a decline which will test the November lows. In this, I agree with John Hussman’s view of the markets:

My guess, and it's only a guess, is that the general tenor of the market may remain tepidly positive for a few more weeks, but that we will ultimately observe another frightening leg down in the first part of next year – possibly to re-test the November lows, possibly to new lows, depending on the evolution of economic conditions. The problem isn't that stocks are expensive – they're not. The problem is that the U.S. economy will probably not see the beginnings of a recovery until the second half of 2009, and while we've seen a good deal of fear, the stock market tends to go through a great deal of sideways action after panics like we've observed. It's likely that stocks will trade in a very wide 25-35% range for months.

Here are some bullish signs that are supportive of a short-term rally:

  • Bespoke reports that stocks up by institutions are up big. This indicates that there is institutional sponsorship for this rally, which tend to be more powerful.
  • Mebane Faber is expecting a good January. Faber concluded in a recent study that small stocks should enjoy a very good January after the dismal period we have seen in the markets.

Still just a bear market rally
Make no mistake about it, this is still only a bear market rally. While I believe that the market is undergoing a basing period, these kinds of basing periods can involve range-bound markets with explosive rallies and sharp declines. Here are some bearish indications for traders, which should banish any thoughts of sustainability when viewing this period of strength.

  • There are still too many people looking the market bottom. A couple of weeks ago, while watching CNBC as the market rallied off the November lows, I was struck by the number of people trying to call THE BOTTOM here. Add to that the rash of articles that came out about that time with the same sentiment (see examples here and here) and you can conclude that the market is still falling on a slope of hope.
  • Earnings Season will start soon. 4Q earnings are likely to be horrendous and guidance will likely be no stroll in the park. What are the chances that we get another wave of negative surprises and a call for a double-dip recession?
  • Disillusionment with Obama could set in quickly. Those looking for their brand of radical transformation from Barack Obama are likely to be disappointed. Obama’s cabinet appointments have shown that he is, at best, bent on evolutionary rather than revolutionary change. The finance posts were filled mostly by people who were prominent in the former Clinton Administration. The appointment of Gates at Defense is nothing more than a signal of “steady as she goes”. Soon after the Inauguration, any market expectations that the miracle worker St Barack of Chicago would fix everything could very well come down to earth.

Enjoy the party, but don’t forget to leave before the coach turns itself back into a pumpkin.

Tuesday, December 16, 2008

Greed is still Good

I received this picture in my email inbox, titled I finally got the Christmas lights up last night. While amusing, this seems to be a metaphor for how Wall Street behaves these days: All sizzle and no steak.

No contrition at all
After the recent train wreck in the world financial markets, you would think Wall Street would be a little bit contrite and be more careful about what kinds of products gets pushed. Apparently, they are only paying lip service to that concept. I encountered this article last week, indicating that bankers were selling FX-based structured products as places to park short-term funds[emphasis mine]:
Clients in the private bank space are already starting to trade some of the new ideas. Amanti says that BarCap is marketing ideas that take advantage of the increased volatility, which is at unusually high levels. Typically, currencies don't move much, but today the volatility on many currency pairs is similar to the vol levels on equities a year ago. Even at those levels, it is still possible to take advantage by using, for example, products that offer a very large range around a spot level or that take a view that the spot will not move as much as the volatility implies.

"Also, given the current high volatility environment, the idea of selling volatility, either within capital protected structures or taking some principal risk, can be very attractive and these ideas are gaining more and more traction," says Amanti.
They are now getting clients to sell volatility to enhance returns? Do these “sophisticated” clients understand the risks, like they understood the risks with the CDO and CDS markets? There are many good discussions of volatility, David Merkel at The Aleph Blog is a good example:
Implied volatility estimates as applied to option pricing formulas are a fall-out. No one thinks they are true, but they are a paramater used to keep relationships stable across options of similar expirations.

Intelligent hedgers hedge options with options; they don’t try to apply the theoretical equivalence that lies behind the traditional Black-Scholes formula and do dynamic hedging with the common stock itself.
Do these bankers have no shame? Having bankrupted little municipalities in Ohio and elsewhere, bankers are now looking for new suckers?

Greed is still Good.

Saturday, December 13, 2008

Giving inflation a chance

All I am saying is…let's give inflation a chance.
(with apologies to the late John Lennon)

OK, so I was wrong about the $100 oil before $150 but $200 before $50 forecast. The commodity markets have been clobbered by this global economic crisis. The World Bank’s latest forecast for commodities is “real food prices are expected to fall by 26 percent between 2008 and 2010, oil prices by 25 percent, and metals prices by 32 percent.” With the news that China’s exports are falling, the Baltic Dry Index in freefall and down over 90% from its peak this year and other signs that the global growth is plummeting, is there any hope for oil and other commodities?

Amidst the devastation, there are numerous signs based on technical, sentiment, macroeconomic and fundamental analysis that the commodity super cycle is not over. There are enough positive indications for me to give the long-term commodity bull the benefit of the doubt. In this post, I focus mainly on oil because of space considerations, as this post is already too long. However, much of my analysis can be extended to other commodities.

Technical underpinnings of the commodity bull
The chart below shows the relative returns of the Amex Oil Index (XOI) compared to the S&P 500. The sector broke out of a multi-decade base in 2005. Given the length of the base, the sector is nowhere near its upside target and it’s likely that this is just a correction within a long-term bull phase.

The chart also shows that the relative uptrend is intact. The uptrend line as indicated by line A is still arguably in force despite the minor trend violation. Additionally, the relative return line could even decline to the uptrend as marked by line B and the bull trend could still be intact.

Sentiment is washed out
As well, excessive bearish sentiment is in evidence for the CRB Index, which is contrarian bullish. When the likes of Macro Man writes little ditties about commodities are a joke and invites his readers to contribute to the theme, you know that that investor sentiment is getting washed out in the asset class.

Blowing another bubble by turning on the printing press
I have already written about the fiscal and monetary authorities stand ready to rescue the world economy. With world trade seizing up because of frozen credit markets, any normalization of conditions should start to facilitate world trade flows again.

It seems the Powers That Be believe the solution to today’s problem is to blow another bubble. There are, indeed, 50 ways to beat deflation. It seems that every other day we hear about new proposals of fiscal stimulus around the world. A recent FT article questions whether governments can actually pay for the rescue:

As governments around the world plan to issue hundreds of billions of dollars worth of bonds in the next year, bankers are questioning whether they will be able to meet their funding needs. "Governments are already running into problems, which does not bode well so early after the recapitalizations and extra funding needs have been announced," said Roger Brown, global head of rates research at UBS. "We do have to ask whether there will be enough investors to buy the bonds, or at the very least over whether this will push yields substantially higher to attract them."
With the likes of China Investment refusing to put any more money into foreign financials, it seems unlikely that the rescue can be financed by anything other than central bank printing presses. Helicopter Ben has indicated in a speech that he has more ammo and will use virtually any means to fight deflation. That seems to be as clear a signal from any central bank that it stands ready to monetize debt issued by the Treasury. With core CPI headed down over the next few quarters, I think that there is a consensus among central bankers that there is room for the implementation of extraordinary measures to avoid another Great Depression.

On the other hand, fiscal and monetary authorities have also shown themselves to be backward looking when looking at measures of inflation. While Keynesian economic prescriptions call for the stimulus to be withdrawn once signs appear that the recovery is in place, it will be difficult as many of the measures will become institutionalized and acquire political constituencies. No doubt that we will have to pay the piper for this wall of paper money pouring into the system in 2010 and beyond.

This downturn hasn’t corrected all imbalances
Usually, economic downturns are supposed to correct the excesses from the prior cycle. Remember all those “imbalances” that analysts like Stephen Roach used to write about? They still exist.

I would have thought that with this crisis, the world would shift away from the US consumer being the main engine of growth. Countries like China would move away from her focus on export oriented policies. Other economies around the globe would become the locomotive for world growth. That way the world could proceed with a more balanced growth path.


Bretton Woods 2 is still alive. The USD hasn’t collapsed but strengthened, arguably for technical reasons relating to demand for greenbacks. Nevertheless, the consensus seems to be that the way to rescue the world’s economy is to revive the US consumer.

This recovery path suggests that the adjustment in the next cycle is a fall in the US Dollar, which is commodity bullish.

Remember Peak Oil?
Remember the thesis that the world is reaching the Malthusian limits of oil production, otherwise known as Peak Oil? The latest IEA Outlook forecasts that we will not see peak oil production until 2030. However, there are some important caveats to their forecast [emphasis mine]:

The projected increase in global oil output hinges on adequate and timely investment. Some 64 mb/d of additional gross capacity — the equivalent of almost six times that of Saudi Arabia today — needs to be brought on stream between 2007 and 2030.
There are some other brave assumptions on how supply evolves:

Modern renewable technologies grow most rapidly, overtaking gas to become the second-largest source of electricity, behind coal, soon after 2010…

Ultimately recoverable conventional oil resources, which include initial proven and probable reserves from discovered fields, reserves growth and oil that has yet to be found, are estimated at 3.5 trillion barrels.

The supply response will put a floor on oil prices
A lot of IEA’s projected supply increase is based on the assumption of massive energy infrastructure investment. How likely is that in the current environment with oil prices in the $40s? Might some production capacity even get shut down in the current climate? Estimates today for the Gulf States indicate that breakeven oil price is between $40 and $70 for current production. Saudi Arabia is the lowest at between $40 and $50. For the more expensive projects such as the Alberta tar sands, we are already seeing a supply response as large energy companies like Shell and Statoil have announced curtailment of new capacity addition. Promising discoveries such as the ones in offshore Brazil will no doubt face similar problems.

With the reduced and curtailed investment in the production pipeline, what does that mean for the demand-supply picture? The IEA indicates that [emphasis mine]:

We estimate that the average production-weighted observed decline rate worldwide is currently 6.7% for fields that have passed their production peak. In our Reference Scenario, this rate increases to 8.6% in 2030.
At $40 to $50 oil, there aren't going to be a lot of supply additions. What happens when current production falls 6.7% a year? Does nominal world growth falls 6.7% a year to match? Already, we are seeing a demand response as US gasoline demand recovers.

Isn’t all this bullish for oil prices over the medium term?

Europe is already worried about gas supplies
Europeans already recognize the supply threat. A recent article in the UK’s Guardian states [emphasis mine]:

Russia's four major energy companies – Gazprom, LUKoil, Rosneft, and TNK-BP – depend heavily on debt to finance operations, and are scaling down their investments. They have already been forced to seek an allocation of more credit to refinance their external debts. But with Russia now facing a $150bn shortfall in its spending plans for 2009 and where Russian markets have lost 70% of their value in just six months since May, it is all too likely they will be forced to slash their investments further.

The consequences of this for the EU and the UK are very serious. Since the EU gets 40% of its gas from Russia, where 70% of the gas fields are already in decline, any further major cutting-back in future oil and gas investments could act as a pincer on EU and UK energy supply. Indeed, the Russian energy industry has warned that if the decline continues, Russia may not be able to service even its own domestic gas needs by 2010 – this from a country where Gazprom is the largest extractor of gas in the world.
There is already the threat of government nationalization in Russia. Should that happen, Russia's energy industry will become less efficient as government owned entities tend to optimize for revenues, current cash flow and for employment, not profitability. This would further serve to further constrain supply additions in the future.

Investment implications: Too early to buy aggressively
What does that mean for investors? One of the first things I learned about technical analysis is that resource stocks are late cycle plays (where interest-rate sensitive names are early cycle). Despite the long-term bullish case on commodities, it is probably too early to be buying aggressively in these sectors.

The commodity stocks have corrected but they need some time to base before launching a new bull leg. I would expect that resource sectors to be volatile and trade sideways for the next year or so. As an example, the point and figure chart of the Energy Select Sector SPDR (XLE) below shows that the sector has trying to bottom at these levels. It has broken out of a downtrend and is undergoing a sideways consolidation pattern.

Better opportunities lie elsewhere for now, including a bet at the appropriate time on the Phoenix effect. I would wait for the certainty of a market and economic recovery before seriously overweighting the hard asset plays. The time to do that is probably the late 2009 or 2010 timeframe.

Thursday, December 11, 2008

More on the CGM Focus record

Following my last post Heebner gets really bullish, I saw that Tim Knight at Slope of Hope questioned Heebner's recent (unfortunate) returns. For the skeptical, you can find the track record for CGM Focus at Morningstar here.

Despite Heebner's high turnover and swing for the fences style, no mutual fund portfolio manager can be day and swing traders like the audience at Slope of Hope. Heebner's batting average is pretty good and his judgement should be respected. He is just one of many respected managers with good track records who have found value in this market.

Wednesday, December 10, 2008

Heebner gets really bullish

I thought that it’s time to revisit Ken Heebner’s macro exposures after the recent WSJ article about Heebner making a big bet on Financials. I had written about Ken Heebner’s CGM Focus Fund before. CGM Focus has an excellent long term track record and its portfolio manager Heebner manages it as a high turnover fund to make large sector and macro bets.

My analysis shows that Ken Heebner is making more than just a bet on Financials, he is betting on a cyclical market recovery.

Financials an early-cycle sector
As the chart below shows, my reverse engineering of the CGM Focus Fund’s estimated exposures confirms the WSJ article about the extent of Ken Heebner’s overweight position in Financials:

Interest sensitive stocks such as Financials are early cycle movers. This exposure seems to be part of his overall theme of betting on a market recovery. The chart below shows the CGM Focus position in market beta, which shows the fund moving from a defensive position to an aggressive position:

I also estimated the fund’s exposure to the Morgan Stanley Cyclical Index and it shows a big bet on a cyclical recovery:

CGM Focus Fund has neutral to slight overweight positions in Technology, Energy and Materials. The fund's underweight positions are mainly in the defensive sectors such as Health Care...

…and Consumer Staples.

Ken Heebner, who went on record as having turned bullish in October, is showing now that he has turned really bullish.

Sunday, December 7, 2008

10 contrarian reasons for a bottom

A couple of weeks ago I wrote about seeing constructive long-term sentiment readings. To expand on that post, I offer 10 contrarian reasons to be long-term bullish on the stock market. The first three I already mentioned from my previous post:

10 The buy-and-hold discipline is dead and market timing lives. Financial planners tell their clients to build an asset allocation plan and to stick with it - but there are numerous signs that individual investors are abandoning their buy-and-hold discipline. Barry Ritholtz pointed out that AAII data shows that individual investor stock allocations are at levels consistent with previous bear market lows. CNBC recently aired a segment on the Death of buy and hold as an investing discipline.

On the other hand, Mebane Faber's market timing system is shooting the lights out compared to a buy-and-hold strategy, with returns at all-time highs comparable to 1974 bear market low levels. These results are not surprising given the terrible environment for equities.

9 Stock prices are just plain beaten up. Bloomberg reports that “[t]he worst annual decline in the Standard & Poor's 500 Index since 1931 has dragged down every industry in the benchmark gauge and 96 percent of its stocks.” Bespoke recently reported that the spread of stocks from their 200 day moving average is consistent levels not seen since the Great Depression.

8 Speculation is dead. Trading volume on pink sheet stocks, the most speculative in the US market, are now moribund (see this Minyanville article).

7 NBER declares that the recession is here. As NBER will themselves admit, they would rather be right than timely. As experienced investors know, a good time to buy equities occur when NBER declares a recession because the market is forward looking and economic indicators are backward looking.

6 Mr. Market has gone through most of the stages of “grief”. Gillian Tett of the FT (see this worthwhile but rather long webcast) says that the market is finally near the “acceptance” stage of grief.

5 VIX and More reports that the TRIN Index is flashing a buy signal. While this contrarian indicator doesn’t pinpoint the exact bottom, it is an indication that sentiment is washed out.

4 A Chinese SWF refuses to invest in foreign financials. This is another sign that we are in the capitulation phase of the market. Does this sound like the head of a multi-billion dollar sovereign wealth fund or a shellshocked individual investor [emphasis mine]:
Lou Jiwei, chairman of China Investment, said the sovereign-wealth fund will not pour any money into foreign financial firms after losing billions on investments in Morgan Stanley and Blackstone Group. "I don't dare to invest in financial institutions now," Lou said. "The policies of the developed nations on these institutions are not clear. Until they are clear, I don't dare to invest in them. What if they go bust? I will lose everything."
3 The market doesn’t go down on bad news. Given the awful employment numbers out on Friday, don’t you find it surprising that the market opened up down but finished up on the day?

2 Nassim Taleb tries to out-bear Roubini. In this recent interview with Charlie Rose, Taleb states that “I think it’s worse than Roubini thinks”.

Drum roll please....

And the number 1 reason:

1 Nouriel Roubini is partying like a rock star and seems to have groupies. 'Nuff said.

A Santa Claus rally, setback and then the bottom
My inner investor tells me that I should be dollar-cost averaging into this market at these levels. While there may be some downside risk, equity prices should be quite a bit higher in a 3-5 year timeframe.

My inner trader tells me that with the positive market action on Friday in the face of the disappointing employment release, we are poised for the Santa Claus rally. Near term resistance on the S&P 500 is in the 900-920 area, with next resistance at about the 1,000 level. My expectation is that the market would then retreat and test the November lows before launching a new bull phase.

Friday, December 5, 2008

Time for hedge funds to return to their roots

With the news getting worse and worse for the hedgies (e.g. Fortress, Thomas Lee, D. E. Shaw), it’s time for a rethink on hedge funds.

For hedge fund investors: You probably went into them believing that they were uncorrelated absolute return vehicles, or pure alpha. Isn’t it funny how correlations all go to 1 in times of crisis? Maybe it’s time to return to your roots and understand the role of alternative investments in your portfolio.

For hedge fund managers: The really successful ones began fifteen or twenty years ago as small, nimble, guerilla investors. Somewhere along the way the guerillas came down from the hills, got big and became the government. Maybe it’s time to return to the hills again.

Investors thought hedge funds were the panacea when the hedgies showed positive returns in the post-Tech bubble crash. Ultimi Barbarorum writes:

Last time we had a bear market, hedge fund fortunes were made. Andor Capital, William von Meuffling, Crispin Odey, Chris Hohn, even Jim Cramer when he was trading, all made out like bandits producing 20-50% returns on the short side in 2000-2002, many after having doubled their money by being long in 1999. This made them look, if not like gods, then at least jolly clever and deserving of an investment. Hedge fund managers were smart, nimble, slightly less eminent versions of George Soros, milking the patsies in the long only community for vast profits. Hugh Hendry would come on CNBC Europe and wow us with his acumen and hibboleth-smashing iconoclasm; everyone was wrong! Only he could see the truth, it seemed. Chris Hohn would rarely have a down month, let alone a quarter, and at the end of the year give half his profits away to charity, that was how much he thought of the armani-wearing, white-toothed, fake-tanned, long only growth managers whose pockets he was picking. The successful hedgies ran maybe $1bn, most ran less, and Andor, the biggest long-short manager, ran about $6-7bn.
Ultimi Barbarorum made the further point that hedge funds got too big and became the market. Size for a hedge fund is not necessarily the answer.

The guerilla returns to the hills?
Not all is lost. Hedge funds do have a role in a portfolio. Don’t forget what they are and what they aren’t:
  • Small
  • Opportunistic guerilla investors who are able to change their stripes
  • Not an asset class
Once the industry started to get institutionalized (not small) with hedge fund indices of various flavors, consultants and HFoFs started pigeonholing everybody (once you were a convertible arb fund you had to stay a convertible arb fund, even if the opportunities went away), the guerilla got pinned down (not opportunistic) and that was the beginning of the end.

What a lot of people don’t understand is that hedge funds were never an asset class, unlike other alternatives like real estate. One of the key characteristics of an asset class is the ability for an investor to construct a low-cost passive index portfolio, with known component holdings and known weights. Hedge funds were originally marketed as pure alpha, or portable alpha vehicles with low correlations to the major asset classes. These are characteristics that you can’t pin down with an index.

Hedge funds have been here before
This is not the end for the hedge fund industry. AllAboutAlpha reports that hedge funds went through a similar crisis in the late 1960s. The same problems that exist today existed then. Horrible returns, fund blowups – these aren’t new inventions. Hedge fund investors found out what they had wasn’t a contract with a hedge fund manager, but a call option on a management contract. When the incentive fees dried up, the manager packed up and went away.

After the blowup, the hedge fund industry went through a period of contraction and reinvented itself. No doubt we are in for some version of that same story going forward.

Thursday, December 4, 2008

The (mini) ride of the Phoenix

I have written often about the Phoenix effect, or the profit potential of holding low-priced, beaten up and near-bankrupt stocks in a bullish recovery. Bespoke recently documented an example of the performance of such a basket here.

When the Phoenix does finally rise, the upside potential for a portfolio of such stocks is a triple or more. However, I wouldn’t rush out and buy them yet. Wait for a market rally and a re-test of the recent lows before buying in. I would expect that re-test to occur in the next few months.

Monday, December 1, 2008

What year is this?

Despite the sense of panic out there, I don't believe that the world is about to see a repeat of 1929. We are just experiencing a deep and nasty recession. The world will emerge out of this downturn sometime next year and investors should be positioned in anticipation of a recovery.

The importance of a historical perspective
When people react to difficult events, their immediate reaction is to reach for parallels from their own experience. This is problematical in this current bear market. For a portfolio manager with ten years of working life, his bear market experience consists of the post-NASDAQ bubble crash. Twenty years gets you the post-NASDAQ bubble and the bear market of 1990. Both of those occasions involved fairly mild recessions.

I was personally involved in the market during the peak in 1980 and the subsequent bear of 1982. I apprenticed mostly under people who lived through the recession and bear of 1974. Those were inventory recessions, caused by the central bank putting on the brakes on an overheated economy. Those recessions, while deeper than the downturns of 1990 and 2000-2, were not good parallels to today.

Grizzled veterans like Warren Buffett lived through the Go-Go years of the 1960s and their collapse in 1968, as well as some of the markets in the 1950s. Even those markets were not good parallels to this current period of macroeconomic stress. To analyze today’s conditions we need to delve deeper into market history.

Looking for parallels in Non-US economies
Many American investors make the mistake of thinking that market history start and stop at the US border. I can remember a lot of silly analysis that went on after 9/11. Analysts cited the market’s reaction after Pearl Harbor as to the probable market reaction after the start of a war. Did World War II start in December 1941? It did for America, but was that true for the rest of the world, or more importantly, Mr. Market? Ask the Europeans. Did the German blitzkrieg invasion of Poland in 1939 mean nothing? What about the fall of France in 1940? Did Mr. Market think that Operation Barbarossa, the massive German invasion of the Soviet Union in the summer of 1941, mean that the war was “well-contained” like the sub-prime crisis? Meanwhile over in Asia, the Japanese occupation of Manchuria began in 1931 and well pre-dated the German invasion of Poland. Was that just a historical blip?

If we look at non-US markets for parallels, many analysts cite Japan’s Lost Decade as a parallel. I have also suggested that the case of German re-unification could give us some historical perspective. While both those periods do give some insights, they are less than fully satisfying models for today as those downturns were localized. This time, it’s global.

The Great Depression as a model
Many others have sounded alarms about another Great Depression (see examples here and here). To be sure, parallels exist. Too much leverage and speculative excess were seen in the boom that pre-dated 1929. After the Crash, we saw de-leveraging in the subsequent bust. The Great Depression was a classic downturn reminiscent of the depressions seen in the 19th Century, which caused a great deal of concern for economists like John Maynard Keynes.

Nevertheless, there are important differences. We don’t have the massive and soul-destroying 20%+ unemployment seen during that era. There were no automatic stabilizers built into the economy. The effects of the Great Depression were exacerbated by problematic policy response. Today we have many policy tools available to avoid a repeat of the Great Depression.

Fiscal and monetary policy saves the day?
In short, there is no exact historical parallel to today. The current downturn has two unique characteristics: a high degree of financial stress and global reach. The closest might be 1929. Unlike 1929, policymakers have many more tools to combat the current crisis. No doubt today's authorities will make their own mistakes and the efficiency of some programs will be less than perfect. (FDR's New Deal didn't always work either). Nevertheless, the level of global awareness and sense of urgency and purpose by fiscal and monetary authorities around the world should prevent this downturn from becoming a repeat of the Great Depression.

I believe that the current situation is best characterized as a cross between Japan's Lost Decade and German re-unification. Richard Koo of Nomura Research says that the world can learn the lessons of the 1990s from Japan. He believes that the correct response is an aggressive expansionary fiscal policy which can be summed as "spend, spend and spend until it hurts" (see his webcast here, it's long but well worthwhile). Koo’s prescription is an echo from a previous era, when Keynes advised FDR to do the same thing.

President-elect Obama seems to be listening to the likes of Koo. In his weekly address, he appears to be calling for a New Deal style stimulus package:
I have already directed my economic team to come up with an Economic Recovery Plan that will mean 2.5 million more jobs by January of 2011 — a plan big enough to meet the challenges we face that I intend to sign soon after taking office. We’ll be working out the details in the weeks ahead, but it will be a two-year, nationwide effort to jumpstart job creation in America and lay the foundation for a strong and growing economy. We’ll put people back to work rebuilding our crumbling roads and bridges, modernizing schools that are failing our children, and building wind farms and solar panels; fuel-efficient cars and the alternative energy technologies that can free us from our dependence on foreign oil and keep our economy competitive in the years ahead.
In addition, we have a Fed Chairman whose life work was the study of the Great Depression and he has made it clear that he intends to avoid the policy mistakes of that era. Consider these excerpts from the FOMC Oct 28-29 minutes [emphasis mine]:

In the forecast prepared for the meeting, the staff lowered its projection for economic activity in the second half of 2008 as well as in 2009 and 2010. Real GDP appeared to have declined in the third quarter, and the few available indicators that reflected conditions following the intensification of the financial market turmoil in mid-September pointed to another decline in the fourth quarter...The staff expected that real GDP would continue to contract somewhat in the first half of 2009 and then rise in the second half, with the result that real GDP would be about unchanged for the year.

...the Committee agreed that it would take whatever steps were necessary to support the recovery of the economy.
The Fed well recognizes that the economy is in a slowdown and will do whatever that’s necessary to mitigate the downturn. Thus we see the alphabet soup of rescue programs. When it has an important message to convey, Fed governors typically fan out across the country to spread the word, as Don Kohn did recently in a speech before the Cato Institute as he spoke about the perils of deflation.

Global stimulus
What's more, fiscal and stimulus is not isolated to the United States alone but global in nature. In early November, China announced a large stimulus package. Over in Europe, there seems to be room for Eurozone rates to fall as inflation rates decline. What's more, the ECB has signalled that it is ready to deviate from its inflation fighting mandate by becoming the lender of last resort in Eastern European countries such as Hungary.

It’s only a recession
The IMF released a study indicating that financial stress presages a severe downturn, but the length of the downturn doesn’t seem to be any different than other recessions. The FOMC minutes cited above indicates that the Fed expects the economy to bottom out at the end of 2Q 2009. To me, that seems to be a reasonable estimate.

As for the stock market, bear markets tend to end a few months before the economic trough. With equity valuations reasonable, insiders in a buying frenzy and long-term sentiment washed out, investors should be positioning in anticipation of the revival of the next bull and rise of the Phoenix.