Thursday, October 16, 2008

Will The Manic Depressive Market Grind Higher?

Let me begin by stating that I have new responsibilities that preclude me from writing lengthy blogs where I update things throughout the day. I will try to keep posting interesting topics but my new responsibilities take precedence over the blog. Feel free to still email me and I will try to respond in a timely fashion.

This morning I read a Bloomberg article stating that Citadel Investment Group, one of the best of the large multi-strategy hedge funds, fell as much as 30 percent this year because of losses on convertible bonds, stocks and corporate debt:

Kenneth Griffin, who founded Citadel in 1990, said in a letter to investors this week that returns for the $10 billion Kensington Global Strategies Fund may swing wildly as markets are battered by the global credit crunch. Griffin holds 30 percent of the firm's $18 billion of assets in cash, according to an Oct. 8 report by Standard & Poor's.

``In the weeks to come, I expect we will continue to see significant volatility in our earnings as the world manages through the unfolding crisis,'' wrote Griffin, 40. ``It is incumbent upon us to navigate through this period and to create value for our stakeholders over the years to come.''

Kensington's loss, more than double the decline of the Credit Suisse/Tremont Hedge Fund Index, may dent Griffin's reputation as a consummate risk manager with no patience for traders who can't make money. Kensington's only annual loss was a 4 percent drop in 1994.

Katie Spring, a Citadel spokeswoman, declined to comment.

Citadel may have difficulty selling convertible bonds, which accounted for about a quarter of the loss, because there is little demand. The market tumbled 13 percent in October, according to a Merrill Lynch & Co. index. The benchmark is down 21.5 percent since the end of August.

``It's very hard to get out of positions,'' said Tom Sowanick, chief investment officer at Clearbrook Financial LLC in Princeton, New Jersey, which manages $22 billion.

But Mr. Griffin isn't ready to throw in the towel:

Even with the losses, Griffin continues to take steps to turn Citadel into a diversified financial firm. He is close to hiring a senior executive for his capital-markets business, according to a person familiar with the matter. At the beginning of the year, Citadel separated that business, which includes an options market-making group and a service that handles administrative chores for hedge funds, from its money-management operations. The options market-making group has returned about 30 percent this year.

Citadel also plans to start single-strategy hedge funds, including a fixed-income fund, a macro fund and a convertible- bond fund. These funds will charge investors 2 percent of assets and 20 percent on any investment gains. Citadel's current funds also get 20 percent of any gains, and instead of paying a management fee, clients cover the fund's expenses.

I wouldn't bet against Ken Griffin and I am confident he will reemerge from this brutal hedge fund shakeout a stronger and better money manager. I can't say the same thing about 95% of the hedge funds out there, but he is one manager who understands what true alpha is and he knows how to capture it.

Hedge funds will not be getting any help from U.S. Secretary of Treasury Henry Paulson who today said his plan to inject capital into financial companies is focused on banks and thrifts, indicating unregulated firms such as hedge funds won't initially get government aid:

``It is important to me that when you look at financial institutions that we not have perverse incentives or people's interests in compensation encourage excessive risk-taking,'' Paulson said, while declining to comment on compensation at specific firms.

Mr. Paulson walked away from Goldman Sachs with $500 million and a tax exemption on capital gains when he became Treasury Secretary, so he is now eminently qualified to lecture the rest of Wall Street on distorted compensation schemes (!#@?!).

Meanwhile, Bloomberg reports that the U.S. Treasury's pledge to inject $250 billion into banks may coax private-equity leaders Stephen Schwarzman, David Rubenstein and Henry Kravis to resume investing after more than a year spent mostly on the sidelines:

The founders of Blackstone Group LP, Carlyle Group and KKR & Co. LP told investors in Dubai this week that the biggest government intervention in the financial system since the 1930s will help attract private capital to lenders. The U.S. plan, following similar steps by Britain and other nations, may lead to investments of tens of millions dollars, not the $20 billion- plus deals that capped the leveraged-buyout boom of 2006-2007, they said.

Private-equity firms have been hunkered down since the onset of the credit crisis about 16 months ago, scarred by broken deals and frustrated by the evaporation of debt financing crucial to buyouts. The efforts to shore up the credit system may pave a slow road back to deploying the almost $500 billion in uncommitted cash they have raised from pension funds, endowments and foreign governments.

``There's a crying need for capital, and now there's a chance that the government will invest alongside,'' said Rubenstein, the 59-year-old co-founder of Washington-based Carlyle, whose $80 billion in assets rank it second in the buyout industry after Blackstone and ahead of KKR.

I am willing to bet you that Comrade Paulson's next gig will be sitting on the board of one of these "prestigious" private equity funds collecting huge "advisory" fees.

But my sarcasm aside, investors should pay attention to what these private equity funds do, not what they say. If they do come back to the market, it is very bullish, signalling an end to the credit crisis and the beginning of an important market consolidation phase.

If that happens, I would also expect mergers & acquisitions to pick up and bring the market higher as firms get taken out at higher multiples.

The injection of private equty capital couldn't come soon enough. The volatility that Ken Griffin alluded to earlier in my post was once again present in today's stock market as stocks came back from testing the lows and soared into the close:

It is clear that investors are reacting in the extreme to any negative economic news, including disappointing numbers Thursday on industrial production that sent stocks skidding. But traders are also responding to the market's own dynamics, and when there was no late-session plunge, as there was on Wednesday, buyers piled in before the close.

Analysts expect this extraordinary volatility to continue, and warned that just as Monday's huge 936-point surge in the Dow was overdone, there was little reason to trust that Thursday's gains would hold.

I happen to disagree. As I stated yesterday, institutions like hedge funds, mutual funds and pension funds will do everything they can to bring this market up from these depressed levels to make up for the numbing losses they suffered thus far this year. This is my "vested interests" theory and why I believe this bear market rally has legs to continue grinding higher.

But as we grind higher, it will remain a choppy and volatile market:

``We have a manic-depressive market,'' said Frederic Dickson, who helps oversee about $20 billion as chief market strategist at D.A. Davidson & Co. in Lake Oswego, Oregon. ``The speed at which markets are reacting to news right now is close to mind-numbing. If the bond insurers are going to line up at the Treasury, that's probably a good thing. Oil at $70 a barrel has just given the American public a tax break.''

So fasten your seatbelts and keep my "vested interests" theory in mind as you watch this volatile market grind higher. When you finally muster the strength to open your monthly statements at the end of the month, just remember that institutions have not fared better in these savage markets and they have a lot of catching up to do before they see greener pastures.

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