March Madness
31 March 2008

In spite of numerous upsets in the NCAA Tournament, the Final Four is making history for being the first ever contest of top seeded teams. College basketball appears to have exported its “March Madness” to Wall Street, where yesterday’s top seeds are falling and winners are yet to be named.

Securities prices are in a volatile “gap” mode, where prices can change dramatically due to low market liquidity. It is difficult to remember a time when money supply has grown dramatically while liquidity has disappeared. De-leveraging is a stranger to the U.S. financial thought process, and what we have observed in March has been a self-fulfilling spiral.

The best way to shrink a financial institution’s balance sheet is to raise the cost of money to the point where businesses can no longer put capital to profitable use. Today the real cost of money, 2.25%, doesn’t discourage. In fact, it makes it almost impossible for a bank not to make profits for the current account. But a surcharge that effectively doubles the internal cost of funds helps shrink balance sheets. And currently, a number of the largest financial market players are implementing increased rate schemes to discourage new loans, trading positions and investments. The result? The market has lost major market-makers. Bear Stearns, Citi, Merrill Lynch, not to mention Lehman, UBS, Bank of America and others, have virtually lost their bid side. Liquidity is a rare commodity. The only price worth paying attention to is the bid from the Fed. Today it is strong for mortgage paper. Tomorrow, it may need to include municipals. Can bridge loans for Private Equity be next? No, but the freeze on traditionally marketable securities is taking its toll on hedge fund managers.

What’s next?  Regulating investment banks is fair quid pro quo for providing liquidity “windows.” Regulating prudent risk taking is a losing proposition. Bad judgment is not illegal. The fact that Bear Stearns would still own $29B in Tier III paper seven months after its costly experience with its hedge funds last August seems incongruous. Had the firm dealt with its problems by selling last year or going to the Fed sooner this year, it could still be in business. The real world oversight consists of the severe punishment poor management inflicted on themselves and the rest of the firm’s hapless shareholders. The rest of the story will determine how much of Bear’s fate was sealed by traders who shorted the stock and pulled business to create the downward spiral. Will handcuffs return to Wall Street?

Fear is in control at the moment, but greed will return. We already see investment managers raising billions to invest in mortgages, vulture funds buying real estate at bargain prices in Florida, Las Vegas and California. The record amounts of money in money market funds will find ways to escape the low yields to take advantage of opportunistic investments.

The market needs to be cleared so that securities can trade and commerce may continue. The Fed is punishing short-sellers by taking illiquid paper out of the market. The banks are rebuilding their balance sheets with cheap money. Foreign banks with low credit exposure are taking advantage of the weak dollar to build business in the U.S. There will be more mergers and pink slips on Wall Street. Those who sit still will be surprised on the downside. Nimble traders will find profitable price relationships. Inflation will rise (and has already) and the stagflation of the 70’s will compete with the Fed for economic dominance. But the size of profit opportunities and the cost of being wrong are at levels many young people in the business haven’t seen. Regulation will make little difference except that it will cost money for everyone in the securities business.

“Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.”
– Will Rogers

Surprise?
A Look Back on 2007 Revelations and What They Mean for 2008
14 January 2008

“It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”
– Mark Twain

Most investors thought they knew a few things in 2007 that turned out not to be so. Now that we are in the throes of an uncertain election as well as a volatile market, the Risk Diet we advocated at the beginning of 2007 isn’t any less important now than it was then.

Our notion of taking equity risk off the table while market volatility was at a 45-year low was intended to help investors avoid the waistline bulge (aka volatility surge) that 2007 brought. Now that the scales indicate that the weight of the VIX has risen from 10 to the mid 20’s, risk levels in equities require close examination. Investors who believe in the stock market over the short run must accept the fact that only a percentage return in the mid 30’s will justify taking the risk of being slammed around by 27% volatility. While these returns may be there for some investments, a prudent investor would have to constrain equity investment exposure at this time.

So the events of 2007 have left scars and a number of people at all levels have received pink slips. It was hard to imagine the fallout of such a small business segment, sub-prime mortgages, decapitating giants like Merrill, Citi and Bear. But a gentle scratch below the surface reveals the great mistake of ’07. Permitting financial firms and people unconstrained by reason to originate, package and sell flawed structures is unpardonable. Perhaps the old rule “If you wouldn’t put it in your own portfolio – don’t sell it to someone else” will find its way back to the conduct of the market in the New Year. But predictions of higher volatility and bets against sub-prime mortgages were last year’s winners. Now we have to deal with today and the future.

We start with the things we believe are true:

• The US consumer is wounded, having lost the almost bottomless piggy bank of home equity borrowing that allowed him to get into debt trouble.
• Unemployment is rising.
• North American and European economic activity is slowing.
• Oil consumption is rising globally and few American politicians seem willing to push alternative energy sources, especially nuclear energy.
• The dollar is cheap, but it is now more difficult to find currencies to be cheap against (except the RMB).
• Prices of food and other commodities show no reason to decline appreciably.

New issues are clearer than before:

• Time Magazine selected Putin to join other high impact leaders such as Stalin, Krushchev, and Hitler as “Person of the Year.”
• Foreigners are buying stakes in large American enterprises and it is a good thing; we need the capital.

It looks like 2007 has set the stage for a year of uncertainty in 2008.

If the markets wear themselves out and volatility settles into a trough somewhere at 15-20% (the average between the 10% lows of 2006 and the current level around 25%), where does that direct investors seeking safety and a reasonable return on risk? Reducing directional bets is the first step. Equity risk will still be too high, pushing risk-adjusted return hurdles into the high twenties, even if we find the “trough.” Diversifying investment risk will be the next major focus.

Absolute return strategies will continue to expand in terms of styles and instruments. Shorting sub-prime mortgages was not only highly profitable in 2007; the risk characteristics provided a terrific hedge against other strategies. Going forward, investors should diversify portfolio risk by including attractive investment strategies with low portfolio correlations. Arbitrage opportunities will not be obvious to everyone, but will be about as good as they can get for talented managers of hedge funds. Spread changes will create uncertainty for sure, and losses for mean reversion advocates, but long/short managers with vision should be able to control risk and produce returns well above LIBOR. Venturing into some of the more developed LDC markets makes sense as long as the liquidity and manager expertise is dependable.

Clearly 2008 is a good time to be proactive about portfolio management. While it is impossible to predict surprises, the best match for uncertainty is diversification.

As Will Rogers told us, “Things ain’t what they used to be and never were.”

The Human Factor
12 November 2007

We ended the unsustainable “wall of cash” era with a loud bang, causing some of the most powerful financial firms on earth to toss their leaders and regroup. The weakest link in credit excess, sub-prime mortgages, went down in flames as they should have. Irresponsible lending practices are currently in remission. Time will tell if they have actually become suitably conservative to avoid the next round of disregard for risk. August was the equivalent of the “refresh” button for credit, closely followed by the financial institutions affected by credit and then by the market at large. Next comes the human response.

One of the most important victims of the Fed’s decision to accommodate the market by lowering the cost of money is the US dollar. The financial press is replete with articles about institutions and noted investors and even supermodels who are running to other currencies. Chartists enjoy drawing the trend line on the dollar and forecasting that the US currency will continue to fall. Meanwhile, the mis-pricings of value that have been created are largely overlooked.

Americans were quick to embrace Tom Friedman’s theory that the “world is flat” and that the newly added inexpensive labor is positive for the enduring edge America has enjoyed. But now we have to deal with the other part of “flatness” which brings on the advent of hundreds of millions of new capitalists competing for the resources we use and the way we live.  Historically, investors from countries with strong currencies have been willing to overlook poor liquidity in emerging markets in order to purchase inexpensive assets. At various points in the currency cycles of the 80’s and 90’s Americans, Europeans and Japanese became large investors in South America and Southeast Asia knowing that if their investment appreciated they could, if they were patient to find a buyer, harvest their profit.  Today however, the landscape is considerably different. Assets that are cheaply priced for Canadian, European or Chinese investors happen to be located in the most liquid market in the world, the US. The dramatic change in the value of the dollar, market surges in the bourses of Europe, Canada, Brazil and Asia and the relatively low price to earnings relationship in the US have combined to create startling comparisons in relative corporate value.

The result?  Investors behave according to their best self interest. Toronto Dominion Bank would have had little interest in purchasing a US regional bank if the loonie had remained at 85 cents on the dollar (January /07). But at an exchange rate of $1.09, US assets are attractively priced in general and a foothold in the US financial services business becomes irresistible. While the loonie creates a number of problems for Canadian exports, it could result in Canadians owning considerable pieces of US companies.

Who will buy Merrill Lynch? Any large financial institution in Europe with capital reserves and aggressive management could purchase one of the most powerful distribution and money management companies in the world. Ranking 22nd on the Fortune 500 List with over 64,000 employees, an international network in 38 countries and over a trillion dollars under management, Merrill “on sale” is an enticing value.

And then we have China. The enigma surrounding China is that their double digit growth rate continues, their trade balance is skyrocketing and PetroChina has just become, by some measures, the largest company in the world. Over the past years, China has been there to purchase the US deficit through the accumulation of treasury bonds.  Lately the Chinese have made forays into equity investments such as a piece of Standard Bank in South Africa, the Blackstone Equity Partnership, and most recently a $1B investment in Bear Stearns. Taking the Chinese logic to the natural conclusion would suggest that they wish to diversify their investment holdings away from US debt and into more profitable ventures. The best example might be an investment in a company that distributes a large measure of Chinese manufactured goods. How would the US feel if the Chinese, recognizing the higher margins and investment returns of marketing and distribution in the US with the products that they already manufacture, were to buy Wal-Mart?

Which takes us to our final point for consideration on the Human Factor: a relatively important national election. Geopolitics are tough, particularly for a country whose constituents are isolated and used to running the geopolitical world. We are victims of our own preferences for news, dominated by meaningless accounts of enhanced story lines of celebrities. Our lack of focus on geopolitical events that shape America’s future is appalling and dangerous.  Our politics are void of the intellectual curiosity that drove our forefathers to create a country that utilized freedom of thought and expression as its most powerful geopolitical strength. Hopefully the election will engender clarification on important economic and energy issues. Up until now, dominated by the relentless crises in Iraq and Afghanistan, most of the political capital has been spent solving the terrorist threat and anticipating the next challenges with Iran and Russia. By the time we actually vote for the next American president it is at least possible that the crisis in Iraq may lose its grip on center stage. Replacing the politics of war may not be the oft-predicted recession of /08, but rather the not so gradual change in ownership of US businesses.

We know for certain that a country’s standard of living cannot improve when the value of its currency declines.  Market volatility in the US will not recede any time soon and returns relative to high risk will continue to be marginal. “Mis-pricings” in securities will be measured in relative values to foreign investors. Companies that are considered cheap by American investors that don’t have strategic value to foreign investors may not have much upside potential. Volatility in equities (the VIX is currently at 23), not to mention politics, (perhaps we need a new volatility index for “left” and “right” rate of change), is entirely too high for conservative investors. The reward of owning US stocks and bonds will continue to be lower on a risk-adjusted basis than the value of investing in hedge funds capable of taking advantage of relative values. The “Risk Diet” theme we first created at the end of 2006 (published in P&I, February 2007) must continue for prudent investors. Properly managed portfolios of competent absolute return strategies will continue to outperform “long only” investments on both a risk-adjusted and absolute basis. The numbers support the theory and the logic flow is hard to argue.

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