Wednesday, October 31, 2007

Whose Fed Is It Anyway?

The 180 the Fed sprung on everyone last month needs to be rectified and clarified with today’s rate decision and subsequent minutes by sending a clear and convincing signal that this Fed and not Wall Street’s bankers is calling the shots based on the needs of the economy and not the needs of bankers who made poor business decisions. The key word in the previous sentence is convincing for everyone knows what were the stated reasons for last month’s reversal. However, as with the claims of Patriots coach Belichick that they are not running up the score, the rhetoric doesn’t seem to match the actions.

Investment Strategy Implications

History demonstrates that rate cuts result in increased asset values. In the multi decade, mega trend of the Debt Supercycle (see prior commentaries) with the tipping point of too much debt still in the future plus the powerfully positive effects of globalization, the productivity and growth benefits from advances in information and communications technologies, and the embracing of market economies in nearly all segments of the world, rate cuts will produce higher asset values.

Moreover, given realistic expectations that a US slowdown will result in only a modest decline in global growth, a sustained decline in the cost of capital is yet another reason why rate cuts will result in higher asset values in such an environment. The risks are, however, on both the inflationary and central bank credibility side.

With global growth as strong as it is, high levels of liquidity, high levels of growth of liquidity (see previous comments re MZM), strong balance sheets (corporate and nation states), and reasonable valuations the investment strategy decision comes down to the expansion and contraction of the asset allocation mix (cyclical/tactical calls) and the sector and style picks for what increasingly looks like an emerging inflationary global environment.

Improvisation may work well on the entertainment stage. But in the high stakes game of global finance and the world economy, the risks of sending the wrong message via a decision process that is confused, if not conflicted, are great. Knowing whose Fed it is would help.

Have a fun Halloween.

Tuesday, October 30, 2007

The Year End Rally in Waiting

Now that we are well into the current earnings season several earnings trends are matching recent stock performance, most notably the polar ends of the performance scale - Financials and Tech. As the table* to your left shows, however, the overall earnings picture ex Financials is about in line with expectations - low single digit growth.

Investment Strategy Implications

Once tomorrow's Fed rate decision is behind us, the year end price action for equities will depend in part on the answers to three key questions:

• Will the US economy experience a soft or hard landing?
• Has the global economy decoupled from the US to a sufficient degree that will enable global growth to remain robust?
• How far along are we in the black hole of credit derivatives discovery process?

Notwithstanding all the issues that threaten to derail the aging bull, with liquidity so abundant, corporate and nation state finances in excellent shape, valuation levels reasonable, and technicals in compliance, should all three questions be answered in the affirmative the odds for a decent if not strong end of year rally are high.

*Click image to enlarge.
Source: Wall Street Journal

Monday, October 29, 2007

Surfing the Liquidity Wave

excerpts from this week's report:

"Summer may have ended but not so for the liquidity boys. The boards remain well waxed and the investment/trading surfers continue to seek the perfect wave.

With MZM growth now averaging 20% (see report)..."

Investment Strategy Implications

"The global macro crisis in progress will lead to a day of reckoning but that day has been forestalled time and again thanks to the bounty of liquidity and easy money. Hedge funds and private equity have not witnessed a reduction in their collective $2.5 trillion. And that money, like the excess liquidity the Fed has pumped into the real economy, has to go somewhere. Where that capital is deployed should be the focus of equity investors regardless of their justifiable concerns over a debasing US dollar and emerging market bubbles.

Until such time when the technical indicators warn of a mega trend change, financial assets that are not tainted with..."

also in this week's report:

* Valuation Model
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus: Dollar versus Euro - The Crowded Trade Rally
* Sectors and Styles Market Monitor
* Key Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

Friday, October 26, 2007

Quotable Quotes: Ben Graham

While preparing for the fall Equity Analysis classes that I teach for NYSSA, I came across this priceless quote from Ben Graham. Most fitting in the current age of financial wizardry.

"In a manuscript from 1936 (reprinted in Ellis 1991), Benjamin Graham pictures the chair of a major coproation outlining how his company will return to profitability in the middle of the Great Depression of the 20th Century:

"Contrary to expectations, no changes will be made in the company's manufacturing or selling policies. Instead, the bookkeeping system is to be entirely revamped. By adopting and further improving a number of modern accounting and financial devices the corporation's earning power will be amazingly transformed."

The top item on the chair's list gives a flavor of the progress that will be made: "Accordingly, the Board has decided to extend the write-down policy initiated in the 1935 report, and to mark down the Fixed Assets from $1,338,552,858.96 to a round Minus $1,000,000,000...As plant wears out, the liability becomes correspondingly reduced. Hence, instead of the present depreciation charge of some $47,000,000 yearly there will be an annual appreciation credit of 5 percent, or $50,000,000. This will increase earnings by no less than $97,000,000 per annum." Summing up, the chair shares the foresight of the Board: "...The Board is not unmindful of the possibility that some of our competitors may seek to offset our new advantages by adopting similar accounting improvements...Should necessity arise, moreover, we believe we shall be able to maintain our deserved superiority by introducing still more advanced bookkeeping methods, which are even now under development in our Experimental Accounting Laboratory."

"Equity Asset Valuation"
Stowe, Robinson, Pinto, and McLeavey

The more things change, the more they remain the same. Simply substitute credit derivatives for manufacturing and asset values for depreciation and viola!

Have a good weekend.

Thursday, October 25, 2007

Technical Thursdays: Playing to Win

What September giveth October taketh away.

The October takeaway of September’s Fed rate cut inspired gift is right on schedule. FUD (fear, uncertainty, and doubt) has returned and angst is on the rise again. No surprise from this strategist’s perspective.

As noted at the start of both September (see “September Swoon? Not Likely”) and October (Boo!) the commentary on this blog and in my reports forecast a market that would be a net zero by the time Halloween came and went (see prior blog postings). And while only a crazy man would try to be so cute in timing each wiggle and swiggle of a highly dynamic economic and market environment, sometimes conditions line up just right where making such a call is worth the risk. Playing to win trumps playing not to lose.

The fundamental argument for the net zero view centers on the unresolved credit problems that were first considered dealt with when the Fed cut the discount rate as the momentum lemmings put their mountain of capital to work. A little premature and quite a bit simplistic, to say the least.

The unresolved credit derivative’s risk factor is counterbalanced by the positive effects of high degrees of liquidity (aided further by the Fed’s dubious rate cut), very strong balance sheets (corporate and government), and strong global growth, among others that have been noted on this blog and in prior reports time and again.

One technical argument (among others) for a flat September/October time period is illustrated in the above chart on the S&P 500. Applying my long term price action indicator, the moving averages principle*, to the current price action of the S&P 500 it is plain to see that no violation of three elements of the principle – price relative to moving averages, 50 day relative to 200 day, and the slope of both moving averages – has occurred. Therefore, until all three conditions are met, the established trend must be assumed to be the mega trend in force. Which is another way of saying it’s a bull market ‘til it ain’t. And ain’t happens when a major market top is formed, part of which involves the aforementioned moving averages principle.

Investment Strategy Implications

From a technical perspective, the current October correction of September’s rate cut mini euphoria suggests a move to the 200 day moving average, which is right around 1470. Given the strong downward move in MACD, should the S&P 500 reach 1470, it will probably have to trade around that level for a short while thereby repairing the technical damage that all corrections produce before any November/December year end rally can get underway. My estimate is < 2 weeks. Then it’s off to the year end races.

*See prior Technical Thursdays entries for more info on the moving averages principle.

To view a larger version of the charts, click on the image.

Wednesday, October 24, 2007

The Hidden Value in Valuation Models: The Message of Mr. Market

"I think therefore I predict."

This is the motto of all investment strategists. And rightly so for what other purpose does an investment strategist serve than to analyze then predict? There is, however (you knew there was an however coming), a complementary role that an investment strategist serves which is to assess the valuation calls made by Mr. Market expressed in the form of an expected return. Accordingly, using the simple yet very effective Modified Fed Model above (click on table for larger image) we can explore some of the predictive elements of Mr. Market.

As of yesterday’s close, the inputs for equities (S&P 500) and interest rates (10 year US Treasury) are 1520 and 4.41%. Operating earnings estimates for the S&P 500 for 2007 are right around $92. Now, if operating earnings for S&P 500 for 2007 come in around $92, full value for the S&P 500 is somewhere between around 1700 and 1766. That interprets into a 12 to 16% gain from current levels. Not bad for just over 2 months! However, as tantalizing as an average of 14% for 2 months (84% annualized) might be, it is more reasonable to assume that Mr. Market has some other time frame and set of inputs in mind.

Let’s say Mr. Market is a good student of market history. Therefore, he is looking beyond the next 2 months and well into 2008. Perhaps he is looking as far ahead as the next twelve months, give or take. Under those circumstances, Mr. Market seems to be gravitating more toward a more traditional annual rate of return, something closer to the long-term return on large cap equities of 12%.

In that case, to produce a 12% return Mr. Market seems to be calling for one of several scenarios to unfold. In one assumption, rates and operating earnings rise by ½ % and 4.3%, respectively. In another, rates remain unchanged while earnings slump 4.3% from $92 to $88*. (Both are highlighted in the boxed areas of the yellow shaded zone.) Or perhaps both rates and earnings remain unchanged (boxed returns noted above).

Investment Strategy Implications

The question an investor needs to answer is “What are the probabilities of certain earnings and interest rate scenarios given specific inputs?”

All investment strategists have their views. We pontificate on them with great regularity. Nevertheless, it is incumbent upon every investment strategist and investor to attempt to understand just what Mr. Market is saying in the form of scenarios based on rates of return, be it this valuation model or some other that has a comparable track record.

At present, Mr. Market is in a fairly narrow zone of probable outcomes. That will no doubt change as the multi faceted aspects of the valuation inputs evolve over the coming months and year ahead. Then again there is the possibility that Mr. Market is way off the mark and rates and/or earnings move dramatically away from the narrow zone currently forecasted.

Getting that call right generates the alpha all investors fervently desire, something Mr. Market just cannot help provide. What's your call?

*Of course, a third option exists – the model is all wrong. The inputs are too high, too low, or just plain irrelevant. While this may be the case, the fact that the inputs and the adjustments made (raising the capitalization factor, the 10 year Treasure rate, by 80 to 100 basis points) are derived from actual experience over the life of the current bull market suggests that there is some validity in its methodology.

Tuesday, October 23, 2007

Info Tech, Growth Investing, and the Crowded Trade

“…every monetary tightening cycle has almost always produced a financial or economic crisis, which in turn has marked the beginning of a new reflation cycle.”

Bank Credit Analyst
Strategy Outlook Part 1 – Fourth Quarter 2007, September 14, 2007

The reflation cycle is well underway. The Debt Supercycle (see report October 15, 2007) underpins the perpetual rise in assets, rolling from one to the next, producing bubble after bubble only to have the bursting bubble be resolved with more liquidity. And so the story goes.

Accompanying the Debt Supercycle is the tendency of sectors to get overowned producing a crowded trade. And an opportunity for keen-eyed investors to exploit.

I made this point several times before but it bears noting again, particularly in light of the very solid earnings news eminating out of one of my favored areas – Info Tech: Growth investors need to find growth issues to own. One of their favored areas, Financials, is now toxic. Yet, the money allocated to growth not only remains but is actually increasing as investors shift money from value to growth plays. So, what do growth money managers do when one area goes from favored to toxic? They find another area to overown. Enter Info Tech.

Investment Strategy Implications

With an end of year rally setting up nicely, the momentum lemmings are poised to act like Santa’s little helpers and get busy, busy, busy driving prices higher once we get the spookiness that is October out of the way and 2007 comes to a close. In the process, Info Tech (and Industrials) should remain very solidly in the upper quartile of performers.

Amidst the joy, however, there is one style area that certain investors still remain confused with – The Smids

Yes, large cap and specifically large cap growth appears to be the better place to invest. However, converting an underperforming Smid group into a negative return group is a mistake and runs the risk of leaving lots of money in selected areas on the table.

For reasons stated previously (including what is noted above), excess liquidity, decent earnings growth, reasonable valuation levels, and the pressure to perform will continue to help drive prices higher in the Smids. Therefore, don’t overlook the opportunities that may be buried in the Smids, particularly in the Info Tech and Industrials sectors.

Monday, October 22, 2007

Moral Hazard Be Damned

excerpts from this week's report:

"Last week's plunge should have come as no surprise to investors, provided they held the view that the game that was in force for the past two decades is back on since September 18th. I am referring specifically to the reincarnation of the Greenspan put now the Bernanke put.

During the Greenspan reign, the economy and markets enjoyed sustained steady growth and low inflation punctuated by mini panics from time to time. When needed, those mini panics were met with the prescribed preemptive solution of more liquidity every time pain seemed to be unbearable for important segments of the economy and markets. And why not?

After all, conventional economic analysis says that as long as growth is healthy and inflation muted, pumping more money into the system will not impact those vitals statistics. Of course, a byproduct of large amounts of macro liquidity is yet another bubble. But that is of no concern as each bursting bubble will be met with, you guessed it, more liquidity. Moreover, since each bursting bubble failed to produce damaging global macro effects (growth and inflation), there is little cause for concern (from a traditional thinking perspective).

Which brings us to the current environment..."

also in this week's report:

* Valuation Model
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus: MZM
* Sectors and Styles Market Monitor
* Key Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

Friday, October 19, 2007

Quotable Quotes: History Lessons

It was twenty years ago today…

A few words on history and the lessons we learn on this historical stock market day.

“History will be kind to me for I intend to write it”
Winston Churchill

“The only thing new in this world is the history that you don't know”
Harry S. Truman

“More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.”
Woody Allen

“Most of the people who came for dancing lessons had Rumba ambitions and minuet bodies”
Bob Hope

Have a good weekend.

Thursday, October 18, 2007

Technical Thursdays: Long Story Still a Short

When a dominant sector of a bull market enters rough waters, some investors may be tempted to establish a contrarian long position. Case in point - Financials.

Such inclined investors might perceive that the current bad news for the Financials is close to fully discounted. After all, with the low point for Homebuilders, and thereby Financials, forecasted by certain prognosticators to be the spring of ’08, the requisite lead time of six months to an economic trough in the sectors seems plausible. Therefore, given the discounting mechanism of the market, the contrarian reasoning says now is the time to establish long positions. The advice from this contrarian’s desk is don’t do it.

The above chart shows the Financials sector firmly in the grip of a neutral to negative longer-term pattern as the very reliable moving averages principle indicates: Price below moving averages, 50 day below 200 day, both 50 and 200 day moving averages pointing south.*

It should be noted that in 2005, XLF produced a somewhat similar neutral to negative moving averages signal. So, perhaps the same will occur this time. However, as with most technical indicators, it is far better to wait until a clear cut signal is made and pay a few percent more than to anticipate a reversal of an established pattern.

Investment Strategy Implications

There’s a time when being a contrarian makes sense. From a technical perspective, when it comes to Financials this is not that time.

*See prior Technical Thursdays entries for more info and examples re the moving averages principle.
To view a larger version of the above chart, click on the image.

Wednesday, October 17, 2007

Pop Goes the Weasel

How about a little thematic thinking?

As everyone knows, investing, finance, and business rely on confidence. And confidence relies on trust. For example, if the pricing of assets cannot be determined, then trust is eroded and confidence is shaken. On a financial markets basis, solutions to such problems tend to be very disruptive yet solvable. Recent case in point, sub prime mortgages and credit derivatives. A work in progress, but progress is being made. It is, however, quite another story when it comes to world’s economic leader, the US.

If confidence in the world’s economic leader is brought into question, then investors start the process of self preservation of their assets. Such is the case with the weakness in the US dollar, the single one factor that strikes fear in the hearts of the superbulls.

With the US so far out of step with the rest of the world on so many levels (geo political and economic, for example), it is understandable that the US dollar should bear the brunt of any loss of confidence. What matters most is the fact that it won’t take much to tip the balance and require more than the usual stopgap, emergency words and actions to stem a tide of fear that results from a heightened case of a lack of confidence.

In a larger context, it is reasonable to assume that, in time, the current world economy and markets will be viewed as being in a transition phase. Like a first year college student, the body may be in college but the mind and heart are still stuck in high school. Such is the case with our 21st century world.

Economies and markets, made up of people, are products of their past. And that includes systems and processes that may not be best suited for new era, one wrought by globalization and innovation.

Now, what is most worrisome is when things go wrong, very wrong, say a precipitous decline in the dollar. Or some other unforeseen global macro event that requires a more comprehensive and coordinated solution. What then? Are the policy makers prepared to manage such a massive disruption? Or will the world accept the blended solution of the market discipline and individual country driven policy actions?

Investment Strategy Implications

A crisis looms in our future that liquidity, technological and financial innovation, strong corporate growth and profitability, globalization, and good old-fashioned animal spirits have thus far helped to forestall.

When, not if, that crisis emerges, a new world order will be called for in which economic, monetary, social, and cultural issues will have to be addressed in a more cohesive fashion. The fragmented nature of a market based global economy coupled with nation state agendas will prove to be unworkable when, not if, a global disruption emerges. And when, not if, that occurs, the pressure to resolve the issues that are truly global in nature will be enormous. Hopefully, the policy makers will be up to the task.

For investors, when the global crisis does occur, all the traditional tools of equity valuation analysis will go out the window as the crush to get out the door will put into motion George Soros’ “reflexivity”, with its feedback loop to the real economy will be felt, as animal spirits run wild (in reverse) and conventional thinkers do lots of head scratching.

Until that day, happy times will be punctuated by mini panics. The US yesterday, India today, somewhere else tomorrow.

The music will stop one day. It always does. Until then, it’s all around the Mulberry Bush, as the monkey chases the weasel.

Note: Click on the above blog title for a little musical treat.

Tuesday, October 16, 2007

SMIDs: Not Dead Yet

Of late, there has been much talk heralding the death of the SMIDs. Based on the following, such talk is premature.

As the first chart above shows, beginning in the spring of last year the US equity markets have experienced three corrections – two minis (< 10%) and one that briefly exceeded the fabled > 10% level (this summer). Over the course of the three corrections, the SMIDs have trailed the large and mega cap styles by a fair amount leading some to conclude that the SMIDs era of outperformance is over. I say, not so fast.

Without a doubt, the fundamental argument for underperformance is a strong one. SMIDs are largely domestic US companies and, therefore, will suffer the consequences of a weakening US economy to a greater degree than the large and mega cap companies who receive a greater portion of their revenues and profits from the global growth story than do the SMIDs. Adding to this argument is the forecast for a weak US dollar, which helps US export companies, the same large and mega cap group.

While I do not disagree with the fundamental reasoning, the technicals of the SMIDs are only one half as bad. Specifically, the deteriorating relative strength shown in the first chart is fairly clear and makes plain that the quality migration cycle is well underway as money moves from lower to higher quality issues*. However, applying the longer term moving averages principle (see second chart**) argues that whatever problems do and might afflict the SMIDs, it hasn’t shown up in a violation of its longer term mega trend.

Part of the answer for this persistent strength resides in the hedge fund world and the need for alpha via higher risk bets. With liquidity still very high and the pressure to perform always on very high, hedgies have little choice but to find the bets that generate whatever alpha they can get their hands on. Another supportive argument is the fact that valuation of the SMIDs versus the large and mega group is not excessive. P/Es and PEG ratios are right around the large and mega cap rates. Lastly, part of the argument for a SMID underperformance or even negative return rests with weakness in the US dollar. Now, while there is little disagreement re the long term direction of the US dollar (down and dirty), over the very near term the large speculator bets have become so lopsided to the short side (third chart) that what is known as a crowded trade has developed which presents the potential for a counter rally in the dollar over the near term. Such a rally would help allay some of the dollar related fears for the SMIDs.

Investment Strategy Implications

Without question, where you want to be is in the big boys' space. However, there remains many SMID bets that can work and, while the bulk of an investor’s assets belong in the large and mega cap space, investors should not shy away from selective opportunities in the SMIDs.

*Smaller cap = lower quality, large cap = higher quality.
**The small cap ETF, IJR, is illustrated. The same picture is seen using the Mid Cap ETF, MDY.

Note: to view a larger version of the above charts, click on the image.

Monday, October 15, 2007

The Debt Supercycle

excerpts from this week's report:

"While traveling to and from my hedge fund seminars of last week, I had an opportunity to finish reading two Bank Credit Analyst reports – their outlook for 2007 global economy and markets and a recent update (September 2007) titled “An Inflection Point in the Debt Supercycle”.

What is most instructive about the views expressed by BCA is the strong bullish case they make from both an economic and investment perspective. No doubt their thinking is the mainstream mega trend view of many bulls as its optimistic roots lie in the soil of what they call the “Debt Supercycle”.

Here are a few observations on their views as seen from the Debt Supercycle perspective..."

"These “structural forces” have combined with the Debt Supercycle to produce a rotating asset inflation with ever higher asset prices being one of the results.

While acknowledging that various risks exist, most notably..."

Investment Strategy Implications

"The current investment conclusions by BCA are that there is more than ample room for policy makers to produce..."

also in this week's report:

* Valuation Model
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus:CPI
* Sectors and Styles Market Monitor
* Key Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

Friday, October 12, 2007

Quotable Quotes: The Truth - Whole and Otherwise

"Since mark to the market is still absent from many alternative investment instruments, alternative pricing methods (mark to model, to ratings, to marketing, and/or to myth) set the stage for a number of potentially suspect "transactions".
Vinny Catalano blog entry, October 11, 2007

"Some marks can be pretty imaginative. They call it 'marking to market,' but it's really marking to myth."
Warren Buffett quoted in "U.S. Investors Face An Age of Murky Pricing."
Wall Street Journal, October 12, 2007

So where does the truth lie? Perhaps a few words on the subject will help.

"How many legs does a dog have if you call the tail a leg? Four; calling a tail a leg doesn't make it a leg."
Abraham Lincoln

"Everyone is entitled to their own opinion, but not their own facts."
Daniel Patrick Moynihan

"The pure and simple truth is rarely pure and never simple."
Oscar Wilde.

“It's no wonder that truth is stranger than fiction. Fiction has to make sense.”
Mark Twain

Have a good weekend.

Thursday, October 11, 2007

Hedge Fund Seminar Data Points - Day 2: The Power to Exploit

Sometimes the deeper you dig the more you get to appreciate the many nuances and special wrinkles that make up a given complex subject such as alternative investments. Such is the case with yesterday's hedge fund seminars that I conducted. To my ear, two points among the many superb and often insightful comments made by my excellent expert panelists stood out and I share them with you here.

At my luncheon session, Rob Blabey with Jim Hedges' firm noted that there are no secrets among hedge fund players, particularly the equity players who are reasonably well informed. As with traditional positions (say long only) taken by your typical portfolio manager, the positions taken by most hedgies are fairly well known among those who make it point to know their markets. This occurs despite the opacity that is part and parcel of a largely unregulated business because the information network can be rather porous in areas. Nothing new here. However, where this gets most interesting is when things go wrong.

During such times, the Darwinian approach to money management kicks in and those that are in difficulties are left to twist in the wind until the pain can be taken no more. The pack then swoops in and makes the most hay out from the residue of the bad bet made.

I suppose none of the above should come as a surprise. It is, after all, the nature of the free market system. You place your bets, you take your chances. I guess I just never gave it much thought as to how ruthlessly it all plays out, especially during times of market stress.

The dinner session produced a piece of actionable information for all investors.

As this year wraps up in a couple of months, there is likely to much window dressing conducted by the hedgies. Given the summer experience of the pre Bernanke put era ("we didn't bail anyone out", wink, wink) and the fact that so much remains to be uncovered (including the real value of the assets on the books), it is quite reasonable to assume that many market-related cross currents will continue to occur and will likely intensify as the year comes to a close. For with the end of the year comes the auditors and audited investor reports as well as the performance fees "earned". Since mark to the market is still absent from many alternative investment instruments, alternative pricing methods (mark to model, to ratings, to marketing, and/or to myth) set the stage for a number of potentially suspect "transactions". With so much money (and careers) at stake, the free market system operating in a largely unregulated space could produce a number of, shall we say, interesting "transactions".

Investment Strategy Implications

There will be additional points in next Monday's weekly report (subscription required). For now, the central issue is the exploitative mindset that the rest of us, the more traditionally-oriented investor should develop. When it comes to thinking about the alternative investments space, much like the Darwinian example above, it is what an investor can do to exploit the situation that matters most.

With knowledge comes power. From an investment perpsective, that power is expressed in the ability to exploit the situation.

For despite the once in a century storm that actually occurs every five years*, alternative investments (hedge funds, private equity, structured products, etc.) are here to stay. An investor's mission, therefore, is not to bemoan the situation but to exploit it. The power to exploit is in the ears and minds of all investors attuned to changed game of investing.

*With the implications for equity valuation models via the destruction of the normative bell curve distribution of returns. A point made before and one that I will return to in future reports and blog entries.

Wednesday, October 10, 2007

Hedge Fund Seminar Data Points - Day 1

Every Hedge Fund/Alternative Investments seminar I conduct produces a wealth of useful and insightful information. Last night’s kick-off event in Tampa was no exception.

The first points of value I wish to share comes via Tim Hayes the highly regarded Chief Investment Strategist from the equally highly independent research firm, Ned Davis Research. In Tim’s excellent handout are three data points (among many) that I found particularly interesting:

* Of 7,300 hedge funds, the largest 200 account for 75% of hedge fund assets. 40% of hedge funds don’t last five years. (source McKinsey & Company)
* A Greenwich Associates survey indicates that during the next three years, 34% of U.S. institutional investors plan to increase their investments in private equity, 22% to increase investments in hedge funds.
* At the end of September 2007, monthly dollar flows into Exchange Traded Funds by hedge funds reached a record $19.9 billion, eclipsing August’s record at just over $14 billion.

Three initial conclusions reached by all three of my seasoned and well experienced expert panelists (which included D. Scott Luttrell of LCM Group and Daniel O'Conner of M&I Investment Management) is that high end, high quality hedge funds will weather the storm quite well, with many exploitig the misfortunes of their lesser talented peers; for most investors, sticking with the better run, better disciplined fund of funds managers is superior to selecting individual hedge fund managers (the data supports this view); and that the effects of the recent credit crunch will be felt more on existing deals and private equity.

I will provide today's two events and their insights and comments in tomorrow's blog entry.

Tuesday, October 9, 2007


In preparation for tonight’s first of three Hedge Fund seminars, I have come across a little piece of information that I frankly found rather startling.

According to an August 21st report from Goldman Sachs, “The typical hedge fund has an average of 58% of its assets invested in its ten largest positions compared with 33% for the typical large-cap mutual fund, 24% for a small-cap mutual fund, 20% for the S&P 500 and just 2% for the Russell 2000 Index (see chart to your left*).”

Let me state that again: 58% of the assets of the typical hedge fund are concentrated in its ten largest holdings.

Investment Strategy Implications

While it is understandable that the purpose of many hedge funds (versus your garden variety mutual fund) is to provide concentrated holdings, the consequences of such a portfolio strategy utilizing highly liquid, publicly traded stocks, the same highly liquid, publicly traded positions held by garden variety mutual funds and other traditionally constructed portfolios, is an area requiring further investigation and analysis. A point I intend to pursue during the upcoming three hedge fund seminars to be conducted this week. More to follow.

*To view a larger version of the chart, click on the image.

Monday, October 8, 2007

A Tale of Two Risk Stories: Small/Micro Cap and Emerging Markets

excerpts from this week's report:

"With the liquidity game back on, the return of the risk trade has also made its re-entrance – with a vengeance. Last week’s power move to the upside led by the higher risk segments of global equity markets has driven certain indices to new all-time highs. Bye, bye fear, hello risk.

The chart on the next page (see report) shows the inverse relationship between the VIX and the high volatility segments of the US and global markets – Small and Micro cap, Emerging Markets and Latin America 40. Here one can see the most pronounced effects of the return of the liquidity game (and the establishment of the Bernanke put). Clearly liquidity has a very stimulating effect on the higher tier of the risk spectrum with the concurrent decline in fear in the form of a lower VIX. There are, however, reasons to be less than completely sanguine re both groupings as they each have risk factors that should give a prudent investor pause.

The chinks in the bullish armor for the Small and Micro cap styles center on two..."

"In regards to the Emerging Markets and Latin America 40 grouping, the risks are primarily..."

also in this week's report:

* Valuation Model
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus:The US Consumer
* Sectors and Styles Market Monitor
* Key Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

Friday, October 5, 2007

Quotable Quotes: What Else? Jobs!

A lighter look at the employment scene (plus Jobs on Gates).

“Oh, you hate your job? Why didn't you say so? There's a support group for that. It's called EVERYBODY, and they meet at the bar.”
Drew Carey

“Economics is extremely useful as a form of employment for economists.”
John Kenneth Galbraith

“It's just a job. Grass grows, birds fly, waves pound the sand. I beat people up.”
Muhammad Ali

“I wish him the best, I really do. I just think he and Microsoft are a bit narrow. He'd be a broader guy if he had dropped acid once or gone off to an ashram when he was younger.”
Steve Jobs

Have a good weekend.

Thursday, October 4, 2007

Technical Thursdays: When Technical Analysis Doesn’t Work

Every prior edition of Technical Thursdays espouses the value and benefits of Technical Analysis (TA). In today’s blog posting, I wish to highlight a different aspect of TA – when it doesn’t work. Case in point: the yield on the 10 year US Treasury.

Employing the first of the two primary charting tools I use – moving averages, the above chart of the 10 year* is a hodgepodge of erratic price movement that is matched by the frequent crisscrossing of price to moving average (50 and 200 day) as well as the moving averages to themselves (50 crisscrossing the 200 day). Of course, one could argue that the trend is range bound. That is clearly evident. But the predictive value in the moving averages principles (noted on numerous prior Technical Thursdays) rests not on forecasting the sideways action of an asset (which it cannot do) but on its ability to forecast sustainable up or down mega trends. In other words, when it comes to the 10 year yield, there is no up or down trend predictability using the moving averages principle (use the label link below to see prior Technical Thursdays for examples).

As for the second charting tool – momentum and MACD, the timing value of these tools is rendered largely (but not completely) useless as the divergences principle (trend highs or lows not confirmed by momentum and MACD) that works so well in other situations (again, use the label link below to see prior Technical Thursdays for examples) is of limited value here. For example, the August decline in yield produced several non confirmations in both momentum and MACD before the yield finally turned higher. The net investment/trading effect would have been a loss or at best a breakeven transaction.

Investment Strategy Implications

Perhaps it is the single issue aspect (versus markets, whole sectors, industries, or styles) that nearly eliminates the predictive value of the two tools. Or perhaps it is nature of the instrument with all its external influences (economic and political) that reduces the ability to predict its future price action. Whatever the reasons, the fact is that certain TA tools do not work in all situations.

The moral of the story: Knowing the limitations of any predictive tool is just as valuable as knowing its strengths.

*To view a larger version of the chart, click on the image.

Wednesday, October 3, 2007

Showing Us The Money

Attending yesterday’s Lipper/HedgeWorld conference in New York City provided a wealth of detailed information re hedge funds. As someone who produces and conducts such events for CFA Societies throughout the US, I am always interested in breakout sessions that go into considerable detail re the inner workings of hedge funds and private equity, the two opaque behemoths of the unregulated money world. Such was the case with the two breakout sessions I attended, one titled “Strategy Focus: Credit Derivatives/Structured Products”, the other “Strategy Focus: Looking Abroad and Beyond the BRICs”.

Here are a few comments on each:

The first session on credit derivatives and structured products provided an amazing example of the risks inherent in complex, customized deals. The story, described by one of the panelists, was from the last 1990’s and dealt with a structured product for Russian treasury obligations created and marketed by a major investment bank. The deal had two component pieces to it.

The first piece was the return produced by the yield on the core instrument. The second piece was the return expected from the currency translation. Two interrelated returns – yield and currency – that together would counterbalance one another should one part of the equation, say the yield, go against the investor. Rates rise, price goes down, currency goes up. Sounds like a normal bond/currency transaction, right? It was except for the fact that when yields rose dramatically during the Russian debt crisis of the late ‘90’s, guess who had stripped out the currency return from the structured product? None other than the investment bank who put the deal together. In other words, the investor(s) was left holding the bag on a highly risky investment simply because they did not have the proper risk management systems in place (lawyers, in this case). Sounds like a one off? Not really.

From my previous hedge fund seminar experiences, many if not most mid and small sized hedge funds lack the rigorous risk management talent necessary to play the high-risk games that they do. Now, when you combine this fact with five other facts - huge sums of money under management, limited practical investment experience of many of the managers, many, many players in the game, a limited number of unique strategies, and the pressure to perform, things can and do get quite sloppy. Moreover, correlations go up as the momentum lemmings have little choice but to play the game to stay in the game.

The second session on emerging markets provided yet another story of the abundant liquidity in the global financial economy. It’s a story that comes straight out the current news, as reported by Reuters this past Thursday: “Ghana sold a $750 million Eurobond Thursday, with order books testifying to abundant appetite for the debut bond from the West African country and possibly for future issues from the continent. The 10-year dollar bond was sold at par to yield 8.5 percent, the tight end of the guidance given on Wednesday, lead managers Citi and UBS said.”

Tight end of the deal! Try 10 times oversubscribed, according to one of the panelists at yesterday’s emerging markets session. And this was no small deal for the B+ rated paper. According to the Reuters article, “The book size was almost $3 billion with about 40 percent placed to U.S. investors, 36 percent with UK investors and the rest in Europe, officials with the banks said.” For those who may not recall, Ghana, is a country that was “part of a historic 2005 $40 billion debt relief effort for Highly Indebted Poor Countries”. That’s two years ago. And in two years time, all is forgiven and forgotten. Bye, bye fear, hello risk appetite.

Investment Strategy Implications

The Ghana story, whose “success comes a day after Turkey sold $1.25 billion in 2018 Eurobonds, which were three times oversubscribed”, along with the structured product story noted above, provide two clear examples of the need to understand the $3 trillion (not including leverage) hedge fund/private equity players better.

Hot money abounds. So does the lack of risk management skills of many hedge fund and private equity players. The powerful combination of the two creates distortions that impact financial assets everywhere. And provides yet another example why the Fed's domestically-driven rate decision looks more irresponsible with each passing day.

Tuesday, October 2, 2007

The Return of the Momentum Lemmings

click on images for larger view

It’s hard to make the large cap argument out of yesterday’s liquidity driven rally by the momentum lemmings. As the one-day chart of the size indices above show (first chart), the Small and Micro styles did best, while the Mid caps held their own. There are two thoughts that come out of yesterday’s hoopla.

To begin, one day does not a trend make. The recent relative performance weakness in the Smids since the S&P 500 made its high on July 19th has produced a non-confirmation similar to what the Dow Theory is now indicating (see second and third charts above). The problem with making too strong of a case for the non-confirm call is the fact that (a) only the gap between the Dow Transports high and current price is wide enough to seriously suggest that the current non-confirmation will hold* and (b) global markets range from acceptable (Japan) to strong (EAFE) to white hot (emerging markets). And that takes us right back to the Fed and excess liquidity, which is the second point.

From an equity market's perspective, yesterday’s run to new highs makes clear the folly of the Bernanke Fed’s rate cut decision as the liquidity game is (mostly) back on and, with it, is the return of the momentum lemming trade. With money still very, very abundant and the pressure to perform always on maximum, the momentum lemmings have no choice but to stampede in when the markets are hot, tending to make them even hotter and, thereby, making excess the rule of the investment land.

Investment Strategy Implications

When the Fed signaled that it was abandoning its liquidity draining efforts with the speculative guess that the US economy might be headed for a recession and, therefore, reinstituted the principles of the Greenspan era – preemption and the moral hazard risks of the Greenspan put – it, to a large extent, turned back the clock to the liquidity game that had reached excessive levels. And, in doing so, unleashed the momentum lemmings to reassert their liquidity game. (Or what Morgan Stanley's former chief investment strategist, Henry McVie, described as the "Misalignment Triangle".)

What yesterday’s action suggests is a return to the kind of bull market the momentum lemmings know and love. And with it the return of liquidity-driven speculation. There is, however, a soft underbelly to the lemmings' enthusiasm as I stand by my concerns re this month (see yesterday’s blog excerpts and report) and would lighten equity holdings into this rally. While it’s still a bull market ‘til it ain’t, I am a buy low, sell high type of guy (the antithesis of the momentum lemming).

*However, that was also the case in late 2006, only to have the Transports stage a powerful rally into early 2007 and confirm the highs. In other words, Dow Theory seems to work only if other indices are also not confirming the highs made by the Dow Industrials.

The fundamental justification supporting this technical approach to market predictions is the signal that other segments of the economy are sending via their stock representatives. In other words, if the Transports are not confirming the Industrials new highs, it is signaling that economic conditions of the companies that comprise the Transports index are experiencing earnings growth or other fundamentally oriented difficulties.

Monday, October 1, 2007


“There is no terror in a bang, only in the anticipation of it”

Alfred Hitchcock

excerpts from this week's report:

"With one half of the dreaded September/October time frame behind us and having got the call for the first half correct (see September 4th commentary and report, “September Swoon? Not Likely.”), it’s time to look at the second half of the dreaded duo – October – and see what might be in store for investors.

There are several concerns for the month ahead, none of which have to do with the spooky history of the month. Here are five for your consideration:

Concern # 1 is more of a political than economic issue. Specifically, October is expected to contain a number of congressional hearings re raising the capital gains tax. And while the prospect of such an increase is doubtful (given an almost certain veto from Bush), just the thought of where this is all headed is enough to add more uncertainty into the equity valuation risk equation. Moreover, this concern ties into the next concern.

"Concern # 2 is also a political one and has to do with the forward-looking, predictive nature of..."

"Concern # 3 takes the same six-month predictive feature of equities and considers the ARM (adjustable rate mortgage) resets that will likely..."

"Concern # 4 centers on the earnings outlooks for 2008 and the uncertainty and..."

"Lastly, concern # 5 deals with valuation. As the table below indicates (see report), only a robust growth phase in earnings (possible) and a decline in rates (unlikely, given the weakness of the US dollar and other factors) will tilt the expected return for equities toward its traditional rate of 12%. If earnings and/or rates move in the wrong direction (from a valuation perspective) however, then the yellow zone (see report) will fast become the more probable target range. Moreover, research data shows that whenever the Fed cuts rates, equities may have an initial one month burst but that is typically followed by a modest mid single digit return (+6.9%, to be precise) over the ensuing twelve months, not far from the valuation model you see below (see report). Given all the uncertainties that have been noted above and others not included in the equation..."

Investment Strategy Implications

"Now, to be clear – an October swoon is not a plunge. And although October will likely witness the return of volatility, the net effect for the month should be down some, say a give back of the 3% gains of September. As for specific actionable steps, I refer you to the Model Growth Portfolio.

As Mr. Hitchcock puts it so well, anticipation can be more frightening than reality. October should provide more than its share of anticipatory chills and thrills."

also in this week's report:

* Valuation Model
* Model Growth Portfolio
* Investor Sentiment Data
* Technical Analysis Focus
* Sectors and Styles Market Monitor
* Key Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.