Thursday, January 05, 2012

Raising the Ante on Last Year’s Big Global Macro Bets

Raising the Ante on Last Year’s Big Global Macro Bets
Institutional Investor, 5-Jan-12
James Shinn

Some traders ruefully describe 2011 as “shockingly volatile,” even as others are pricing new Ferraris in sleek showrooms on Park Avenue and in Mayfair. What combination of asset volatility and fast-car returns is in store for 2012?

In the June 2011 issue of Institutional Investor, I described a reference scenario of the events that global macro traders believed to be moving markets last year, based on a two-day conference at Ditchley Park in Oxfordshire, England. According to this scenario, global macro hedge funds were focused, laserlike, on just four key events: the Federal Reserve Board’s monetary stance, a Chinese hard or soft landing in terms of GDP growth, euro zone stresses and that perennial favorite, oil prices. As I explained in my previous article, “with four big events, there are 16 possible outcomes (two to the fourth power) in the reference scenario ‘decision tree.’?”

With the benefit of hindsight, how did these scenario events actually play out, and how skillfully did our traders predict the four outcomes? Are the same cyclical and secular drivers of these events still at work? Looking forward, will these be the four key variables in 2012? And as the accountants tally up hedge funds’ year-end winners and losers, what is the reference scenario for 2012 — and with what odds?

The Fed’s Stance: Loose or Looser

The Federal Reserve’s monetary stance is the first big event under traders’ scrutiny, as the Federal Reserve Open Market Committee’s decisions will drive asset markets around the world, for good or for ill.

One branch leading from this decision is moderate economic recovery, reflation of price levels, sustained U.S. government deficits, a slightly tighter Fed stance (and no more quantitative easing), gradual improvement in job creation, gradual repair of household and bank balance sheets, and a sideways movement of the trade deficit. In this branch continued dis-saving by Washington is matched by household savings and the purchase of Treasury debt by foreigners and Ben Bernanke’s Fed, and this is what powers GDP recovery — at least for a while.

The other branch of this part of the decision tree says this party can’t go on for much longer and leads to slower economic recovery, flat employment and selective deflation (or the dreaded “stagflation”), some nominal reduction of the federal deficit, a continued expansive Fed stance and gradual shrinkage of the trade deficit. The former branch might be described as “business as usual,” the latter as “malaise” or “painful adjustment.” At the end of the day, the latter scenario writes off QE2 as a dangerous illusion.

Original Prediction: Painful Adjustment

Traders in our poll overwhelmingly bet on the “malaise/painful adjustment” outcome, 68 percent to 32 percent (with a standard deviation of 17 percent). The individual arguments supporting this view reflected global macro traders’ conviction that long-term adjustment is crucial — “This party just can’t go on forever,” one trader explained. The traders were also confident, in some cases adamant, that financial markets would force a fiscal deficit reduction in Washington: “If Moody’s gives the Treasury a downgrade, even Congress will have to pay attention,” was a popular comment. Most traders have a visceral dislike of quantitative expansion in any form — “QE is just a central bank’s monetization of government debt, any way you look at it,” observed one trader.

I should add that all quotes in this article are guaranteed genuine, but some of our traders’ firms have blanket policies forbidding their employees from being quoted in the financial press.

Actual Outcome: Business as Usual, Plus ‘Twist and Shout’

Contrary to the traders’ average prediction, we are still heading up the “business as usual” branch at the start of 2012, with no real deal on the U.S. fiscal deficit and with another shot of QE via September’s Operation Twist, although, unlike QE1, the Twist was balance-sheet neutral for the Fed.

The U.S. federal deficit in fiscal 2011 was -8.6 percent of GDP, barely down from 2010’s -9 percent. According to International Monetary Fund forecasts, the U.S. fiscal deficit will shrink only slowly, stubbornly sticking above 6 percent five years out. Consensus forecasts for U.S. economic growth are 1.8 percent for 2011 and 2 percent for 2012, with unemployment running at 9 percent and 8.7 percent, respectively. Even as government debt continues to climb, households will deleverage very slowly, and the external trade deficit will keep running at the 3 percent–of-GDP level more or less indefinitely.

The benefits of QE may still be a dangerous illusion in the minds of many financial professionals and has encountered a groundswell of political opposition in the Republican Party. But all indications are that the dominant dove faction on the Federal Reserve Board is keeping this option open. “Public political criticism of the Fed is nothing new and won’t have more than a marginal impact on its policy actions — maybe just on how it communicates them,” says Thomas McGlade, a Greenwich, Connecticut–based portfolio manager and director of U.S. operations for London-based hedge fund firm Prologue Capital.

Drivers: Deflation and Unemployment Fears Trump Deleveraging

As an example of the communication style described by McGlade, in a November 15, 2011, speech at the Council on Foreign Relations in New York City, Chicago Fed president Charles Evans made the case that inflation was essentially under control, displaying slides showing that the FOMC “central tendency” forecasts have core inflation running well under 2 percent for several years while unemployment slowly creeps down from the 9 percent level, still hovering in the 8 to 9 percent range a year hence and not going below 7 percent until 2014. If Evans’s view indeed reflects the central tendency of the Fed, the cyclic driver of slow U.S. recovery and sideways unemployment will wash the urgency out of deleveraging.

The persistence of secular leveraging was called rather rudely to the Fed’s attention by the now-famous paper on “the real effects of debt” by Brandeis University finance professor Stephen Cecchetti and his colleagues, presented at the Fed’s August 2011 Jackson Hole meeting; it later appeared as the Bank for International Settlements’ BIS Working Papers 352. I have seen copies of the graphs from this paper (see graph below, left) taped to traders’ screens and pinned to the corkboard over a trading floor’s espresso machine.

According to the BIS team’s calculations, total nonfinancial debt in 18 OECD countries grew from 167 percent of GDP to 314 percent between 1980 and 2010, an increase of almost 5 percent of GDP per year for three decades, as shown in the graphs. This trend has brought us to the point in many of these countries where debt levels are stifling GDP growth, according to economists Carmen Reinhart and Kenneth Rogoff. This implies that households and then governments must go through a sustained and painful deleveraging process.

Says Paul Brodsky, co–managing member of New York–based hedge fund firm QB Asset Management: “The issue across the board in developed economies is solvency — not discrete liquidity flare-ups among sovereigns, banks or households. Nor is a lack of confidence among consumers the issue. It all comes down to the extraordinary gap separating systemic debt from existing base money. The world needs to deleverage.”

The FOMC may think that deleveraging and adjustment are necessary someday, but putting more of the 25 million unemployed or involuntarily part-time employed Americans back to work appears to be more pressing — the central banker’s version of Saint Augustine of Hippo’s famous prayer, “O Lord, grant me chastity and continence, but not yet.”

Prediction for 2012: The Fed Will Make It Too Dangerous to Hold Bonds

Looking forward into 2012, our sample of traders believes the important choice is no longer between business as usual and adjustment, but between more quantitative easing or not, and the vast majority believe the Fed will engage in QE3. The average bet is 70-30 in favor of QE3, with a standard deviation of 22 percent.

There is broad consensus among traders that U.S. growth and employment are sliding sideways in an L-shaped, “slow and fragile” recovery through 2012, and the real question at this point is when and how much the doves at the Fed will resort to QE3. “How many bullets does the Fed really have left in its gun at this point?” asks Prologue’s McGlade. “From now on, the only remaining impactful policy option is additional QE, which could be balance-sheet neutral or expansive. And sometime in the first half of 2012, provided that the data continues to undershoot the hurdles of the dual mandate, I think we will see additional QE involving balance-sheet expansion rather than another balance-sheet-neutral move like Twist, and most likely involving mortgages this time.”

There is disagreement over what the transmission mechanisms from QE3 back into the real economy are — if any. “By pressing rates so low, the Fed is just making it too dangerous to hold cash and bonds,” concludes a skeptical global macro trader. “If you need yield, you are being forced up into equities and other real assets — not a comfortable position to be in.”

China: Hard or Soft Landing?

Will Beijing keep real Chinese GNP growing somewhere around its current target of 7.5 percent for the next year? Or will inflation fears cause the leadership to dampen demand levels back down toward 5 percent? There is a history of Beijing throttling the economy back and forth rather radically. As Arvind Sanger, founder of New York–based hedge fund firm GeoSphere Capital Management, says, “The Chinese authorities have only two economic management tools at their disposal — one is a flamethrower, and the other is a fire extinguisher.”

One possible outcome from the China event is real growth in the 8 to 10 percent range, with increasing inflation above 5 percent, sustained feverish levels of capital and infrastructure investment, and some reduction in net exports (which together add to 70 percent of GDP) — not quite the flamethrower mode but still pretty hot, and consistent with a “business as usual” view of the world. The other possible outcome is a hard landing: growth around 5 percent, with persistent inflation and expansion of net exports.

Original Prediction: Soft Landing

On average, the traders assigned a 57 percent probability to the soft-landing path and 43 percent to a hard landing, with a standard deviation of 19 percent. The dominant view argued that the leaders in Beijing had a lot of tools at their disposal to drive the economy in the direction they wanted it to land, including ownership of the banking system and a cushion of several trillion dollars in foreign exchange reserves.

Actual Outcome: Headed for Hard Landing but Changed Course

The traders were on the money, on average. We are still in soft-landing territory, with Chinese real growth expected to hit 9.2 percent on an annual basis in 2011, according to Xinhua News Agency. This growth was achieved by sustained high levels of domestic investment and by net exports, although the ratio of net exports to GDP declined from 3.1 percent in 2010 to 2.4 percent in 2011.

“They [Beijing] were tightening at the beginning of 2011, tightening real estate lending and raising some tax rates, but then they changed in October, with a minor monetary ease, some tax cuts for business and a shift toward easier monetary and fiscal policy, suggesting that the Chinese leadership is more concerned about the risk of a “hard landing,” says Laurence Zuriff, managing partner of Granite Capital International Group, a New York–based investment firm.

There is considerable uncertainty about the real rate of inflation, given doubts about the accuracy of reported consumer price index figures: Official 2011 inflation is running at somewhere between 5 and 6 percent (6.1 percent in September and 5.5 percent in October). Some believe this number has been engineered by the government statistics office — for example, by lowering the weights of food in the CPI basket.

Drivers: Rebalance, but Not Yet

Cyclically, the Chinese face the same trade-offs noted in my last article. The Politburo, which charts the basic guidelines for macro policy, fears the twin miseries of unemployment and inflation. If real growth falls below 7 percent or so, China cannot absorb annual increases in the workforce; if inflation rises much above 5 percent, the population gets restive.

Secularly, the members of the Politburo know they need to rebalance the components of GNP sooner or later — probably sooner — because the large weight and high growth rates of fixed investment and net exports can’t continue indefinitely and will have to be replaced with high personal consumption. All the official speeches acknowledge this. But no one in Beijing appears to be in any hurry to accelerate adjustment at the risk of domestic instability.

According to Ben Simpfendorfer, a Hong Kong–based economist for New York–based financial advisory boutique Global Strategic Associates and editor of the “China Insider” newsletter: “China has some of the world’s best economic planners, but the scale of the challenges are daunting, especially in the midst of a political transition. Beijing’s biggest challenge is weaning itself off state-owned heavy industry and revitalizing the private sector. The economy was, ironically, better balanced in 2008, or shortly before the crisis.”

Chinese officials think the shrinkage of net exports will continue, although some in Beijing are already raising alarms about a possible sharp swing down. According to Zhang Yansheng, director of the Beijing-based Institute for International Economics Research, under the National Development and Reform Commission, “What we’re facing now is a grave situation for exports, and slowdown is inevitable in the third and fourth quarters.”

So a soft landing is still the target, though what constitutes “soft” appears to be somewhat slower nominal growth — say, 8 percent rather than 9 percent — and the danger zone of hard-landing growth is a bit higher: say, 6 percent rather than 5 percent.

Prediction for 2012: China Needs Reform, Not More Easing

Looking forward, the traders believe that China’s glide path toward lower growth is still one of the big four events that will move financial markets in 2012. The average prediction continues to see a soft landing, but the odds fell from 57 percent in June to 53 percent looking forward into 2012.

“China has the firepower to prevent a hard landing in 2012, but the economy needs more reform, not more policy easing,” says Simpfendorfer. “Flushing the system with more credit will only worsen imbalances. China’s middle-income trap is approaching fast unless productivity gains start replacing labor and capital as the main drivers of growth. Policy easing can only delay, not avert, the challenges.”

Granite’s Zuriff agrees that 2012 will be a tougher growth environment for Beijing’s leaders. “Global demand will likely be lower, and their wage inflation is reducing their competitive advantage in a lot of export sectors,” he says. “And there have been a series of frauds and corporate governance issues, like Sino-Forest and Alipay, that are undermining inward foreign investment. The housing sector is overbuilt and vulnerable to a big price correction, and the Communist Party leadership itself is going through a big transition in the second half of the year. When trying to determine if we will see a hard landing in 2012, we have to ask if the party leaders will try to buy growth to buy stability in front of the leadership transition — and if they’ll succeed.”

Of course, the 53-47 split of our poll indicates average confusion more than anything else, as the standard deviation of the forecast widened from 20 percent to 23 percent. “We can’t understand economic policymaking in Brussels or Washington anymore, much less in Beijing,” complains one trader. “Plus, if the Chinese don’t make their growth or inflation targets, they can just make it up. But at the end of the day, the Chinese can have a soft landing because they can afford it — they have the resources needed to carry them through a transition period.”

Euro Zone: Extend or Breakup?

Will the EU peripheral states force bondholders to take a haircut on their debt? Or will the EU, the European Central Bank and Germany somehow manage to bail them all out in a way that doesn’t force big write-downs?

All macro traders believe the question isn’t whether the periphery writes down its sovereign debt, but rather how it does so. One branch of the European debt limb of the decision tree is what one trader describes as “extend and pretend,” with some kind of government bailout that keeps holders of Irish, Greek and Portuguese sovereign debt from taking big write-offs, thereby averting contagion to the European banking system. This is business as usual in the euro zone. The other branch is an ugly adjustment that reveals the scale of the exposure of French and German banks to peripheral sovereign debt and threatens to spread to Italy and Spain.

Original Prediction: Extend and Pretend

The average probability estimate for “extend and pretend” was 53 percent, versus a 47 percent prediction of an ugly default, with a standard deviation of 25 percent, a wide distribution around the mean.

The average prediction gave the euro authorities almost even odds between going up the “extend and pretend” path with a bailout that didn’t result in a haircut for the holders of euro zone periphery sovereign debt and an ugly default on the periphery, which would rapidly spread to Italy and Spain as well as threaten the credibility of the European banking system, including the core French and German banks. The big standard deviation suggests a fairly wide dispersion around the mean by individual traders. Some believed the Europeans could trudge toward a solution and eventually muddle through. Others insisted that markets wouldn’t wait that long.

Actual Outcome: Ugly Adjustment

The funding crisis of European banks and sovereigns alike is driving them both pell-mell into the reluctant embrace of the ECB. This surely constitutes evidence that we are going down the ugly-adjustment pathway.

In the last half of 2011, French banks’ dependency on the ECB for liquidity exploded, from €10 billion to €100 billion ($13 billion to $130 billion). The FTSE index of French and German banks dropped from 100 to 60. Moody’s Investors Service downgraded the credit ratings for BNP Paribas, Crédit Agricole and Société Générale, while Fitch Ratings downgraded the long-term ratings of Barclays, Credit Suisse and Deutsche Bank.

Euro zone authorities are still pretending that the monetary union part of the “European project” is on track, but this could fall apart any day now. They are also pretending that there has been no default event for the holders of European sovereign debt, even while twisting their collective arm to take a big haircut — a truly surreal juxtaposition. In the meantime, Greek debt is trading at a deep discount to par, which is surely a write-down in the real world. Beyond the Continent everyone is watching the circus of euro negotiations with a combination of anxiety and disbelief. “Demographics have caught up with the European social welfare state, and European governments made promises they can’t keep, so what we’re seeing is the bursting of the entitlements bubble,” says one Connecticut-based global macro trader. “These last weeks have been a fiasco for European authorities. The EFSF [European Financial Stability Facility] is hamstrung, the outlook for the euro is bleak, and any chance of a year-end rally is gone. The banking crisis will deepen, sovereign bond yields will continue to increase, and we traders are facing grindingly volatile markets with a downward trend.”

Drivers: The Sovereign Debt Danger Zone

The cyclic and secular drivers of euro zone survival going into 2012 are the same as in mid-2011. The euro zone is sliding into a second recession, and the long-term problems of center-periphery price adjustment (or lack thereof) and sovereign debt remain unresolved. The sheer scale of the political compromises and subsequent approvals required to alter the euro zone agreement — particularly in Germany — is dragging out the adjustment process and amplifying the cyclical crisis.

The basic math on the sustainability of sovereign debt is still in place: Once sovereign yields climb above the likely GDP growth rate, the debt burden will climb and sooner or later crush the state. By this measure, all of the so-called PIIGS — Portugal, Ireland, Italy, Greece and Spain — are already above the sovereign yield danger zone.

Prediction for 2012: Either Way, It’s Game Over in 2012

Our traders remain almost equally split on the euro zone trajectory — 53 to 47 — with an average forecast that Brussels and the European authorities can somehow pull off an extend-and-pretend bailout of the periphery and the core through 2012, but the standard deviation of the forecasts narrowed from 25 percent to 19 percent. The overall tone, however, is increasingly skeptical as traders and other market participants watch the European authorities dither through endless summits, deadlines and “senior consultations.”

“With some help from other wealthy European states and ECB repo operations, Germany has the money to do a wholesale credit wrap of euro-area bank and sovereign debt,” says Prologue’s McGlade. “But there are stringent conditions from the Germans for that wrap. Plus, the political and nationalist constraints in the other states that have to accept those German conditions are uncertain and volatile. The scale of funding needs in the first quarter at the sovereign, banking and corporate level in Europe is absolutely huge, and that means some sort of climax is imminent.”

From his market soundings, McGlade believes he is not alone in this view. “The ECB is dancing as fast as it can to preserve the European banking system, and the market is sniffing this,” he explains. “[ECB president Mario] Draghi’s hawkish refusal to allow the ECB to expand the bond purchase program has begun a new, dangerous chapter in the euro crisis. The global pool of capital will not fund those debt rollovers unless it is at a steep discount, and at such a discount the debt-service load becomes untenable and the government business models unsustainable.”

Another Greenwich-based macro trader is equally pessimistic. “The euro is destined to be a weak currency in 2012,” he says. “Rates are going to zero or just 25 basis points, Brussels’ interventions will remain haphazard, and the ECB will continue to disappoint those calling for full-force monetization of struggling sovereign debt. Greece and Italy will both default in 2012, and the ‘core’ European banks are going to have to get recapitalized. We are on the precipice of a nasty election cycle globally, and there is going to be a lot of tearing of social fabric.”

Not all observers are so bleak about the euro zone’s prospects, though they agree that 2012 is a year of decision. “The political obligation on the part of the Germans to avoid the disintegration of Europe is so great that ultimately they will choose the lesser of two evils and decide to take the hit and guarantee debt. The Greeks and Italians will write rules, and the Germans will sign the checks,” predicts a senior investment banker. “Either way, it’s game over within 2012. Either Germany concedes or the euro zone dies.”

Oil: Medium or Expensive?

The final big event is oil prices. Every day since the Arab Spring broke out in December in Tunisia, traders have been running and rerunning the odds that chaos in the dusty streets of Middle Eastern and North African capitals will result in fewer oil tankers passing the Strait of Hormuz. Since it is well established that there is very little swing capacity in the oil market with which Saudi Arabia could maintain stability in oil prices (even if it wanted to), a minor disruption in oil exports from the Gulf could result in big price increases. One possible outcome is expensive oil, $125 or more a barrel; the other is medium to expensive oil at about $100 a barrel.

Original Prediction: Medium Oil

The majority view of the macro traders was the second outcome, toward medium to expensive oil, but only narrowly so, with an average 52 percent probability and a large standard deviation of 21 percent. Traders were more concerned about possible supply shocks caused by the Arab Spring rippling more widely through the oil-supplying countries of the Middle East and less concerned about variations in demand, especially from China and India.

Actual Outcome: Medium Oil as Libya Is Off-Line and Then On-Line

The prediction was right — we are down the path of $100 to $110 oil. “Oil in 2011 was all about Libya,” says one macro trader, who spent a decade as an energy specialist. “Libya went off-line in February and came back on-line in the fall. Before the war they were pumping 1.6 million barrels per day, which then dropped to zero. That’s the chief reason Brent got up to $130 per barrel. But Libya has exceeded expectations recently and is back pumping between 800,000 and 900,000 barrels per day.”

Drivers: Finely Balanced Supply and Demand

The same cyclic and secular drivers are likely to be propelling oil prices in 2012. Emerging-markets demand has absorbed the small incremental pumping capacity that softened developed market demand is freeing up. On the supply side there is still political instability in several major suppliers: Iran, Libya, Nigeria and Venezuela.

In terms of secular drivers, the Arab Spring has resulted in massive injections of funds back into those nations’ societies by nervous sheiks and kings. This puts some pressure on them and OPEC to pump more. On the other hand, it also gives them an incentive to cut back on supply so they can raise prices. For example, because of enhanced fiscal commitments, the price of oil that Saudi Arabia needs to balance its budget — the so-called budget break-even point — went up to $80 a barrel and may climb to $115 a barrel in a year or so at current production rates.

The secular drivers increasing supply or substitutes outside of politically dicey areas in the Middle East and Africa through oil shale, deepwater drilling and fracking are steady but will take time. In the meantime, conventional oil capacity is increasing only about 1 percent per year on a net basis, which, combined with slim marginal capacity, could produce quite a bit of volatility in 2012.

Prediction for 2012: It’s All about Geopolitical Risk

Traders seem to have changed their minds about oil prices more decisively than about the other events. The average forecast is 59 percent that oil will stick at $100 or below throughout 2012, with a standard deviation of 18 percent.

“We are entering 2012 with low oil inventories but with overall demand flat because of recession here and in Europe, and with OPEC pumping at high levels, inventories will build in the early parts of the year, which will knock prices down,” says the energy-specialist-turned-macro-trader. “If Libya holds together, the balances for the second half of 2012 are very bearish. Prices should go flat to down through the year. So we’re really looking at geopolitical risk here. If one more big supplier goes off-line for whatever reason, these prices must go up again to ration demand.”

The Arab Spring continues to reverberate in traders’ minds. “For whatever reason, the capital markets have simply turned a blind eye to the situation or have gotten comfortably numb with all that has transpired in the Mideast, beginning with the immolation of that Tunisian vegetable vendor that sparked the Arab Spring,” says Stevyn Schutzman, chief macro strategist at RBC Capital Markets. “But these situations in the Mideast are all interconnected. The ripple effects that U.S. withdrawal from Iraq may have on the capital markets could be enormous — not just on the oil price but more broadly into energy policy and even defense spending.”

One Extreme or Another?

Some traders insist that oil prices could also move upward in response to higher inflation expectations generated by several central banks engaging in quantitative easing throughout 2012 — a wall of money pumped into the world economy by the Fed, the Bank of England, the Bank of Japan and the ECB. “The financialization of money over the last generation demands the monetization of finance now,” says QB Asset Management’s Brodsky. “The value of goods, services, assets and labor must be reconciled in real terms with our global currencies, both for takers and providers of them. So I expect inflation because of central bank money manufacturing that forces the general price level higher.”

This is an uncomfortable reminder for all forecasters — in academia or trading — that the big events that will move markets in 2012 are not the truly independent variables so prized by the runners of regressions but rather covariant in complex ways.

When smart traders are equally split on the odds while the markets are getting both volatile and increasingly cross-correlated, one strategy is to simply bet on both ends. According to Alen Mattich in his Wall Street Journal blog: “The hope may be for a muddle through when it comes to the euro crisis, but investors are increasingly betting on one extreme or another. Take a look at the oil market . . . [with] very heavy activity in out-of-the-money options on oil prices — at either end of the spectrum. Although prices are currently hovering at around $100 a barrel, investors are betting that prices either collapse by half or surge by 50 percent. But it’s not just oil. Everywhere you look, asset prices seem unstable.”

Concludes Brendan Dornan, principal of New York–based Dornan Capital Management: “The best strategy for this is to sell at-the-money puts and calls, and use the proceeds to fund purchases of many more out-of-the-money puts and calls. This is the ‘barbell strategy’ advocated by Nassim Taleb.”

So what do you need to sleep easily through the new year with your barbell bets? Probably a lot more information than you have. Peter Bernstein, the preeminent academic historian of risk-taking, described the trader’s dilemma, likely to be as true throughout 2012 as it was in 2011:

* The information you have is not the information you want.
* The information you want is not the information you need.
* The information you need is not the information you can obtain.
* The information you can obtain costs more than you want to pay.

James Shinn (jshinn@princeton.edu) is a lecturer at Princeton University’s School of Engineering and Applied Science. After careers on Wall Street and in Silicon Valley, he served as the national intelligence officer for East Asia at the Central Intelligence Agency and then as assistant secretary of Defense for Asia at the Pentagon. He serves on the advisory boards of GSA, Oxford Analytica and CQS, a London-based hedge fund.

Wednesday, December 28, 2011

12 Predictions for 2012

Here is what other market sage are saying
* Byran Wien
* Doug Kass


12 Predictions for 2012
1) Barack Obama will beat Mitt Romney with or without the entry of Ron Paul as a 3rd Party candidate.
2) Republican will take the Senate while the House falls to Democrats.
3) European crisis will persist through year-end but will not spill into the US because European policymakers will react to contain the problem whenever it arises. Greece/Italy stay in the Euro.
4) Iran vs the world drama continues and that'll add volatility to the oil market but there will be no attack against Iran.
5) China's 2012 GDP growth will surprise to the downside i.e. below 8%.
6) US 2012 GDP growth will surprise to the upside - current consensus is ~2.1%.
7) By December, US non-farm payroll growth will reach 250K and the unemployment rate will fall below 7.5%.
8) The Fed will not shrink its balance sheet.
9) Yield on 10-year will end the year above 3%.
10) S&P500 will finish the year above 1,400 i.e. +11%.
11) Financials will be the best performers followed by tech and consumer discretionary.
12) No, the world will not end on 12-12-12.

Friday, August 19, 2011

Swiss Franc & Singapore Dollar Swap Spread Turn Negative

Swiss 2-Year Yields Turn Negative, 10-Year Yield Down the Most Since 1994
Bloomberg, 18-Aug-11
By Keith Jenkins

Swiss two-year note yields stayed negative for a second day after central bankers announced more measures to weaken the franc, showing investors may sacrifice capital for the perceived safety of investment in the currency.

The Swiss two-year note yield fell five basis points to negative 0.06 percent at 4 p.m. in London as stock markets slid around the world. The yield yesterday slid 10 basis points into negative territory, indicating investors will receive less when the bonds mature than the sum they paid for them. Ten-year Swiss yields tumbled 19 basis points today, the most since Bloomberg began collecting the data, to 0.86 percent. (>>>)

Negative swap rate signals Singapore rethink on SGD rise
Reuters, 17-Aug-11
By Kevin Lim

Singapore is attracting an unwelcome flood of U.S. dollars that has caused a key interest rate to turn negative, complicating efforts to dampen inflation and prompting speculation the central bank will tweak its policy to slow the rapid rise in the country's currency.

While Singapore prides itself on having a highly globalised and open economy, the stream of investors seeking refuge from international market turmoil in recent weeks could fuel price pressures on the tiny island, adding to fears of a potential property bubble, even as the economy shows signs of slowing.

That could persuade the city's central bank to reconsider its policy on allowing further appreciation in the local currency. (>>>)

Monday, May 23, 2011

The Missing Link

The Missing Link
The Economist, 19-May-2011

Economic growth helps investors only if they are clairvoyant

IT MAY seem obvious that faster economic growth should translate into higher equity returns. So it was quite an upset when academics found some years ago that this had not been the case in advanced countries over the 20th century. A subsequent paper discovered that the story was similar for developing economies as well.

These findings are awkward for emerging-market enthusiasts, who usually cite the superior growth prospects of such countries as the reason to invest in them. The counter-attack has duly been led by Jim O’Neill of Goldman Sachs Asset Management, who as a strategist coined the wildly successful BRIC acronym for the big developing economies of Brazil, Russia, India and China. Yet the surprise is not only that the response has been so long in coming but that the case it makes is so limited.

The Goldman paper admits that there is no evidence that equity returns for any given year are correlated with GDP growth in that same year. But it says that “equity markets are a lead indicator of GDP growth and react strongly to expectations about the future.”

This conclusion is hardly new. Stockmarket movements are a standard component of economic lead indicators. But this link is of little use to investors, who are looking instead for a lead indicator for equity performance.

Goldman argues that investors can take advantage of upgrades in economic-growth forecasts, which signal better prospective returns especially in the developing world. But its evidence for this claim is quite limited (just ten years of data for Brazil and Mexico, for example). If one takes the American market over the past 40 years then there is a negative relationship between changes in growth forecasts and equity returns.

This raises another doubt about the Goldman analysis. It is rather dismissive of the long-term stockmarket returns compiled by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (LBS), who published their findings in 2005. “Averaging over a century fails to account for potentially important structural breaks and changes in the way economies and markets operate,” the report says somewhat sniffily. But the data are the data; it is not scientific to leave out large chunks of evidence.

But what if superior GDP growth showed up in stockmarket returns not immediately but over a prolonged period? The LBS academics tackle this issue in their 2010 work, the “Credit Suisse Global Investment Returns Yearbook”. They take the records of 83 countries from 1972 to 2009 (the most comprehensive set available) and rank them by GDP growth over the previous five years. Investing each year in the countries with the highest economic growth over the preceding five years earned an annual return of 18.4%, but investing in the lowest-growth countries returned 25.1%.

The interesting question is why this phenomenon should occur. One explanation is that investors pile into the stockmarkets of high-growth countries until they become overvalued. That herd-like behaviour makes their subsequent returns disappointing.

Another possibility is that economic growth does not always get captured by the stockmarket. The fastest-growing companies are often unquoted: in emerging markets, for example, many businesses are family-owned or controlled by the state. Even when businesses are quoted, their growth may be financed by additional equity issuance that does not boost the returns of existing shareholders. One paper suggested that this effect could reduce returns by as much as two percentage points a year.

Although analysts often forecast annual profits growth of 10% or more, the LBS academics found that dividends failed to keep pace with GDP growth in every developed country (bar one) they studied between 1900 and 2009. Re-invested dividends are a vital component of long-term equity returns.

If investors could forecast future economic growth, then Goldman would be right: superior returns would be achieved. But there is precious little sign that such clairvoyance exists. And the evidence that past economic growth is of no help remains pretty compelling.

Wednesday, December 22, 2010

Facebook for Finance

Facebook for Finance
08-Oct-2010
By Len Costa

Blogs, online networks and other social media web sites are creating new opportunities for investment research. Social media sites are supplementing, and in some cases supplanting, the traditional Wall Street information ecosystem that transmits sell-side investment research and stock calls to the buy side.

If information "wants to be free," as one half of the famous aphorism goes, somebody forgot to tell Wall Street. This fall a federal appeals court in New York will weigh in on a long-running and widely watched legal dispute pitting Barclays Capital, Bank of America Merrill Lynch and Morgan Stanley against Theflyonthewall.com, a New Jersey–based web site that publishes sell-side analyst recommendations before the market opens — and often before the firms can distribute their own research to clients. The firms contend this hurts their commission revenue. This past spring a lower court judge ordered Theflyonthewall.com to delay publication of the firms’ stock calls until one half hour after the opening of the New York Stock Exchange, among other restrictions. The web site countered with an appeal and won a temporary stay.

Even if the brokerage firms prevail in their battle against Theflyonthewall.com, winning the war to preserve the primacy of their investment research won’t be easy. Bolstered by the low cost of online publishing and the rising popularity of blogs, discussion forums and commenting, a growing number of niche web sites are creating opportunities for new forms of investment analysis to emerge — and for buy-side professionals, even those at rival firms, to collaborate and learn directly from one another. These social media web sites are supplementing, and in some cases supplanting, the traditional Wall Street information ecosystem that transmits sell-side investment research and stock calls to the buy side. The sites’ popularity has been fueled by the limitations and shrinking coverage universe of sell-side research and the failure of establishment experts — from Wall Street analysts and strategists to the credit ratings agencies to the financial news media — to call the credit crisis.

“The sell side can often be slow to twist and turn with where the market is going,” says David Jackson, a former Morgan Stanley technology analyst and the founder and CEO of Seeking Alpha, a leading investment blog backed by blue-chip venture capital firms Accel Partners, Benchmark Capital and DAG Ventures. But crowd-sourcing investment ideas, he says, has its benefits: Throughout the rise and crash in the price of oil in 2007 and 2008, the unraveling of the housing market and the implosion of Bear Stearns Cos. and Lehman Brothers Holdings, Jackson’s more than 3,000 handpicked contributors and vocal readers were “uncannily on topic in terms of what was driving the market — at a macro level and an individual stock level.”

In mid-August, as part of the U.S. Treasury Department’s ongoing outreach to the financial blogosphere, seven bloggers were invited to a private meeting with a small group of senior officials, including Treasury Secretary Timothy Geithner, to discuss financial reform. As four of the seven bloggers regularly contribute to Seeking Alpha, the meeting was a nod to the site’s growing influence.

Finance pros have taken notice. According to audience tracker Nielsen Co., Seeking Alpha, which launched in 2004, now attracts more financial professionals than any other major financial web site. The site recently hit 540,000 registered users, and its opinion and analysis pieces, which are free, are read by more than 2.8 million people a month. Nielsen data suggest that more than 385,000 of these individuals are professionals: money managers, sell-side analysts, investment bankers, financial advisers, business leaders, entrepreneurs and sophisticated retail investors. Morgan Stanley’s sell-side research, by comparison, goes out to roughly 250,000 institutional investors, though the firm’s reach is much broader when you factor in its retail network of 18,000 financial advisers and their clients.

“Blogging is absolutely democratizing the investment business,” says Barry Ritholtz, who is CEO and director of equity research at independent quant research firm FusionIQ, and who writes The Big Picture, a well-regarded blog about macro investing themes. A Wall Street veteran and the former chief market strategist at New York boutique investment bank Maxim Group, Ritholtz says that 20 years ago the typical Wall Street strategist had an economics degree, went to one of a half dozen leading MBA programs and came up through the ranks at a big firm: “You’re talking about members of the same club — similar schools, similar background, working at the big Wall Street firms, quoted in the major media.” But these days, he contends, “that model is totally broken.”

For every form of investing, to tweak Apple’s catchphrase, “there’s a blog for that.” Naked Capitalism, which specializes in financial and economic commentary, is overseen by Yves Smith, the nom de plume of a former Goldman, Sachs & Co. and McKinsey & Co. executive, and is widely read by hedge funds. Footnoted.org, launched by journalist Michelle Leder, reports on the things that companies try to bury in their Securities and Exchange Commission filings and was recently acquired by Morningstar. And Jeff Matthews Is Not Making This Up, written by te founder of Greenwich, Connecticut–based hedge fund RAM Partners, delivers blunt analysis of everything from the sources of revenue growth at Hewlett-Packard Co. under former CEO Mark Hurd to Wall Street’s earnings coverage.

The explosion in socially generated investment analysis is both a blessing and a curse, especially when you consider the volume of short messages containing financial content that are transmitted every day via Twitter, the microblogging service that is especially popular among active traders (see sidebar, opposite). To manage what traders might call the high “signal-to-noise ratio” of public web sites, at least three private online communities now cater specifically to professional investors: Value Investors Club and Distressed Debt Investors Club, which were founded in 2000 and 2009, respectively, and each cap their membership at 250 investors, who are anonymous to fellow users; and SumZero, which launched in 2008, combines user-generated investment research with social networking features and now boasts a membership of more than 4,000 buy-side analysts and portfolio managers.

All three sites are rivals of sorts but share some members. Generally speaking, they screen applicants based on the quality of a sample investment thesis and require members to post write-ups on securities and regularly rate other community members’ ideas. The sites may also offer incentives to encourage participation; Value Investors Club, for example, awards a weekly prize of $5,000 for the best idea.

SumZero is betting that scale, transparency and Facebook-style networking features will set the site apart from its two smaller rivals. “The dynamic is that the bigger the idea database gets, the more compelling it becomes to contribute to,” says co-founder and CEO Divya Narendra, a 28-year-old former analyst at Boston-based hedge fund Sowood Capital Management who is running the site while pursuing law and business degrees at Northwestern University.

Networks are something that Narendra has spent a lot of time thinking about. As an undergraduate at Harvard University, he co-founded social network ConnectU, and he remains locked in a long-running legal battle with Facebook and its co-founder Mark Zuckerberg, a Harvard classmate whom Narendra accuses of stealing his idea. SumZero’s name and tagline, “The opposite of zero sum,” suggest a Facebook-like zeitgeist. It’s a cheeky riff on the idea — which seems out of place in the cutthroat world of money management — that investors can create value for one another by openly collaborating and sharing ideas.

And they are. James Kilroy, a portfolio manager at Gainesville, Georgia–based Willis Investment Counsel, which oversees about $1 billion in institutional and high-net-worth assets, joined SumZero when it was a third of its current size. He says that he often posts a detailed investment thesis to the site after completing his research and building a position. His goal is to stress-test his ideas — “I want to understand how I can be wrong,” he says — and to share them with an influential community that is prepared to act on a persuasive argument.

“You want to be early and first,” explains Kilroy, a former Bear Stearns analyst who covered multi-industrials, “but ultimately you need other investors to share your point of view for the stock to go up.” Kilroy likes the fact that SumZero members must disclose whom they work for and the type of funds they manage. “It forces you to a higher level of accountability,” he adds.

Access to contrarian investment thinking is also a key driver of investor interest in these social media sites. Jackson credits Seeking Alpha’s success to the diversity of viewpoints expressed by the site’s writers and commentators, who create a wide-angle view of a stock that he says is unmatched by traditional Wall Street research. SumZero’s Narendra agrees. “Somebody might put up a thesis [on SumZero] where a stock trades at $2 and the target is $10,” he says. “That’s the kind of stuff that the investment community needs — a divergence of viewpoints, as opposed to herd thinking.”

Still, investors must proceed with caution. In a 2007 study of 340 buy and 160 sell recommendations posted on Seeking Alpha, Veljko Fotak, a Ph.D. student in finance at the University of Oklahoma, found that the stock picks exhibited some value and market impact, as measured by returns in the 20 trading days after publication, but that the quality of the investment advice varied. He found scant evidence of any factors that could predict the quality of a blogger’s recommendations.

Size may be the enemy of the good. Wesley Gray, an assistant professor of finance at Drexel University in Philadelphia and a co-founder of Empirical Finance, a recently seeded $50 million quantitative hedge fund, has studied the investment write-ups posted to Value Investors Club, whose founders, Joel Greenblatt and John Petry — longtime partners at New York hedge fund firm Gotham Capital — strictly enforce the 250-member cap. Gray’s analysis, which formed the basis of his Ph.D. dissertation at the University of Chicago Booth School of Business, found that stocks recommended on the site delivered an average one-year buy-and-hold return of 9.52 percentage points above the predicted return, after controlling for risk. Gray and his colleagues performed a similar, unpublished analysis of recommendations on the SumZero web site, which has a much larger user base and a shorter track record, and found no statistical evidence that the ideas posted there were, on average, market-beating.

That comes as no surprise to the Value Investors Club founders, who admit just one in 15 applicants. “If every member of the buy side joins SumZero, over time you’re going to have the aggregate return of the market,” says Petry.
Blogs, online communities and crowd-sourcing platforms like Twitter may hold promise for investors, but their reach is still limited, especially among more-seasoned professionals. “Most portfolio managers over 35 are ignoring this stuff,” says Steven Goldstein, co-founder and CEO of Alacra, a New York–based content aggregator that helps investment firms track information published on blogs, social media sites and other online sources.

Tapping into the right networks can be a Herculean task. “Yes, there is a proliferation of information and a lot of debates happening on social networking sites, but I think if anything it obfuscates the issues,” says Barry Hurewitz, chief operating officer of investment research at Morgan Stanley. He contends that good sell-side analysts, thanks to their own professional networks, are better equipped to define the debate and understand market expectations. “They tend to have the conversations with investors that matter the most,” says Hurewitz.

The proponents of online communities and social networking have no delusions of grandeur, but they are firm in their belief that these new online tools will ultimately change the way investors conduct research and vet new ideas. “I don’t want to sound ridiculous,” says SumZero’s Narendra, who positions his site as an alternative source of information that complements existing sources, such as sell-side research, 10-Ks and investors’ own proprietary models. Still, the entrepreneur can’t help but ponder the possibilities. “If we get to the stage where there are 10,000 to 20,000 buy-side analysts all in one community,” he says, “I think that’s really, really powerful.”

THE FACT THAT professional money managers share investment ideas online is perplexing to academic economists. After all, in an efficient and competitive market, money managers should be inclined to keep valuable insights private so that they can exploit the information advantage to outperform their rivals and attract greater sums of investment capital.

In practice, though, sharing has long been one of the most important ways that fund managers discover new investment ideas. Private “idea” dinners and gatherings like the twice-annual Value Investing Congress, launched by Whitney Tilson and John Schwartz, have long been a staple of the business. In a 1988 academic paper, written back when social networking meant working the cocktail party circuit rather than friending somebody on Facebook, Yale University economist Robert Shiller and then–Harvard economist John Pound found that roughly 53 percent of the institutional investors they surveyed attributed their initial interest in a stock to another investment professional. When the inquiry was limited to a small sample of stocks that had experienced rapid price increases, 75 percent of the investors traced the origins of their ideas to fellow fund managers.

Sharing good ideas with competitors, it turns out, is an entirely rational undertaking. Drexel’s Gray cites three reasons: the collaboration argument (originally put forward by another academic, Harvard economist Jeremy Stein), which holds that managers will share information if doing so provides access to constructive feedback; the diversification argument, which holds that sharing is rational when it gives managers access to a wider pool of high-quality ideas; and the awareness argument, known more pejoratively as “talking your book,” in which a manager profits by persuading other investors to buy, thus bidding up the price.

The speed and scope of information sharing among investment professionals got a big boost in the late 1990s with the rapid adoption of instant messaging on Wall Street. With IM, brokers and traders — much like the teenagers who popularized the technology — found that they could share information with multiple individuals simultaneously and that sending an IM was more real-time than e-mail and more convenient than the telephone.

Sensing an opportunity, Reuters and Bloomberg introduced their own instant messaging platforms in 2002 and 2003, respectively, marking an important turning point. Unlike most consumer IM platforms at the time, both companies offered investment firms security, auditing and privacy controls, helping compliance officers get comfortable with the technology amid growing scrutiny by the SEC and other regulators that oversee brokerage firms.

As Reuters and Bloomberg terminals became ubiquitous in the investment business, they emerged as linchpins in what might be deemed Wall Street’s formal network for the distribution of research and stock calls to the buy side. Today, once an analyst releases a research report, it is typically published to the firm’s password-protected web site for clients and distributed simultaneously to entitled customers via Thomson Reuters (as the company is now known), Bloomberg or other third-party distributors, such as Capital IQ. Brokers and traders also e-mail research to clients, disseminate the substance via IM and host private conference calls or webcasts to discuss the investment opinions.

Thomson Reuters and Bloomberg are themselves working to build on strengths in instant messaging to create new opportunities for investment professionals to share and collaborate online — but in a way that affords firms ample control over who can see their content and how their employees share research and other proprietary information. Both companies’ flagship data products allows users to create profiles, follow updates from individual users and share charts and data, along with comments. “Bloomberg built systems to meet our customers’ networking needs before the concept of social media even existed,” says Jean-Paul Zammitt, Bloomberg’s head of core terminal products and services.

Even a Wall Street lawyer could love this kind of networking: As Eran Barak, Thomson Reuters’s global head of community strategy, puts it, the goal is to “bring the power of community and collaboration into financial professionals’ work flow,” while giving IT departments and compliance officers “all the tools to be compliant with regulation and perform risk management.”

Outside of this formal distribution network, socially generated investment opinion is for now less heavily regulated, but potentially very lucrative, for those who can tap into the right source. Value Investors Club, the most exclusive of the online venues aimed at pros, is seen as a particularly fertile source of high-quality ideas. In early May, for example, user “cxix” recommended shares of NBTY, the world’s largest maker of vitamins and supplements, then trading at $39 a share. The company, cxix wrote, was “a better business than it’s generally given credit for” and prone to “blow-ups” — such as the one in the previous week, when shares fell 20 percent intraday — because management “doesn’t play the earnings guidance/smoothing game.” With the stock trading at $54 in mid-September, investors who bought on the dip were up nearly 40 percent.

“When you submit a good idea to Value Investors Club or SumZero, others get on board,” says Alan Axelrod, a member of both sites and a former managing director at Ziff Brothers Investments, who now oversees $50 million in separately managed long-short domestic equity accounts. “You can immediately see some volume change plus the stock going up on a long you might suggest or down on a short.”

THERE is NO DOUBT that invest ment recommendations posted to social networks, however exclusive they may be, can be subject to biases. The 2007 paper by Fotak of the University of Oklahoma found that the stock picks from bloggers on Seeking Alpha tended to focus on large-cap names with recent abnormal returns and trading volumes. Long picks were consistent with contrarian strategies, he found, while shorts reflected momentum strategies.

Conversely, stock picks posted to Value Investors Club and SumZero are more likely to be small-cap stocks or special-situations opportunities, according to Drexel’s Gray. He noted in his Ph.D. thesis that the median market cap of long ideas, which make up the vast majority of recommendations on both sites, was $393 million for Value Investors Club and $559 million for SumZero. Most users of both sites are themselves employed by small and midsize firms. Based on an analysis of SumZero’s membership, Gray found evidence that larger fund managers were less willing to share new ideas than smaller managers were. (His interest isn’t just academic: Gray’s hedge fund trades in part on quantitative models that analyze the flow of information through social networks like SumZero and Value Investors Club.)

Apart from discovering and vetting new investment ideas, these specialized social media sites — the ones that don’t permit anonymity, at least — also provide crucial networking opportunities. Narendra says that SumZero is in many ways an extension of the information provided by services like Bloomberg. He points out that a Bloomberg terminal can be used to find out the names of firms that are 5 percent holders of a company’s stock, but not the names of the analysts at those firms who actually cover the company. On SumZero, however, users can search for a 5 percent holder and find out which of its analysts is covering the company. Users can also figure out who they know in common, whether they both used to work at Goldman Sachs or even whether they attended the same business school. “We’ve taken elements from social networking and [online encyclopedia] Wikipedia and applied them to the buy side in a way that nobody really has in the past,” says Narendra.

Over time, social networking may reduce the advantage that more-sophisticated asset managers with deeper pockets enjoy over smaller firms. “You’re gaining an extension of your own staff of smart people to render an opinion,” says money manager Axelrod. Although he generally prefers anonymity when connecting with peers online, he hasn’t hesitated to take advantage of the networking opportunities afforded by SumZero, using the site to identify fellow investors with whom to strategize. “It provides avenues for what social media is all about: relationships,” says Axelrod. “Not frivolous relationships but very valuable points of access.”

Alexander Rubalcava, founder of Los Angeles–based wealth management firm Rubalcava Capital Management, agrees. He recently posted on SumZero an analysis of offshore oil exploration and production company ATP Oil & Gas Corp., which has substantial operations in the Gulf of Mexico. As the BP oil spill dragged on, the web site “helped me keep track of all the changes proposed by the government,” says Rubalcava, a former analyst at Santa Monica, California–based venture capital firm Anthem Venture Partners. “Keeping up with that was beyond any one firm, but a lot of people were exchanging their findings on SumZero.”

The market for online investment opinion is helping some firms reach new clients. Chicago-based independent equity research firm Applied Finance Group, which typically serves institutional investors and large bank trust departments, publishes a daily investment thesis on a proprietary blog called Value Expectations and regularly contributes ideas and analysis to Seeking Alpha. Co-founder Rafael Resendes says the exposure has helped introduce his firm to registered investment advisers and brokerage teams that haven’t typically been big buyers of independent research. “Who knows how this will change the client landscape,” he says.

The Big Picture’s Ritholtz also attributes business wins to his blog. His firm, Fusion IQ, runs an asset management business that has attracted more than $300 million in assets, primarily through word-of-mouth referrals. “I suspect there’s a comfort level thanks to my blog,” says Ritholtz. “It makes the process of someone validating you that much easier.”
Networking and information exchange may be especially valuable in niche areas of the market. A case in point is Distressed Debt Investors Club, the brainchild of a credit analyst who goes by the handle “Hunter” and has eight years of experience on the buy side. Hunter, who declines to reveal his real name or the name of his employer, says that about three quarters of the roughly 200 investment ideas on the web site are distressed-debt and event-driven plays, with the remainder split between equity and special-situations opportunities.

“A lot of people on the site have either formal credit training or a leveraged finance background, so people understand the bankruptcy and restructuring process,” explains Hunter, who says his site marries the best of Value Investors Club and SumZero. (He is a member of both.) “On other sites or in sell-side reports, you might not have people well versed enough to understand the implications of, say, a fraudulent conveyance ruling.”

Still, money managers trolling for new investment ideas must proceed with caution. Academic studies of retail investors have found strong evidence that stock message boards lead to confirmation bias. Studies of professional investors’ offline behavior suggest that they are prone to the same temptations. With the balkanization of online information sources and the rise of the number of networking sites for professionals, myopia is a hazard. “You run the risk of reading just the people who agree with you,” says Ritholtz.

Conflicts of interest are another danger. Seeking Alpha differentiates itself with a contributor policy that requires its bloggers, who range from hobbyist investors to professionals, to provide the site’s editors with their real names for verification purposes, even if they blog anonymously, and to disclose positions in the securities they write about. Still, compliance with the policy is not policed by the site and thus depends on contributors acting in good faith.

The founders of private buy-side communities that permit anonymity say that they too know everyone’s identity, even if fellow users don’t, and that their sophisticated, highly vetted user bases assume that people are writing about positions they already own. “It’s preselected for people who will see through pump-and-dump,” says Value Investors Club’s Greenblatt.

Will these nascent social networking sites for financiers flourish — or will they remain a pursuit for just a narrow slice of the investment community? There are challenges to growth. For starters, regulators and compliance departments alike are still trying to figure out how to adapt existing rules on disclosure, supervision and recordkeeping to the unruly world of social media communications. Many firms are ordering employees to steer clear, and in some cases they are simply blocking social media sites from office computers.

“The new technology keeps morphing,” says Margaret Paradis, a partner in the investment fund and asset management practice at law firm Baker & McKenzie in New York. “That’s the challenge on the regulatory side.”

Making money is another hurdle. Some sites, like Value Investors Club, will no doubt continue to be run as quiet side projects for a select few. But other sites, such as Seeking Alpha and SumZero, aim to become profitable businesses. Seeking Alpha relies primarily on advertising, but in October the site will launch a platform featuring more than 20 applications for stock and exchange-traded-fund research as well as screening and charting tools, says CEO Jackson. SumZero is contemplating a different model. Rather than pursuing advertising, Narendra and his partners are considering strategies for selling or licensing to third parties the investment selections and recommendations that are featured on the site.

Back on Wall Street, many of the major brokerage firms say they aren’t yet ready to discuss how they might deploy social media tools to extend the reach of their investment research. But at least one firm is taking a page from the digital media playbook. In August, Morgan Stanley became the first Wall Street firm to launch iPad and iPhone apps allowing institutional clients to search and browse its research. According to research COO Hurewitz, the firm has already begun streaming research presentations on video.

And in a world awash in information, Morgan Stanley is helping its analysts validate their investment theses by leveraging a three-year-old internal custom research group called AlphaWise, which uses tools like quantitative market research and data mining to uncover primary evidence on any topic, from casual dining trends in the U.S. to equity issuance in India.

By strengthening its research with proprietary data sources and delivering the content through new digital channels, such as apps that enable the firm to control access with a log-in, these initiatives are consistent with the firm’s protective stance in its case against Theflyonthewall.com, but at odds with the open, collaborative and freewheeling nature of the social web. Whether these two approaches to creating professional-quality investment opinion can coexist in the information age, or whether they will ultimately converge as they have in other industries, remains to be seen.

Len Costa is the director of innovation and emerging media at CFA Institute, a global association of investment professionals.

Wednesday, February 17, 2010

The Greek Problem!

The Greek Problem!
By Macrostrategy.com

The biggest issue in the global financial market at this time is whether or not Greece is going to default on its sovereign debt. That depends on Germany. Germans are not keen on bailing out the profligate Greeks but German and Euro establishment may not have much choice. We'll see how the events unfold but the Greek 5-year CDS spread (355bp) implies 28% default probability over that period. The last time a sovereign defaulted was in 2002 when Argentina abrogated its obligations to international bondholders. How Greece and Europe deal with the problem will impact the Euro and the dollar. So, what exactly is the Greek's debt problem? Why is it become so now?

Greek debt became the headline issues late last year when the finance minister announced that the country's deficit to GDP ratio for 2009 would be 12.7% instead of 6.0% originally forecast. This raised alarm bells amongst international investors because Greece needs to roll-over Euro 16 billion of its debt in April/May. As the focus on Greek finance intensified more nefarious activities started to come to light. Specifically, Greece was accused of consistently under-reporting its debt to the Eurostat, the European statistical agency by using complex derivative transactions. In actuality this was an open secret; in fact, an Italian academic Gustavo Piga wrote a paper on this exact topic back in 2002.

The genesis of the problem goes back to 2001 when Greece joined the Euro. In lieu of its entry, it had to abide by the Stability and Growth Pact (SGP) established in 1996. SGP set two important targets for member states: a debt to GDP ratio of less than 60% and a deficit to GDP ratio of less than 3%. At the time of entry, Greece was within the deficit limits but its debt was over 100%. In 2002, the European Commission pressured Greece to reduce its debt not just interest payments on those debt. In order to comply, Greece used cross-currency swaps in very innovative ways.

A cross-currency swap involves the exchange of payments denominated in one currency for payments denominated in another over fixed time period. Payments are based on a notional principal amount the value of which is fixed in exchange rate terms at the swap's inception. Like any derivatives, cross-currency swap can be used either as a hedging instrument (against exchange rate fluctuations) or as a speculative instrument (to bet on movements in currencies and yield curves). Cross-currency swaps do not change the size of debt (principal) at the beginning of the contract. At the end of the contract, debt value can change or not change based on nature of the contract. Swaps do alter periodic interest payments depending on the relative movements of exchange rates and interest rates in reference countries.

Swaps do not reduce the size of debt, just the costs of borrowing. So how were Greeks able to reduce debt using cross-currency swaps? The simple answer is because the Eurostat accountants allowed them to. ESA95, the accounting standards for government debt and deficit allowed "up-front swap payment" to reduce debt because it did not take into account the corresponding increase in payment at the end of the contract. Greece and Goldman Sachs took advantage of this accounting loophole to comply with EC's demands.

Starting 2002, Greece and Goldman Sachs entered into series of cross-currency swaps exchanging Greek's dollar-denominated and Yen-denominated debt for Euro-denominated debt. The transactions totaled about US$ 10 billion with tenor (maturity) of 15 to 20 years. Instead of using spot Euro/US$ and Euro/Yen exchange rates to swap debt, they used "off-market" rates whereby the reference Euro rates were lower than spot rates. This in effect was equivalent to one-time foreign exchange gains for Greece causing Goldman Sachs to make US$1 billion up-front payment followed by higher than otherwise periodic interest payments. As per ESA95, Greeks reported this up-front payment as a reduction in debt. The currency gain was going to reverse and Greeks were expected to payback Goldman Sachs at the end of the contract but they did not have to report that to the Eurostat. Goldman Sachs on the other hand hedged its exposure to the Greek transaction by taking off-setting positions with Frankfurt-based Deutsche Pfandbriefe Bank.

The bottom line is that Greece will not be able to roll-over its debt without some kind of international guarantee but what form that takes and who leads it (Germany or IMF) if at all is an open question. Lets see how this plays out!

Reference
Bank of America, January 2007. Introduction to Cross Currency Swaps
Bernard Connolly and John Whittaker. What will happen to the euro? (6-Nov-2002)
BMO Capital Markets. Cross Currency Swaps
Economist. Financial WMD? (22-Jan-04)
Gustavo Piga. Do Governments Use Financial Derivatives Appropriately? Evidence from Sovereign Borrowers in Developed Economies, International Finance, Vol 4 # 2 (16 Dec 2002)
Nick Dunbar, Risk Magazine. Revealed: Goldman Sachs’ mega-deal for Greece (1-Jul-03)
Vishal_Damor. Greece Soverign Debt Crisis, The Way Forward, if Any! (11-Feb-10)
Wolfgang Reuter. Greek Debt Threatens the Euro, Spiegel (8-Dec-09)

Tuesday, February 16, 2010

2003 Risk Magazine Article Exposes Greeks-Goldman Swaps

Revealed: Goldman Sachs’ mega-deal for Greece
Risk magazine, 01-Jul-2003
By Nick Dunbar

With the help of Goldman Sachs, Greece has been using giant swaps deals to ensure its national debt ratios meet EU targets. But these deals are likely to prove controversial. By Nicholas Dunbar

Ever since the deficit and debt rules for eurozone member states were drawn up in the early 1990s, there have been persistent rumours and allegations that governments have used derivatives to get around them. For some time, economists have argued that the combination of strict external targets with considerable local autonomy in sovereign debt management almost inevitably leads high-deficit countries towards derivatives.

It is now widely known that since 1996, Italy’s Treasury has regularly used swaps transactions to optically reduce its publicly reported debt and deficit ratios. Such trades remain controversial, and were the subject of fierce debate in late 2001, when Italian academic Gustavo Piga published a paper accusing eurozone countries of ‘window dressing’ their public accounts using derivatives (Risk January 2002, page 17).

Now, Italy has been joined by the Hellenic Republic of Greece, as evidence emerges of a remarkable deal between the public debt division of Greece’s finance ministry and the investment bank Goldman Sachs. The deal is not only likely to reopen an old debate on public accounting for derivatives, but also sheds light on the way banks charge clients for taking credit and market risk exposure.

Intended to rein in fiscal profligacy among aspiring eurozone entrants, the Stability and Growth Pact (SGP) – established in 1996 – sets two important targets for member states: a debt/GDP ratio of less than 60% and a deficit/GDP ratio of less than 3%. Of the two, the second is considered more important. Countries that show persistent breaches of the 3% target are liable to pay heavy fines to Brussels of up to 0.5% of GDP under the so-called Excessive Deficit Programme (EDP). Performing the key regulatory role of determining whether the targets have been met is the European Statistical Office (Eurostat).

Greece, which joined the single currency in early 2001, resembles mid-1990s Italy in certain respects. Until recently it was a country of high deficits and high inflation, and for this reason did not bother joining the first wave of eurozone countries in 1998. In the run-up to joining the eurozone, Greek inflation and budget deficits fell sharply, and GDP grew as the incumbent socialist government pursued a policy of UK-style public-sector reform. However, like Italy, Greece’s debt/GDP ratio has remained high, at over 100%, and as a result its interest costs are the highest in the eurozone.

Public statement

In November 2001, the Greek finance ministry’s public debt division made a public statement about its debt management strategy. It acknowledged that its debt was a ‘critical macroeconomic parameter’, and pledged to reduce debt servicing costs by means that included ‘the extensive use of derivatives’. Apparently, this was not enough for Brussels. In February 2002, the European Commission pointed out future deficit forecasts by Greece relied ‘primarily’ on achieving reductions in interest costs. It called for Greece to reduce its ‘very high’ debt ratio, and to provide ‘more detailed information on financial operations’.

Although Greece’s public debt division points out that it uses 18 derivatives counterparties, there is no doubt that the division, which is headed by Christopher Sardelis, has a particularly close relationship with Goldman Sachs. Indeed, the account has been handled personally at Goldman Sachs by Antigone Loudiadis, the London-based European head of sales for the firm’s fixed-income, currencies and commodities unit. Highly respected by other dealers, Loudiadis has enjoyed a successful career at Goldman, joining the firm’s partnership committee and attaining her present position in 2000. According to sources, by early 2002, Loudiadis and her team put together a deal aimed at alleviating Greece’s problem of debt ratios and high interest costs.

The transactions agreed between the Greek public debt division and Goldman Sachs involved cross-currency swaps linked to Greece’s outstanding yen and dollar debt. Cross-currency swaps were among the earliest over-the-counter derivatives contracts to be traded, and have a perfectly routine purpose in debt management, namely to transform the currency of an obligation.

For example, an issuer with foreign fixed-rate debt might choose to lock in a favourable exchange rate move. To do this, it could swap a stream of fixed domestic currency payments for a stream of foreign currency ones, referenced to the notional of the debt using the prevailing spot foreign exchange rate, with an exchange of the two notionals at maturity. Because they are transacted at spot exchange rates, cross-currency swaps of this type have zero present value at inception, although the net value (and credit exposure of either counterparty) may subsequently fluctuate.

However, according to sources, the cross-currency swaps transacted by Goldman for Greece’s public debt division were ‘off-market’ – the spot exchange rate was not used for re-denominating the notional of the foreign currency debt. Instead, a weaker level of euro versus dollar or yen was used in the contracts, resulting in a mismatch between the domestic and foreign currency swap notionals. The effect of this was to create an upfront payment by Goldman to Greece at inception, and an increased stream of interest payments to Greece during the lifetime of the swap. Goldman would recoup these non-standard cashflows at maturity, receiving a large ‘balloon’ cash payment from Greece.

Since neither Goldman nor Greece will comment on the deal, much of the details remain vague. It is not clear which exchange rates were used in the actual contracts. Under the terms of a similar ‘off-market’ deal transacted by Italy in 1997, the exchange rates prevailing at the time of the underlying bond issue were used, which would have made sense in the case of Greece since the deal happened after a period of euro strengthening against the yen and dollar.

Although the overall deal is believed to have consisted of three or four individual transactions or tranches, according to sources, the total cross-currency swap notional was approximately $10 billion, with tenors ranging from 15 to 20 years. While the size of upfront payment to Greece’s public debt division is not clear, it seems the total credit risk incurred by Goldman Sachs was roughly $1 billion. Effectively, Goldman Sachs was extending a long-dated illiquid loan to its client.

Goldman Sachs is known for its conservative approach to credit risk, and chose to hedge its exposure to Greece by immediately placing the risk with a well-known investor in sovereign credit: Frankfurt-based Deutsche Pfandbriefe Bank (Depfa). According to sources, Depfa entered into a credit default swap with Goldman Sachs, selling $1 billion of protection on Greece for up to 20 years. Depfa declined to comment.

Total charge

Details have also emerged of the way Greece’s public debt division was charged for the transaction. According to market sources, the total charge was approximately $200 million. This charge can be broken down into several components. First, Greece was charged for the credit risk in the transaction. Long-dated Greek government bonds were trading at a spread of 30 basis points in 2002. A billion-dollar investment in such bonds, purchased in asset swap form and held for 20 years, would yield about $60 million. According to Risk’s sources, Depfa demanded a substantial premium for taking on what was in effect an illiquid, privately placed loan.

Second, Greece paid a principal risk charge to Goldman Sachs for its market risk exposure. Although standard euro/dollar and euro/yen cross-currency swaps are highly liquid instruments that trade at tight bid-offer spreads in the interbank market, such large, off-market transactions cannot be hedged in this market without significantly moving the price against the dealer. Goldman Sachs may have hedged some of the risk using futures, forwards and interest rate swaps, while retaining substantial cross-currency and interest rate basis risks in its portfolio. Of course, the ultimate profit and loss experienced by Goldman Sachs on the transactions remains unknown.

Equally murky is the exact effect of Goldman Sachs’ transactions on Greece’s publicly reported national accounts. Since the deficit was a comfortable 1.2% of GDP in 2002, it is more likely that the cashflows were either used to help lower the debt/GDP ratio from 107% in 2001, to 104.9% in 2002 (by funding buybacks) or to lower interest payments from 7.4% in 2001 to 6.4% in 2002. But why did the large negative market value of the swaps not appear on the liability side of Greece’s balance sheet?

The answer can be found in ESA95, a 243-page manual on government deficit and debt accounting, published by the European Commission and Eurostat in 2002. As revealed by Piga, the drafting of ESA95’s section on derivatives was the subject of fierce arguments between the government statisticians and debt managers of certain eurozone countries.

The statisticians wanted derivatives-related cashflows to be treated as financial transactions, with no effect on deficit or interest costs, and with the derivatives’ current market value stated as an asset or liability. The debt managers opposed this, insisting on having the freedom to use derivatives to adjust deficit ratios. The published version of ESA95 reflects the victory of the debt managers in this argument with a series of last-minute amendments.

In particular, ESA95 states in a page-long ‘clarification’ that ‘streams of interest payments under swaps agreements will continue… having an impact on general government net borrowing/net lending’. In other words, upfront swap payments – which Eurostat classifies as interest – can reduce debt, without the corresponding negative market value of the swap increasing it. According to ESA95, the clarification only covers ‘currency swaps based on existing liabilities’.

Legitimate transaction

There is no doubt that Goldman Sachs’ deal with Greece was a completely legitimate transaction under Eurostat rules. Moreover, both Goldman Sachs and Greece’s public debt division are following a path well trodden by other European sovereigns and derivatives dealers. However, like many accounting-driven derivatives transactions, such deals are bound to create discomfort among those who like accounts to reflect economic reality. For example, the Greece-Goldman deal may be of interest to credit rating agency Standard & Poor’s, which upgraded Greece’s long-term debt from A to A+ in June 2003.

Among other derivatives dealers, the deal is bound to create envy at Goldman Sachs’ skill in solving the risk management needs of such an important client. As long as the current Eurostat rules do not change, the use of derivatives in deficit and debt management by eurozone sovereigns is likely to flourish. The planned expansion of the eurozone to include 15 east European countries may lead to especially rich pickings for dealers able to seize such opportunities.

Monday, February 16, 2009

Summary Provisions of $789 billion Stimulus Package

AP, 12-Feb-09

Many provisions of the nearly $789 billion compromise stimulus plan expire in two years. Additional debt costs would add about $330 billion over 10 years.


Highlights:

Aid to poor and unemployed
$40 billion to provide extended unemployment benefits through Dec. 31, and increase them by $25 a week; $20 billion to increase food-stamp benefits by 14%; $3 billion in temporary welfare payments.

Direct cash payments
$14 billion to give one-time $250 payments to Social Security recipients, poor people on Supplemental Security Income, and veterans receiving disability and pensions.

Infrastructure
$46 billion for transportation projects, including $27 billion for highway and bridge construction and repair; $8.4 billion for mass transit; $8 billion for construction of high-speed railways and $1.3 billion for Amtrak; $4.6 billion for the Army Corps of Engineers; $4 billion for public housing improvements; $6.4 billion for clean- and drinking-water projects; $7 billion to bring broadband Internet service to underserved areas.

Health care
$21 billion to provide a 60% subsidy of health care insurance premiums for the unemployed under the COBRA program; $87 billion to help states with Medicaid; $19 billion to modernize health information technology systems; $10 billion for health research and construction of National Institutes of Health facilities.

State block grants
$5 billion in aid to states to use as they please to defray budget cuts.

Education
$54 billion in state fiscal relief to prevent cuts in state aid to school districts, with up to $10 billion for school repair; $26 billion to school districts to fund special education and the No Child Left Behind law for students in K-12; $17 billion to boost the maximum Pell Grant by $500 to $5,350; $2 billion for Head Start.

Homeland security
$2.8 billion for homeland security programs, including $1 billion for airport screening equipment.

Law enforcement
$4 billion in grants to state and local law enforcement to hire officers and purchase equipment.

Taxes
New tax credit
About $115 billion for $400 per-worker, $800 per-couple tax credits in 2009 and 2010. Credit phases out for individuals with adjusted gross incomes of $75,000 to $90,000 and couples with AGI of $150,000 to $190,000.

Alternative minimum tax
About $70 billion to spare about 24 million taxpayers from being hit with the alternative minimum tax in 2009. The change would save a family of four an average of $2,300.

Expanded college credit
About $13 billion to provide a $2,500 expanded tax credit for college tuition and related expenses for 2009 and 2010. The credit is phased out for couples with incomes over $160,000.

Home buyer credit
$3.7 billion to repeal a requirement that an $8,000 first-time home buyer tax credit be paid back over time for homes purchased from Jan. 1 to Aug. 31, unless the home is sold within three years.

Bonus depreciation
$5 billion to extend a provision allowing businesses buying equipment such as computers to speed up depreciation through 2009.

Auto sales
$2.5 billion to make sales tax paid on new car purchases tax deductible.

Wednesday, January 07, 2009

Today's Reading List

CORPORATE GOVERNANCE
Satyam Chief Admits Huge Fraud

NYT, 7-Jan-09

Mr. Raju said Wednesday that 50.4 billion rupees, or $1.04 billion, of the 53.6 billion rupees in cash and bank loans the company listed as assets for its second quarter, which ended in September, were nonexistent... In the four-and-a-half page letter distributed by the Bombay stock exchange, Mr. Raju described a small discrepancy that grew beyond his control.

Satyam Computer Services, a leading Indian outsourcing company that serves more than a third of the Fortune 500 companies, significantly inflated its earnings and assets for years, the chairman and co-founder said Wednesday, roiling Indian stock markets and throwing the industry into turmoil
...

REAL ESTATE
Commercial Property Loses Shelter

WSJ, 8-Jan-08

New data from Deutsche Bank show that delinquencies on commercial mortgages packaged and sold as bonds nearly doubled during the past three months, to about 1.2%. The delinquency rate will likely hit 3% by the end of 2009... An unusually high number of the underlying CMBS loans that are going bad were made and securitized in the past three years... a $125 million mortgage secured by a shopping center in Corona, Calif. called Promenade Shops had cash flow of $6.3 million when J.P. Morgan underwrote the loan in July 2007 but the loan was based on the assumption that the cash flow would rise to about $10.5 million.

Delinquencies on mortgages for hotels, shopping malls and office buildings were sharply higher in the fourth quarter, as the weaker economy hit landlords and threatens to cause losses for investors in the $3.4 trillion market
...

VALUATION IMPAIRMENT
Timely Warning on Cable Values
WSJ, 8-Jan-08

A key determinant of asset impairment, in addition to market prices, is the long-term cash-flow generation potential of a business... By resetting the level of shareholders' equity through write-off they enhance future returns on shareholders equity.

Shareholders in cable-TV companies might have forgotten in recent weeks -- as they have congratulated themselves on their foresight in owning relatively recession-proof stocks -- that the industry isn't without its competitive challenges from phone companies and the Internet
...

TECHNOLOGY
Intel Outlook Pared Again; Rivals Unveil New Products
WSJ, 8-Jan-09

Intel said Wednesday it now expects to report $8.2 billion in revenue for the fourth quarter and the company had projected in mid-October that sales would rise 3% from the third period...The company also said that its gross profit margins will be at the bottom of the lowered estimate it issued in November of 55%, plus or minus a couple of percentage points. In mid-October, the company had said the range would center around 59%.

Intel Corp. issued a second warning about deteriorating business conditions, signaling further weakness in the computer sector
...

OIL
Bahrain Credit Outlook Is Downgraded
WSJ, 7-Jan-09

"Break even" oil prices for Iran ($90), Oman ($77), Bahrain ($75), Saudia Arabia ($49), Kuwait ($33), Qatar ($24), UAE ($23)... Bahrain holds fewer liquid assets -- such as foreign-exchange reserves or investments by government-controlled funds -- than other regional oil exporters... Last month, Saudi Arabia said it expects to run its first budget deficit in years, committing itself to spending heavily despite an expected fall in oil revenue.

Moody's Investors Service downgraded the credit outlook for the Kingdom of Bahrain on Tuesday, marking the first sovereign-rating hit to the oil-rich Persian Gulf amid tumbling crude prices and the global financial crisis
...

COMMODITIES
Steelmakers Move Cautiously To Raise Prices, Reopen Mills
WSJ, 7-Jan-09

Troubled auto makers, contractors, appliance and equipment makers have cut back on their steel purchases. The majority of mills closed over the last few months remain shuttered and many around the world are operating below 50% of their capacity... In China, several steel mills have announced price increases ranging from 5% to 25% for a variety of products.

In an early sign that some steel prices may have bottomed out, steelmakers in the U.S., China and some other countries are attempting limited price increases and reopening a handful of mills that were closed because of weak demand a few months ago
...

CREDIT
Defaults Pose a Reckoning for Stock Rally
WSJ, 7-Jan-09

U.S. investment-grade corporate-bond issuance jumped to $108 billion in December, according to Dealogic, near the record $111 billion set in May, and up from a nadir of $15 billion in September... In the U.S. alone, some $758 billion in corporate debt is coming due in 2009, according to Standard & Poor's.

Credit-worthy companies have recently found a healthy appetite for their new debt. It is the older stuff that could cause trouble, both for corporate borrowers and stock investors
...

The “Basic Speed Law” for Capital Markets Returns

The “Basic Speed Law” for Capital Markets Returns
CFA Magazine
November/December 2008, Vol. 19, No. 6

The return of stock prices to levels more consistent with economic growth is mean reversion at work

Recent stock market behavior has been astonishing—down 22 percent in the first half of October, down more than 40 percent in the past 12 months. Much of this drop has been blamed on the current financial crisis, but there are deeper—and yet simpler—economic forces at work. Three truisms are too easily overlooked.

The first truism is that over the long-run real per capita economic growth in the United States, over and above inflation, has been remarkably steady at 1–2 percent, as the top line in Figure 1 shows. Growth over the past 25, 50, and 100 years has averaged 1.4 percent, 1.7 percent, and 1.9 percent, respectively. This real growth rate reflects improving productivity, which over periods of decades varies little. Share prices (the middle line) and per-share earnings for the broad market (the bottom line) exhibit much the same growth, albeit with much more variability. One nuance is often overlooked: Just as the economy is the shared production of a growing population, a growing roster of companies drives that economic growth. Entrepreneurial capitalism—new enterprise creation— is an important driver of economic growth, contributing roughly half of real GDP growth, on average, over time. The other half of overall real GDP growth is contributed by the growth of existing enterprises. This means that share prices and per-share earnings for broad indexes, such as the S&P 500, should match the growth of existing enterprises, roughly half of total GDP growth. As it happens, this growth closely mirrors per capita GDP growth.

The second truism is that if the aggregate real per capita growth rate in the economy is a bit under 2 percent, the broadest sectors of the economy, such as the corporate sector, have to deliver about the same per capita growth rate in the long run. If the growth rate were greater, that sector would eventually become larger than the entire economy, an outcome that is constrained by both economic and political forces.

Over the past several decades, Americans at all levels in business, government, and private life have behaved as if these first two truisms were no longer relevant. Implicitly, and in some cases explicitly, decisions were made, including investment decisions, that were based on the assumption of far greater growth. A common refrain was that even if real per capita growth in the aggregate economy is limited to about 2 percent, that does not apply to us or to our investments, whether our domain is housing, technology stocks, hedge fund investments, or the stock market.

The third truism is that valuation of long-lived assets, such as common stocks, are highly sensitive to the assumed rate of growth. The experience of Google is an obvious example; the stock price has plummeted to $330 from $750, despite continued impressive growth in earnings, because the earnings growth has not been fast enough to justify an initially lofty multiple and expectations for future growth have been continuously revised downward.

Applying these three facts to the market as a whole leads to several stark conclusions. First, as with any broad sector of the economy, corporate earnings are constrained by the same long-run 2 percent speed limit. This means that unless P/Es change, stock prices will also grow, on average, at no more than 2 percent in real terms for the truly long-term investor.

History supports this view. In the past 25, 50, and 100 years, real growth in S&P 500 per-share real earnings has averaged 3.2 percent, 2.0 percent, and 1.5 percent, respectively. Meanwhile, the S&P 500 price index has risen by 5.1 percent, 2.7 percent, and 1.9 percent, respectively, over and above inflation. The earnings have grown faster than per capita GDP growth in recent years, in large measure because of recent earnings that have subsequently proven illusory. Meanwhile, share prices have grown faster still, largely on the back of rising valuation multiples, which we dare not rely on in the future. This recent outsized growth in real per-share earnings and share prices, over and above the per capita real growth of the economy, may be helping to foment the populist backlash we’re now seeing.

In this historical light, the current crisis is seen as more than simply the result of a housing bubble or an overstressed financial system. It is based on a widespread hubris that somehow the laws of economic growth do not apply, that share prices and earnings can grow faster than the overall economy. That hubris was reinforced by organizational structures that allowed executives, insurers, derivatives traders, bankers, and many others to take large amounts of cash home as long as the euphoria continued and as long as customers were willing to set aside logic in favor of a promised nirvana.

The ultimate return of stock prices to levels more consistent with economic growth is nothing more than another example of mean reversion at work. The good news is that, from current levels, mean reversion need not exact as severe a future toll as it has imposed on us in the past 12 months. This too shall pass.

Brad Cornell is a visiting professor of finance at the California Institute of Technology and a senior consultant to Charles River Associates. Rob Arnott is chairman of Research Affiliates, LLC, and former editor of the Financial Analysts Journal.

Monday, January 05, 2009

Today's Reading List

RISK MANAGEMENT
Risk Mismanagement
NYT, 4-Jan-09
By JOE NOCERA

VaR isn’t one model but rather a group of related models that share a mathematical framework. In its most common form, it measures the boundaries of risk in a portfolio over short durations, assuming a “normal” market. For instance, if you have $50 million of weekly VaR, that means that over the course of the next week, there is a 99 percent chance that your portfolio won’t lose more than $50 million... one of VaR’s flaws, which only became obvious in this crisis, is that it didn’t measure liquidity risk... the big problem was that it turned out that VaR could be gamed... It (the risk of CDS) was outside the 99 percent probability, so it didn’t show up in the VaR number. People didn’t see the size of those hidden positions lurking in that 1 percent that VaR didn’t measure.

THERE AREN’T MANY widely told anecdotes about the current financial crisis, at least not yet, but there’s one that made the rounds in 2007, back when the big investment banks were first starting to write down billions of dollars in mortgage-backed derivatives and other so-called toxic securities
...



REAL ESTATE
U.S. commercial property in a downward spiral
NYT, 5-Jan-09
By Charles V. Bagli

The Urban Land Institute predicts 2009 will be the worst year for the U.S. commercial real estate market "since the wrenching 1991-1992 industry depression"... Regional banks may be an even bigger concern. Over the past decade, they barreled their way into commercial real estate lending after being elbowed out of the credit card and consumer mortgage business by national players. Their weighting in commercial real estate has nearly doubled in the past six years, according to government data... In 2006 and 2007, nearly 60 percent of commercial property loans were turned into securities... Effective rents, which have already started to fall, are expected to decline 30 percent or more across the country from the euphoric days of the real estate boom, according to real estate brokers and analysts... The Real Estate Roundtable sees a rising risk of default and foreclosure on an estimated $400 billion in commercial mortgages that come due this year... Already, $107 billion worth of office towers, shopping centers and hotels are in some form of distress.
Vacancy rates in office buildings exceed 10 percent in virtually every major city across the United States and are rising rapidly, a sign of economic distress that could lead to yet another wave of problems for the beleaguered financial sector
...



Monday, December 22, 2008

Today's Reading List

GOVERNMENT SPENDING
A Trap in Obama’s Spending Plan

NYT, 20-Dec-08
By LOUIS UCHITELLE

Public spending, American style, has worked best in good times, when people have jobs and executives are eager to invest. A new public highway is soon lined. A dollar spent by government generates three or four from the private sector... For all the money spent by the Roosevelt administration, public investment was failing to jump-start a key private-sector industry... Like Roosevelt’s dams, Mr. Obama’s expenditures will no doubt generate jobs and wages in the construction phase. But in 1937, Roosevelt, thinking that the private sector could sustain itself, pulled back on public spending. Some historians say this was a big reason the economy sank again.

As the recession deepens, President-elect Barack Obama is gearing up to spend hundreds of billions of dollars on public investment projects, counting on them to lift the economy, as they have in the past
...

CREDIT
Debt Recovery Prospects Darken

WSJ, 22-Dec-08

Professor Ed Altman of New York University's Stern School of Business expects 11% to 11.5% of U.S. high-yield bonds outstanding at the end of the third quarter to default within a year. His proprietary model suggests average recovery, given that default rate, of about 27 cents on the dollar... Loose covenants and the use of payment-in-kind (PIK) "toggles" exacerbate the problem.... There are two bigger problems for creditors to contend with. One is the higher use recently of senior loans, fueled by demand for collateralized loan obligations. The second problem is scarce debtor-in-possession (DIP) and exit financing: the credit extended to bankrupt firms to help them restructure and emerge from Chapter 11.

Bankrupt debtors used to be thrown in jail. Do that now, and America's prison system would collapse. Rather than seek incarceration, today's creditors are focusing on extracting better recovery rates: the amount they get back on defaulted debt. Unfortunately, excessive leniency during the boom years means not only having to deal with more defaults, but also getting very little back when that happen
...

CREDIT, REAL ESTATE
Developers Ask U.S. for Bailout as Massive Debt Looms
WSJ, 22-Dec-08

530 billion of commercial mortgages will be coming due for refinancing in the next three years -- with about $160 billion maturing in the next year... Unlike home loans, which borrowers repay after a set period of time, commercial mortgages usually are underwritten for five, seven or 10 years with big payments due at the end. At that point, they typically need to be refinanced. A borrower's inability to refinance could force it to give up the property to the lender.... At the heart of the financing scarcity is the virtual shutdown of the market for CMBS, where Wall Street firms sliced and diced commercial mortgages into bonds.... While commercial real-estate developers restrained themselves during the boom years when it came to speculative development, property investors bid up the prices of office buildings, malls and other projects to record levels assuming rents and occupancies would keep rising. With cash flows now falling, a growing number of developers are having a tough time repaying their debt... Delinquencies on commercial mortgages jumped to 0.96% in November, up from 0.62% in September. Some analysts predict the delinquency rate will leap to 2% by the end of next year. During the real-estate collapse of the early 1990s, the worst-performing commercial mortgages -- those that were made in 1986 -- sustained losses of about 10%.

With a record amount of commercial real-estate debt coming due, some of the country's biggest property developers have become the latest to go hat-in-hand to the government for assistance
...

PHARMA
Pharmacies Fight Tough Battle on Generic Prices
WSJ, 22-Dec-08

Retail pharmacy generic discount programs have proliferated since Wal-Mart Stores Inc. introduced $4 generic prescriptions for one-month supplies of hundreds of unbranded drugs in 2006, and mass merchandisers and grocery stores responded with their own versions... Walgreen this summer started strongly marketing its Prescription Savings Club, which provides discounts on generics and 5,000 branded medications and rebates on store-brand products... CVS this fall introduced a discount program aimed at the uninsured, offering a 90-day supply of more than 400 generic drugs for $9.99 and a 10% discount at the company's store-based clinics... Rite Aid in late September rolled out nationally a prescription savings card offering hundreds of generic drugs at $8.99 for a 30-day supply or at $15.99 for a 90-day supply, plus discounts on branded drugs and Rite Aid products.

Retail pharmacies are waging what some consider a generic-drug price war that is threatening margins in a typically high-profit area and reflects the intense competition that drug-store chains face in attracting and keeping customers ...

CURRENCY
Why didn't the dollar collapse

Paul Krugman