The price of everything

After Goldilocks

“Today you can go to a gas station and find the cash register open and the toilets locked. They must think toilet paper is worth more than money.” – Joey Bishop.

The so-called ‘Goldilocks’ economic environment, writes Peter L. Bernstein, was aptly named:

 

“low volatility in capital markets and in the real economy, low inflation, central banks in firm control, a healthy appetite for risk-taking in the business world that led to revolutionary technological change, the transformation of the ‘emerging’ economies into ‘developing’ economies, and the resulting boom in globalization.”

 

Bernstein suggests that after the dotcom bubble messily burst in 2000, the business sector was slow to regain any appetite for risk-taking. For this reason, Goldilocks lasted longer than she might have done. But as stability reigned and the global economic system effortlessly grew, in time-honoured fashion it was the banks that stepped in where more intelligent businesses might have feared to tread, and ratcheted up the dial for risk. In equally time-honoured fashion, the housing market became the focus for renewed risk-taking, aided by two deadly contemporary trends: rapidly rising prices, and financial innovation. Three, if you count leverage. Now, “in the aftermath of the fervour for risk-taking, Wall Street and the mortgage banks have created many deep-seated problems for themselves. As an unhappy side effect, the business sector, a relatively innocent observer, is going to have to absorb much of the pain of curtailed consumer budgets and fewer exports to foreign nations affected by the turmoil in the US.”

 

In a letter (“The Shape of the Future”) republished by John Mauldin in his ‘Outside the Box’ column, Peter L. Bernstein goes on to suggest that far too much time is given over to analysis of the present or the anticipated near term – “the short run always tends to dominate mass thinking in any case, but in an odd way the short run is irrelevant to the current situation.. As Goldilocks shreds, we have to start thinking about what kind of long-term environment is going to replace it. Shifts to new environments are always attenuated. They are also rare across time, which means most of us have limited experience with this phenomenon. New environments often tend to sneak up on us and do not announce themselves with a fanfare. Most of us are unaware of what has happened until enough time passes to provide good perspective.”

 

As one might expect from the author of ‘Against the Gods: the remarkable story of risk’ (one of the finest books written about the risk inherent in investment, and the ways to study it), Bernstein’s letter does plenty to encourage longer term contemplation of the state we’re in. Extrapolating just from the short term, the very nature of the western financial system is likely to change profoundly. A badly bruised credit system will take some time (longer, probably, than many commentators suspect) to recover its health. And it may never regain the lofty heights to which it has recently reached, through a combination of economic retrenchment and more intense regulatory friction. As Bernstein points out,

 

“Without securitization, and without the lively derivatives markets that developed around the securitization process, the entire credit system loses an immense source of capacity, hindering deserving borrowers in search of financing and, as a result, the pace of economic growth.”

 

With trust in financial institutions, primarily banks, in total disarray, rebuilding that trust will also take longer, most probably, than many expect. “The pace of change in that direction, however, will be slow, a matter of years rather than months. An entire structure has crumbled and has to be rebuilt, brick by brick. The impact of unforeseen but inevitable credit problems will loom large, detouring and delaying the pace and patterns of recovery on each occasion.”

 

Bernstein’s central argument is that the cause of recent financial market turbulence, the effective bankruptcy of the western banking sector, of an unsustainable rise in leverage combined with opaque financial engineering, came about not from too much inventory nor overexpansion in industrial capacity, not from a burst of inflation requiring tighter monetary policy, but

 

“The root of today’s problems in the financial markets and in the economy as a whole is the household sector.. the shrinkage in the personal savings rate [in the west, at least] is not the result of consumer profligacy, as other commentators persist in describing it. Rather, the savings rate has been suppressed by a slowdown in the growth of household incomes. The shortfall.. has been met by borrowing, and in particular by borrowing against the family real estate. Now the opportunity to borrow has shrunk dramatically, an outcome that will profoundly change the household’s spending power and spending patterns. But the impact is not just on the household. A slowdown in the growth of consumer spending has ominous implications for the entire global economy – and, along the way, the US [and other western sovereign nations’] federal deficit, soon to be overburdened by spiralling benefit obligations. This predicament is not a short-run matter..”

 

Quite what emerges from the reconstituted rubble of the financial system, in however many months’ or years’ time, is obviously unclear. But it seems a reasonable bet that banks as we know them will play a smaller role in the future, constrained by both regulatory fiat and by lingering recollection of how much damage they have spread among a broader and largely blameless economic community. Much doom-mongering has been deployed over the rise of the so-called shadow banking system. Inasmuch as this relates specifically to hedge funds, while the stupidly overleveraged or just plain stupid will continue to go to the wall, there is no reason why the hedge fund sector (to the extent that it constitutes just one homogenous group) will not continue to attract assets at the expense of older and less relevant investment structures – such as the venal and poorly named mutual fund complex, where conflicts of interest between asset gatherers (or euphemistically, asset managers) and investors continue to reign supreme.

 

On this note, last week’s piece by E.S. Browning for the Wall Street Journal (“US stocks’ lost decade”) will have made many traditional fund investors feel distinctly uneasy. Despite the ongoing refrain from the fund management community about investing for the long run, since 1999 the stock markets of the US and the UK have gone.. nowhere. More precisely, taking the S&P 500 Index as a proxy for the broader US equity market, US stocks are exactly where they were nine years ago. Stocks over that period have been beaten by Treasury bonds (an outperformance that both Gilts and Treasuries will struggle to repeat given the parlous state of government finances and the further deterioration implicit if Bernstein’s thesis is correct). The performance of UK stocks over the same period has been even worse. Whether expressed in the form of the FTSE All-Share or by the FTSE 100 Index, UK equities are now worth less today than they were nine years ago. Given that we have just been through a period of extraordinarily benign global growth, that is some achievement.

 

It is not all bad news. Investors today benefit from products and vehicles that simply didn’t exist in anything like their current form nine years ago: low-cost exchange-traded funds (if you resent your fund manager – do the job yourself !); closed-ended listed hedge funds and funds of hedge funds; exchange-traded commodities and precious metals trackers; capital guaranteed structured products.. Not only are equities no longer the only game in town, even if they were, there are now a myriad ways of slicing and dicing market risk to the appetite of the individual investor. And some of the investible themes are little short of compelling. In a piece for the FT’s Insight column in early March, Barclays’ Tim Bond compared the recapitalisation required by the banking system with the funds required by the global energy complex. While estimates of the banking capital shortfall vary from $300 billion to $1,000 billion, that compares with the prospective capital requirements of the resources markets:

 

“According to the International Energy Agency, the global energy sector alone needs a real $22,000 billion over the next two decades to meet the anticipated rise in primary energy demand.”

 

If that doesn’t look like an investment sector that will repay careful study, it is difficult to know what will.

 

Download after_goldilocks.pdf

Not waving but drowning

“The national budget must be balanced. The public debt must be reduced; the arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced, if the nation doesn’t want to go bankrupt. People must again learn to work, instead of living on public assistance.”

- Cicero, 55 BC. (Note: Edward Gibbon dated the actual fall of Rome to AD 476, over five centuries later.)

 

If ludicrously overblown press headlines were a definitive contrarian guide, the financial crisis has reached its nadir. Fortune went last week with ‘The end of Wall Street as we know it’. If only. The London Evening Standard billboard, long a source of gaudy amusement to weary commuters, went with ‘BANK CRASH: LONDON PANICS’. (The Standard, of course, has some form here. Previous measured coverage of topical events from the paper that never discovered lower case has included ‘TOXIC CLOUD HITS LONDON TONIGHT’; ‘THAMES FLOODS: PREPARE TO FLEE’; ‘TOOTHPASTE CANCER ALERT’; ‘EXPLODING LAPTOP COMPUTER ALERT’; ‘KILLER FOG TRAVEL CHAOS’; ‘AAAAAARRRRRRRRGGGGGGGGHHHHHHHHHHHHH!’ (this last entry looks suspiciously like a fake – judge for yourself); ‘IPOD HEALTH ALERT’; ‘EUROPE: IT’S WAR WITH FRANCE’; ‘INSIDE HORROR PUPPY FARM – PICTURES’; ‘SUMMER KILLER WASPS ALERT’..) Other coverage was more nuanced. The Financial Times on Tuesday led with a somewhat baffling photo from the Chicago Mercantile Exchange of someone arms akimbo who may just have been ordering a cheeseburger. The Daily Express, admirably meeting its journalistic responsibilities in addressing the biggest markets crisis since World War 2, led with a headline about Princess Diana.

 

With the fifth largest US investment bank having been repackaged and sold at distressed valuations to what is now the largest, and with several UK banks now optically at least yielding over 10%, it would be redundant to say we are living in extraordinary times. But we are, and as Citigroup’s Patrick Perret-Green points out, desperate times require desperate measures:

 

“It is time for Federal involvement no matter how distasteful the issue of moral hazard is. There are times when only the public sector can halt the rot. I believe that this is one of them. GSEs (Government Sponsored Enterprises, namely Fannie Mae and Freddie Mac) and munis need to be guaranteed and the White House needs to exercise its executive muscle. If it means that you have to replace your Treasury Secretary to enact the equivalent of a “surge” then so be it..

 

“Equally significant is that it is time for the other firefighters (central banks) to become much more involved. The fire may be centred in America but the sparks are floating on the wind and too little has been done to prevent it spreading..”

 

From a behavioural perspective, one of the slightly more positive straws - as opposed to sparks - in the wind is, perversely, the very failure of Bear Stearns: traditionally, the collapse of a major institution would have been treated as symptomatic of the low being in, or at least close by. It is a sign of the times that no sooner had Bear entered the welcoming arms of JP Morgan than the market sniper was directing his crosshairs at the likes of Lehman Brothers and MF Global. The difference this time round would seem to be that the crisis, like the financial system and the international economy, is properly global. So there are likely to be more Northern Rocks and Bear Stearns to fail before the worst can be said to have passed. Particularly in Europe, where the monetary authorities have been surprisingly grudging to offer the financial sector anything (other than simple liquidity) by way of meaningful emergency support in comparison with the Fed. One other, significant, observation: if we are entering a realm of much enhanced government (i.e. taxpayer-) funded support for the financial sector, that is occurring at a time when government balance sheets are already a disaster. Government bond yields run the risk of exploding upwards in an environment of further emergency bail-outs for badly run banks or near-banks.

 

But then these are extraordinary times. RJH Adams, conversely, takes a less than charitable view of the Fed’s energetic and creative intervention:

 

“And now the Fed has decided, post Bear Stearns collapse, that even more largesse is required for the troubles at hand – this time including non-banks and allied to terms of greater secrecy.

 

“This latter feature is both a sop to financials wishing to preserve their reputations which, for some curious reason, they collectively appear to believe are currently held in high esteem; and to stave off depositor / client scrutiny and exit.

 

“The secrecy is, viewed in these terms, a deception upon shareholders and a symptom of a weak banking supervision regime. Banks in difficulty are being allowed to hide and roll over their solvency issues (where they can) in the hope that their catastrophic losses on assets held prove transitory with the underlying security at some future point marketable.

 

“So far the opposite is happening and yet this behaviour is likely to continue until the Fed eventually comes up with a package soft enough to persuade the banks (and other financials who, like Bear, will find an indirect way to access Fed support) to take it up anonymously.

 

“Maybe the Fed just did that; but the opacity of the deal destroys confidence more than the fig leaf excuse of protecting banks’ operations merits. Here is the point: it is currently impossible for investors to determine which banks / other financials are solvent. Allowing all and sundry to tap Fed offers can only turn out to be a drag on the broader economy and delay final settlement.. Banks need recapitalization. That requires transparency – and that someone takes losses. Just ask your average shareholders like Mr. (Joe) Lewis (whose Tavistock Group owns 9.4% of Bear Stearns) and Citic (a Chinese brokerage that agreed in October to invest $1 billion into Bear Stearns). Buying time and pretending otherwise is wishful thinking.”

 

Not every debate last week was over the appropriateness of Federal Reserve support for broker-dealers and other members of the so-called shadow banking system. In a timely piece for The Financial Times, investment consultant David Roche wrote of the commodities ‘lifeboat’ being swamped in a rush to safety:

 

“In the current turmoil, there has been a rush into commodities.. the speculative element has grown sharply.. (but) global growth is declining fast. Recession will ensue and no region or asset class will be immune from its ravages..”

 

Roche suggests that as the Chinese authorities tackle domestic inflation (unlike their western counterparts), China’s growth rate could easily fall by, say, 3% to 8% - which “would remove the ex-ante global supply / demand deficit from energy markets and push most industrial metals, including steel and copper, into significant surplus.. we can expect the price for refined oil to fall 30% and industrial metals by 20% to 30%. The big fall is coming.”

 

Since commodities, and more particularly softs, have recently been the only game in town, Roche’s suggested correction leaves investors with something of a quandary. Government bond yields are pricing in hell on earth. Equities and corporate bonds are trapped in a bear market, along with the US dollar and confidence in the international banking system. If commodities join them, where can despairing investors go – either in search of profits, or simply to preserve capital ?

 

One response would be that a commodities correction might be short-lived: limited, perhaps, to the extent that a Chinese slow-down takes some of the heat out of the market. If it turns out to be an altogether longer-lived correction, even that would be nothing that BMO’s impressive global strategist Donald Coxe didn’t foresee as far back as October 2003 (‘Basic Points: A major investment sonata in a miner key’):

 

“Within months, this Movement will probably end. Whether it will come from disappointing economic news.. or simply because stock prices have gotten ahead of themselves, one cannot know..

 

“The Second Movement will mean further development of the [commodities] theme, but will be more stately, and will frequently be in a minor key. At each of those intervals, the miners will rediscover their primal fear: they must not be up dancing when the music stops.”

 

Donald Coxe goes on to explain that the Second, or middle, movement of symphonies was historically a shorter movement that gave the orchestra a chance to cool down; “Since stock prices for the leading mining companies [and the prices of most commodities] will be up so hugely as this movement begins, there will be itchy portfolio manager fingers to take profits as the rest of the stock market encounters downdrafts..”

 

Again, given that Coxe was writing these words in October 2003, he deserves bonus points for prescience. As he then pointed out, in relation to the metals markets (but surely his words have a broader resonance for the entire commodities complex):

 

“..the demography of the market.. includes those too young to have seen a true bull market for mining stocks, and those who remember all too vividly the ghastly bear market of the 1990s, and the ups and downs of the 25 years before then. Within the mining industry, the aged players are battle-hardened and cautious. Youth doesn’t understand, and age doesn’t believe.”

 

David Roche may well be right in the short term in relation to the overvaluation of commodities, but in the longer run his argument is up against some significant headwinds, including: a secular shortage of supply (40 year low inventories in the case of some agricultural softs); a multi-decade bear market before the most recent gains; the new ease of access into the sector, in the form of low-cost exchange-traded funds; the chronic underweightedness of institutional investors (see, for example, our commentary ‘All in the mind’ of 7^th March, which cited a Bloomberg report claiming that the Calpers pension fund, the largest in the US, having made its first investment into commodities in 2007, was considering increasing its investment some 16-fold); the demand shock represented by a newly emergent and newly wealthier Chindia; a US monetary policy regime that seems determined to sacrifice the dollar on the altar of banking system survival. Commodities markets are always going to be volatile, but rarely have there been so many fundamental reasons to be positive about their longer term prospects in an otherwise acutely unstable world.

Download not_waving_but_drowning.pdf

Bernanke Goes Forth

“Edmund: You see, Baldrick, in order to prevent war in Europe, two superblocs developed: us, the French and the Russians on one side, and the Germans and Austro-Hungary on the other. The idea was to have two vast opposing armies, each acting as the other’s deterrent. That way, there could never be a war.

Baldrick: But this is a sort of a war, isn’t it, sir ?

Edmund: Yes, that’s right. You see, there was a tiny flaw in the plan.

George: What was that, sir ?

Edmund: It was bollocks.”

- From ‘Blackadder Goes Forth’ - Richard Curtis and Ben Elton.

So the Federal Reserve has shown it is willing to act as a prime broker (to the tune of another $200 billion) even if the rest of Wall Street is having second thoughts about the role. This week’s immediate response to another historic liquidity injection was an unsurprising relief rally by stock markets, but the longer term reaction will be an equally unsurprising retreat back to the lows. Stock market investors seem to be thinking, “If easy money got us into this mess, surely even more easy money will get us out.” Replace ‘easy money’ with ‘idiocy’ or ‘leverage’ and you can see the essential logical weakness of the proposition. Diapason’s Sean Corrigan was not alone in wondering whether the Fed would be getting value for money from its latest liquidity experiment:

“According to my reckoning.. the Fed’s extra $253 billion in liquidity enhancing measures bought a 1.3% increase in the S&P 500. Since we need a 19.4% rally to regain October’s Sucker’s High at 1476, we might only need another $4.8 trillion in new measures to do the trick ! Neatly, that would equate to the Fed buying out the outstanding total of Agency / GSE-backed mortgage pools, with enough room to nationalize Freddie and Fannie at current market value, into the bargain. Over to you, Ben..”

Unfortunately, there is just one tiny flaw, cf. Blackadder, in Bernanke’s plan. Not least, a crisis of solvency will not be resolved by the provision of any amount of liquidity. As Marcus Ashworth of Mitsubishi UFJ points out, the latest emergency measure “probably only postpones the latest series of fire sales, allowing some to meet margin calls and hang grimly on pro tem, but it does not recapitalise the financial system. In fact, it helps banks to own [impaired debt] for longer,” and it merely delays what must inevitably come – the transfer of toxic waste to safer longer term hands, where it can either be held, or extinguished.

Wolfgang Münchau, writing in this week’s Financial Times, was pretty unequivocal in his commentary, not altogether subtly entitled ‘Central bankers cannot stop this contagion’:

“For as long as this financial crisis persists, interest rates will be determined by toxic market conditions, not central bankers.. We may even be in a situation where low interest rates give us the worst of all worlds: no stimulus in the short run, and a rise in inflationary expectations in the long run.. What spooks investors is the loud and clear signal from central banks that they are not prepared to stabilise inflation in adverse circumstances.

“This has not been a liquidity crisis, but a hugely contagious solvency crisis, affecting sector after sector, starting off with subprime mortgages, spilling over to the rest of the mortgage market, into municipal debt, corporate debt and many obscure sectors of the financial market.. It will spill over into the rest of the financial market and to the real economy. Perhaps there exist some regulatory devices one could deploy to mitigate the forced-selling problem. [If there are, we can count on the Bernanke Fed to use them.] I suspect we will ultimately end up with some combination of regulatory relief, fiscal bail-outs, nationalisations and many, many bankruptcies of financial institutions not too big to fail.” (Emphasis mine.)

As far as credit markets are concerned, we are evidently entering something of a ‘new paradigm’ world, at least as far as securitisation, credit quality assessment and asset-backed lending are concerned. Unfortunately, while the Fed is at least behaving pro-actively to attempt to forestall further dislocation in the US financial sector, central banks like the ECB are still doggedly fighting the last war against inflation. Inflation is unlikely to be a significant issue once the economy falls into the grip of an economic recession. Rises in commodity prices, and specifically the price of oil, will ultimately be self-correcting (though non-replaceable commodities affected by robust global and Asian demand, and which have seen decades of underinvestment in capacity, may have some way further to run). But in any case there is little that central banks can do to address commodities prices, nor should they try: there is enough manipulation of the money supply going on; the price discovery process in credit has already been suspended by the intervention of the monetary authorities (if only all markets had such powerful ‘Get out of jail free’ cards). We do not need intervention in commodities prices when free markets can and ultimately will lead to some form of equilibrium.

If Wolfgang Münchau’s scenario comes to pass (and we have some sympathy with it), the implications for investors are severe. Coming at a time when public finances in the Anglo-Saxon economies are already stretched, the requirement to support major banking institutions with taxpayers’ money would positively murder the government bond markets. It is for this reason that we still see inflation-protected government debt as the ‘least worst’ debt market investment, inasmuch as investors are hedged against the inflationary scenario, but still given high quality credit exposure and a minimum income – even if the ultimate outcome is actually one of disinflation (consistent with a major economic slowdown). As for equity markets, we continue to see merit in being highly selective. This is not an environment conducive to broad market-based exposure, rather one supportive for very specific businesses outside the financial, homebuilding and consumer arenas . Classic defensive stocks are becoming increasingly hard to come by: the bloom has come off both pharmaceuticals and to a lesser extent telecoms; tobacco stocks are expensive; food company stocks are afflicted by the vicious rise in soft commodities prices; packaging stocks by equally vicious rises in the price of raw materials. One feels that the broader equity markets are now pricing in some degree of (relatively benign) slowdown – what they are not pricing in is another leg down triggered by genuinely new significant bad news on the financial front, such as the failure (or more likely emergency bail-out package triggered by the failure) of a mid- or large-sized financial institution.

A ‘new paradigm’ market environment requires a different sort of investment thinking from the traditional. Return of capital trounces return on capital when the financial markets have become essentially unhinged. Preservation of capital – in real terms – becomes the primary objective. In this world, cash alone does not do the job. It needs to be bolstered by high quality credit, ideally of unimpeachable quality – but try finding that in an environment where ‘AAA’ no longer means what it used to. There are other forms of money, and precious metals represent them. The commodities bull is not dead yet. As Dr. Marc Faber suggests in the context of gold,

“Central banks around the world have no other option but to print money and this will lead to a further depreciation in the value of paper money against precious metals.. But when we consider the upside potential of gold compared to its downside risk, the biggest mistake an investor could make is not to own any gold at all.”

Of course, gold – and other metals, platinum and palladium – could easily see substantial pullbacks from current levels. But since they represent in large part the portfolio insurance of financial assets, a retrenchment in the price of gold would be consistent with a recovery in the price of those assets, and vice versa.

Cash needs to be bolstered, too, by ‘growth’ assets – which we would define as those exposed to the secular growth story of global infrastructure spending and energy and resource provision in both the developed and developing world. There will be pockets of sustainable value elsewhere in the listed equity markets – but investors will have to have an iron constitution (and certainly a patient one) to withstand the shorter term price turbulence inherent in a world of urgent deleveraging and forced selling. There will evidently be opportunities in hedge funds – but given a ‘shoot first, ask questions later’ retrenchment by prime brokers, not all will make it through the pass intact. Diversification, and a concentration on quality in assets of all forms would seem to be the order of the day.

Download bernanke_goes_forth.pdf

All in the mind

“Minds of moderate calibre ordinarily condemn everything which is beyond their range.”

- Duc de La Rochefoucauld. 

 

In ‘Fooled by Randomness: the Hidden Role of Chance in Life and in the Markets’, Nassim Nicholas Taleb – to demonstrate why we are often our own worst enemies – uses the example of a retired dentist with a penchant for playing the markets. This hypothetical pensioner is guaranteed to earn a 15% annual return, but also to incur volatility of 10%. (We have alluded to Taleb’s dentist before and make no apology for doing so again. There are only so many good ideas.) The one thing we know about markets is that they fluctuate. If Taleb’s dentist tracks his portfolio in real time, at any given second he has only a 50.02% probability of experiencing a positive (i.e. profitable) outcome. There is a 49.98% probability of him incurring either sorrow or regret. If Taleb’s dentist spends his whole day tracking his portfolio, he is going to become psychologically exhausted.

 

If, however, our imaginary pensioner restricts his frequency of portfolio observation to once per day, his chances of experiencing a pleasurable outcome rise to 54%. If once per month, that probability rises to 67%. If once per quarter, that probability rises to 77%. And so on.

 

What makes Taleb’s story so compelling is that nothing is changing about our hypothetical investor’s portfolio (he still makes his 15% profit per year) – only the frequency with which he monitors it. But human nature being what human nature is, the likelihood of this – or any investor – being panicked by losses (or lured into taking profits) simply by voluntarily exposing himself to price variability is extremely high. So Taleb’s thesis really involves multiple dentists. Those with the discipline to leave their portfolios alone will get to reap that 15% profit. Those with the lack of foresight to suspend their inquisitiveness will be lucky to garner any kind of positive return. We cannot blame the market for our own inability to conquer our lizard brains. The fault is not in our stars, but in ourselves.

Le marché, c’est moi. (In the case of Jerome Kerviel, that was almost literally true.)

 

The challenge for the aspirant retired dentist is compounded by external influences. In the example above, the hypothetical investor is merely confronted by the influence of price. In the real world, he will also be assailed by newsprint, by airtime abhorring a vacuum and by talking heads – all trying to tell a story. And since the basic commodity of the markets – price – is practically free to access, especially after just a token delay, the talking heads will feel obliged to cloak the price beneath thick layers denoting extremes of either bullishness or bearishness. It is to all practical extent impossible to answer the question “Why did the market go up ?” with the admission, “I don’t know, and I don’t much care.” Our culture obligates us to seek causality, and then to answer the implied second question, “Where now ?” with either extrapolation or rejection of the trend.

 

The sudden collapse of Peloton Partners’ $2 billion hedge fund has been widely attributed to a combination of calling the bottom of the ABS / ABX market too quickly, using an imprudent level of leverage to do so, and to this voluntarily imposed ‘hard place’ coming into rapid collision with the ‘rock’ of heightened margin requirements imposed by increasingly panicky prime brokers. What has not featured as a factor, though it has surely played a role in the failure of other large funds, is the impact of waves of selling (redemption orders) triggered by investors reacting to disclosure of the fund’s first significant losses. Since hedge funds typically price their funds on a monthly basis but often restrict investor inflows and outflows to quarterly or worse, there is a mismatch between valuation and available liquidity. Although the first investor to redeem may be reacting to a purely temporary or ultimately survivable hit to the fund’s capital, by the time the redemption flows turn into an orgy of speculative terror, there may be insufficient liquidity within the fund to cater to investor demands, and a perverse form of Gresham’s law works its inexorable gravity on the fund’s value – ‘bad money’ (redemption orders) drives out the ‘good money’ (profitable positions, or even loss-making positions that might well turn out good were they only given the time to do so) to such an extent that the fund is fatally wounded. Combine this obvious unattractiveness in structure with the strategy opacity that has come to suffuse the hedge fund sector and it is a wonder that any of these vehicles ever got funded in the first place. As the phrase goes, marry in haste, repent at leisure.

 

The irony is that funds investing into illiquid, hard-to-trade instruments must report monthly prices that in some instances surely become red rags to a bull – invitations, in some cases, to “take the fund down”. Would managers involved in implementing such trades not be better served by offering two separate fee structures – high fees to those investors “demanding” monthly pricing, and lower fees to those investors comfortable with less frequent but just as accurate pricing ? If you really wanted to ram the point home, you could give the investors with less frequent pricing more timely access to their capital. Private equity investors seem to cope with less regular pricing without incurring a conniption fit. The very concept of liquidity is overrated (though this might not be the environment exactly to labour the point). As Yale’s David Swensen has remarked, investors – particularly those with long time horizons – pay far too much for it.

 

There is, however, one investment structure that offers both manager and investor a number of advantages over an open-ended fund. It’s called a closed-ended fund. Because both hedge funds and private equity funds invest into variously illiquid assets, the fixed (permanent) capital structure of the closed-ended fund gives the manager freedom to invest at will without the inevitable constraints that come with the provision of daily, weekly or even monthly liquidity to existing unitholders. The ability to buy or sell shares on a recognised market helps to resolve liquidity-related issues for investors more easily than in the traditional open structure. And – in the current environment, this could be the clincher – the closed-ended fund offers enhanced transparency as to underlying investments, not least with a requirement to provide quarterly disclosure of significant holdings. It is therefore hardly a surprise that many of the better closed-ended London-listed (funds of) hedge funds trade at a premium to their net asset value. But less well-disciplined investors should beware: the market will give you a daily price on these funds, whether you want it or not. That the London market also offers closed-ended long-only funds investing into emerging markets at a significant discount to net asset value looks like one of the investment bargains of the year.

 

Notwithstanding the correction to temporarily overheated commodities markets mid-week, it would take nerves of steel (and, we think, imprudence) to bet actively against them. That is, in light of the fact that the underlying drivers of the bull market – demand from developing nations; insufficient capacity investment over the last two decades; distorted supply due to political manipulation of the energy market; ‘safe haven’ buying of instruments reliably free of mark-to-make-believe and financial “innovation”; ‘safe haven’ buying of hedges against fiat currencies and notably the US dollar – seem to be utterly intact. Not only are those trends intact, but so are those afflicting financial assets that are triggering the run into so-called alternative assets – ongoing deleveraging and debt contagion. (Ambrose Evans-Pritchard has written a useful commentary on the inflationary / deflationary impact and political implications of the existing market dysfunction. On the topic of spreading credit contagion, Ed Steffelin of GSC Group provided the quote of the week: “People are calling it financial Ebola.”)

 

The bull market in commodities has quickly climbed a wall of worries, the most prominent of which has been the presumption that institutional investors were already sitting wedged firmly on the bandwagon. Perhaps not. Bloomberg’s Saijel Kishan (“Calpers to boost commodity investments through 2010”) reported on February 28^th that the largest US pension fund was considering increasing its exposure to commodities investments 16-fold. The fund is apparently contemplating an allocation of some $7.2 billion by 2010. Its first investment into commodities was, apparently, last year.


Download all_in_the_mind.pdf

Squinting into fog

“A cynic is not merely one who reads bitter lessons from the past, he is one who is prematurely disappointed in the future.” – Sidney J. Harris.

 

Pimco’s Bill Gross calls them ‘Old Maids’. Canada’s Eric Sprott refers to them as UFOs from Mars. However one wishes to label the risks attendant upon structured products invariably linked to the health of the property and mortgage markets, the underlying reality is that leverage – throughout the financial system – continues to be aggressively unwound, that the “fair” pricing of those products remains opaque at best, and that supposed professionals are not necessarily any closer to understanding the dynamics of this market than otherwise uninformed observers. Bob Parker, vice-chairman of Credit Suisse Asset Management, told clients last week that the worst of the sub-prime mortgage crisis would be over within weeks. Perhaps so. This opinion would, however, have carried more weight had it not come from within Credit Suisse, which just a week after reporting decent fourth quarter 2007 earnings, suddenly announced that it would be writing down an additional $2.85 billion because of unspecified “mismarkings” by a group of traders.

 

That so many storied members of a former global banking élite have been carried out on stretchers during the credit crisis perhaps suggests that we have seen a fundamental changing of the guard during this period of acute financial disfunction. One way of expressing this change is in the coinage used by a number of market commentators: that the days of ‘The Great Moderation’ may be over. The chart below, for example, shows the recent price history of Chicago’s Vix index, a market estimate of future volatility for the S&P 500 stock index.

 

Notwithstanding a short-lived spike during the summer of 2005, the Vix’s longer term trend pointed to “the death of volatility” – until subprime-related concerns progressively set in last year, with a vengeance. Credit Suisse may believe that the worst is passed. Others, including former Federal Reserve chairman Alan Greenspan (who now seems tragically unable to keep his trap shut), believe that the US economy has stalled and may well take longer to recover than normal: “As of right now, US economic growth is at zero.” Bank of England Deputy Governor Rachel Lomax warned last week that in the light of the credit crunch, central banks internationally face their “largest ever peacetime liquidity crisis,” as “each week seems to highlight some new dimension of the ensuing disruption to core financial markets.” Consultancy Gavekal Research may have been among the first to elaborate upon the theme of “The Great Moderation”; as their chart indicates, the last forty years have seen a marked decline in the volatility of growth. The companion chart shows that with lower volatility to growth has come higher profitability.

 

But the trillion dollar question is whether either of these trends is sustainable. Corporate profits in the US, relative to US GDP, had never been higher than in 2007. In the light of a softening property market and a wounded financial sector, it seems reasonable to assume that analyst expectations for corporate profits growth in 2008 are simply unrealistic. Similarly, the thesis that ‘permanently’ low economic volatility can justify sustainedly high price / earnings ratios looks like being stress-tested to perfection this year. If the financial sector over the last 12 months is any guide to the broader market, the ‘p’ can easily get crushed, with the ‘e’ shortly to follow.

 

Tony Jackson, writing in last week’s Financial Times, took a withering view of the Pension Benefit Guaranty Corporation’s decision, as an itself indebted federal protector of pensions for nearly 44 million Americans, to ‘bet the ranch’ by switching the majority of its assets from bonds into equities. Nobody disputes that equities are likely to perform better over the longer run, but the longer run can be longer than you or I can remain solvent. Mr. Jackson made specific mention of the Asia effect, which is surely playing a significant part in the across-the-board rise in the prices of both hard and soft commodities:

 

“The China effect is crucial. In contrast to the shock increase in the world’s labour supply, which for some years proved disinflationary [that Great Moderation again], the acceleration in per capita incomes points the other way. It produces a multiplier effect on consumption of raw materials, to say nothing of strains on the environment. The result – too much money chasing too few resources.. The result.. will be a hoovering up of investment by resource sectors generally, including water, waste disposal and alternative energy. In such a world, diversified portfolios may no longer make sense. In the 1970s, resource-based portfolios were alone in producing real returns.. Meanwhile, equities in general will suffer from the higher risk premium due to economic instability, and bonds from higher inflation..”

 

We wrote last week of the remarkable surge by soft commodities prices. The exquisite challenge of investing across multiple asset classes today is that innumerable investment sectors with solid longer term fundamentals are almost effortlessly taken “there”, seemingly overnight, by more speculative capital. Contrarianism used to be about bucking the trend by buying out of favour investments at revulsion lows. Contrarianism in 2008 might be about, effectively, endorsing the speculative trend - but keeping the faith for the longer term. Shorter term price action, in other words (wheat, anybody ?) amounts just to weather; longer term, secular, sustainable and fundamental trends amount to climate. (In commodities markets, even more than in stock-picking, buy and hold may come to trounce trading strategies, and the recent article by Bloomberg’s Andy Mukherjee, “Food is a great asset – minus the fund manager” also points in that direction.)  Tony Jackson, we hope, is wrong in suggesting that portfolio diversification could be redundant (to be fair, he concedes as much himself). Whether he is correct or not, no rational investor would surely choose to allocate 100% of their liquid capital to commodities and nothing else. But he could be half right – in that investment right now into every distinct asset class requires extreme selectivity and care. Given the heightened volatility of the resources sector at present, and the marked disconnect between the level of equity indices (borderline euphoric) and the tone of credit markets (borderline suicidal), that seems like an eminently reasonable conclusion.


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