Wednesday, December 10, 2008

A Common Denominator of Failure?

Wall Street climbed back on an upward track Wednesday, rising in late trading as a surge in gold and other commodities prices gave investors a reason to snap up energy and materials stocks:
But the market's closing levels masked the fact that it was a confusing day on the Street. Investors had sent stocks higher until mid-afternoon on expectations of a bailout for the Detroit automakers, but the market forfeited that advance on signs that the plan was running into opposition from Republican lawmakers.

Investors then set aside their uncertainty, and plowed back into stocks as they saw the rebound in commodities.

Gold picked up $34.70 an ounce to close at $807.10 on the New York Mercantile Exchange, lifted by a weaker dollar, but also because investors seemed to be more willing to take on some risk -- a trend that has also been apparent in the recent rally on Wall Street. Oil prices also rose on the Nymex, settling up $1.45 at $43.52 a barrel.

In turn, companies that make their money from commodities rallied, boosting the rest of the stock market. Exxon Mobil Corp. rose 2.4 percent and mining company Freeport-McMoRan Copper & Gold Inc. added 16 percent.

Richard E. Cripps, chief market strategist for Stifel Nicolaus, said the rise in commodities suggests that some investors are betting on an economic rebound. "At this point in time, commodities going up are a welcome sign," he said.

Still, investors are extremely wary about the many trouble spots in the global economy. And so shifting sentiment over a possible bailout deal for Detroit's Big Three automakers tugged at stocks throughout the session -- including financial stocks.

Financial houses that hold investments in the car companies could see further strain on their balance sheets if big players like General Motors Corp. file bankruptcy.

In my opinion, the rise in commodity prices has more to do with technical signals than fundamentals. This sector has been decimated since peaking back in the summer and it is long overdue for some bounce.

I was watching energy stocks closely today. In particular, two companies - Chesapeake Energy Corp. (CHK) and Continental Resources (CLR) caught my attention as they both soared 23% and 22% respectively. If you look at their one year chart, you will see they are way, way off of their peaks and can bounce more from these levels.

Another sector that caught my eye was shipping as stocks like Dryships (DRYS), Knightbridge Tankers (VLCCF), and Nordic American Tanker Shipping (NAT) all rallied strongly today.

Keep in mind that contango is paying off big right now as investors can lock in the biggest profits in a decade by storing crude:

Traders who bought oil at the $40.81 a barrel on Dec. 5 could sell futures contracts for delivery next December at $54.65, a 34 percent gain. After taking into account storage and financing costs investors would earn about 11 percent, according to Andy Lipow, president of Houston consultant Lipow Oil Associates LLC. The premium, known as contango, is the biggest for a 12-month span of futures since 1998, when a glut drove crude down to $10.

Stockpiling crude may provide higher returns than commodities, stocks and Treasuries as the U.S., Japan and Europe endure simultaneous recessions for the first time since World War II. Crude sank 70 percent in New York since peaking at $147.27 in July. The Standard & Poor’s 500 Index fell 38 percent this year and two-year government notes yield 0.9 percent.

“The bottom line is that you buy crude at a low price and lock in a profit by selling it forward,” said Mike Wittner, head of oil market research at Societe Generale SA in London. “It’s low risk. The contango can definitely pay for storage and the cost of capital and leave plenty left over.”

Royal Dutch Shell Plc sees so much potential in the strategy that it anchored a supertanker holding as much as $80 million of oil off the U.K. to take advantage of higher prices for future delivery. The ship is one of as many as 16 booked for potential storage instead of transporting crude, said Johnny Plumbe, chief executive officer of London shipbroker ACM Shipping Group Plc.

No wonder shipping stocks are rallying right now. But investors should treat these as trading opportunities, not buy and hold opportunities.

The fundamentals for commodities remain very weak. An excellent must read commentary from Naked Capitalism, Questioning the Commodities Supercycle, highlights the problem with commodities.

From the FT article they quote:

The common belief in the industry itself, and among most Wall Street analysts, is that the market is undergoing a correction but that the boom years have not ended....

But a growing minority disagrees with this rosy view. With its report released on Tuesday, the World Bank has put itself among the most vocal in warning that the commodities boom has come to an end. Some executives in the natural resources industry agree – in private....

Although most proponents of this argument see prices remaining well above the lows of the 1990s, they do not forecast a return to the torrid levels of this summer. That is because a more slowly expanding population and weaker rises in income will ease global economic growth – and commodities demand – in the next two decades.

They dismiss the notion that the credit crunch will trigger shortages in the future as companies cancel investment projects. Any increase in demand will first slowly have to absorb the current build-up in dormant capacity as companies cut their production....

For its part, the natural resources industry points out that falling supply in some areas and commodities – such as mature oilfields in the North Sea or old gold mines in South Africa – will support prices even if demand is weak. But pessimists say that the rapid fall in demand will leave the system with plenty of spare capacity.

Both sides have powerful arguments but history says that commodities booms last about a decade – almost exactly the length of time that oil prices were on the rise.

Whatever the disagreements, pessimists and optimists see eye to eye on the next 12-24 months: it looks grim for commodities....

“The main difference for commodities is that our view for emerging countries’ near-term economic growth is now more pessimistic,” says Thomas Helbling, an IMF economist who specialises in commodities issues. Relatively high-growth emerging countries consume more energy and other basic products than developed nations as they build infrastructure and embrace new forms of consumption, from cars and washing machines to meat and refrigerators....

According to the World Bank, Chinese economic growth will slow to 7.5 per cent in 2009, the lowest rate since 1990. But some bankers and mining executives are even more pessimistic, saying that activity in some sectors has already almost stopped...

But for investors, executives and bankers alike, the commodities boom and bust cycles teach that extrapolating today’s events into the future may prove the wrong bet. Ten years ago this week, when oil prices bottomed at $9.64 a barrel, the common wisdom was that commodities prices were heading down. Today’s forecasts could prove equally fallible.

Just to underscore the fact that this is a global recession, Chinese exports, which had so far been resilient in the face of the global slowdown, dropped 2.2 percent in November from a year earlier - their first fall in seven years, and a stunning reversal from the 19.2 percent growth seen as recently as October.

I agree with Paul Kedrosky who says things will only get worse. In fact, he's long been skeptical of the purported double-digit Chinese economy growth rates. Expect more riots, unemployment and closed manufacturing plans in China; and some dangerous ripple effects around the globe.

The preceding discussion sets up well tonight's discussion on how so many people failed to recognize what was going on the the financial system and how it was going to ripple through the real economy.

I was talking with a reporter today who asked me how did I foresee this disaster? I told him that I connected the big dots. I saw the bubble in securitization (click on chart above) keeping rates artificially low and fueling the bubble in U.S. housing, commercial real estate, commodities, hedge funds and private equity (low rates spurred huge leverage in all these asset classes).

It was all one "HUGE BUBBLE" I told him and now that the party in alternative investments is over, pension funds will be licking their wounds for many years to come.

In terms of hedge funds, according to two former hedge fund managers, the industry was victimized by its own success (click on that link and listen to this interview very carefully!):

"The money came in faster than their ability to manage it," said Rick Schottenfeld, chairman of Schottenfeld Group, a proprietary trading firm. "In order to move a big pool [of capital] they were forced into strategies that were leveraged-based, not alpha-based."

Alpha is a measure of a fund's risk-adjusted return; a higher alpha implies a better return vs. other investment objects with the same market risk.

During the low-volatility days of 2004-2007, many hedge funds gave the allusion of providing alpha. But "when there's a flood of capital, you run out of places to do things that create unique value," says Rob Roy, co-chief investment officer at Atlantic Advisors, which has about $3.5 billion under management. "You reach for things that allow you to create returns, which is different from value."

Indeed, the smooth returns of the hedge fund industry proved illusory when market volatility began to surge. Hedge funds posted losses averaging 22% this year through Nov. 24, Bloomberg reported.

As hedge fund performance tumbled this year, many investors clamored for their money back, which only put additional pressure on over-leveraged positions, hence the recent trend of funds halting redemptions.

Many hedge fund investors are in a "prisoner's dilemma," Schottenfeld says. "If they force the funds to open, there might not be any money left."

To Roy, a former hedge fund manager, this raises the question of whether hedge funds really are a suitable asset for all investors — including pension funds and endowments — as had been the trend prior to 2008.

In 1990 there were just 610 hedge funds, with $38.9 billion under management, according to Vanity Fair. At the end of 2006 there were 9,462, with $1.5 trillion under management. (The industry's assets peaked at $1.9 trillion in June 2008, according to Bloomberg.)

"There needs to be a place for unbridled capitalism," Schottenfeld says. But "people need to change their expectations of hedge funds."

I think 2008 has taken care of that.

So why did so many people get it so wrong? One expert who did predict the crisis, James Galbraith, economics professor at the University of Texas at Austin, says the majority of his peers were blinded by a belief in free-market philosophy and the notion markets are rational:

Alan Greenspan recently admitted to a "flaw" in this philosophy, of which he was the most noted practitioner: "I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such as that they were capable of protecting their own shareholders," the former Fed chairman said.

A self-described "financial ambulance chaser," Galbraith, the son of famed economist and market historian John Kenneth Galbraith, said two major developments in the mid-2000s tipped him off that something was amiss:

  • The huge expansion in household debt as many Americans funded consumption by borrowing, especially via home equity loans.
  • The "abandonment" of regulatory oversight at the Federal level, which insured the "most aggressive, most abusive" players in the mortgage market would flourish.

Unfortunately, Galbraith doesn't hold much hope that this crisis will change much the outlook for economists, noting they don't study history and many are "still in denial" about what's transpired.

Denial is a terrible thing, especially when you are entrusted with billions of dollars in pension assets. Unfortunately, too many pension fund managers are still in denial about what has transpired and how it will shape the future financial landscape (on this last point, you must watch Charlie Rose's conversation with Nassim Taleb).

Today, I read that Connecticut State's pension plan will begin investing in hedge funds after market turmoil wiped out $5 billion of pension assets:

Connecticut State Treasurer Denise Nappier is proceeding with a plan to invest in hedge funds after market turmoil wiped out $5 billion of pension assets.

Nappier, first elected treasurer in 1998, will begin allocating up to 8 percent of the $20 billion she oversees for public sector employees and teachers into hedge funds after the state’s investment advisory council approved the plan today.

Connecticut, which claims to be the world hedge fund capital, is one of the few states that doesn’t invest its public pension in the asset class.

“This is the time to position our portfolio for the long term,” Nappier said today after a monthly meeting of the pension fund’s advisory council in Hartford. “I need that exposure as a diversifier,” she said, referring to hedge funds.

I would advise Ms. Nappier to be very careful with her foray into hedge funds. She'd better sit down with independent experts who will steer her in the right direction or else Connecticut's pension fund risks getting slaughtered and having no "diversification benefits" (remember most hedge funds sell beta as alpha!!!).

She also needs to understand that hedge funds' future may lay in the past:

One possible outline of the future of hedge funds is beginning to emerge from the wreckage of the industry’s six-year boom, and it looks very much like the business did in the 1980s, but with lower fees.

Several of the biggest hedge funds, including the venerable Tudor Investment Corp, run by Paul Tudor Jones, are returning to their roots as traders of the most liquid currency, interest rate and equity index markets. Both have split off toxic, hard-to-sell assets into special vehicles from which investors cannot withdraw their money.

Other funds trading illiquid instruments – credit, structured products and complex derivatives – are stopping investors getting their money back, as they try to defer forced sales of assets. Many are likely to shut down as they eventually pay back disgruntled clients.

At the same time, all the strategies that relied heavily on borrowed money are dead in the water as banks cut their lending and regulators pay more attention.

It is still early to draw conclusions, but the powerful industry appears to be splitting in two. At one end are the funds that can easily sell their holdings to repay investments, following strategies such as global macro – Tudor’s core – and long-short equity trading, which makes up about a third of funds.

At the other end will be funds with long lock-ups, more akin to private equity vehicles, which can justify the restrictions on withdrawals by investing in hard-to-trade assets.

Centaurus Capital, a London hedge fund that is shrinking its main fund after efforts to restrict withdrawals failed to win investor support, is planning two new funds following this model. One will be highly liquid, the other will have long lock-ups, rather than the existing fund mixing the two.

Ratan Engineer, head of the asset management practice at Ernst & Young, says investors caught out by hedge funds invoking small print to restrict withdrawals will now demand more transparency.

“People are going to say they need to understand the underlying instruments, and if they are liquid they will not accept long notice periods and gates,” he says. “But if there is a good investment reason they will accept long lock-ups.”

Increasing transparency is anathema to many secretive funds, which often worry about copycat investments or attacks on their positions.

But they may find it hard to resist investor demands as they try to retain investors, many of whom are quitting the industry.

Morgan Stanley estimates that from June to the end of the year the industry will shrink 35-45 per cent, with redemptions of 25-30 per cent in Europe and 15-20 per cent in the US.

Investors who want to stay are already demanding the removal of some extended notice periods for withdrawals, which they regard as unjustified, and lower fees in return for their loyalty.

“The shoe’s on the other foot now,” says one prominent investor in hedge funds. “Up to now the hedge funds have held the power so they have been able to impose these ridiculous fee terms and lock-ups. We are putting on our size 12s and kicking our managers, telling them change these terms or we are going to pull our money.”

The heads of five funds running more than $15bn, and numerous smaller funds contacted by the Financial Times all said they expected fees to drop – although some thought they would get money locked up for longer in return.

“Hedge funds will want longer-duration capital,” says the founder of one of the US’s largest funds. “You are going to have to incentivise investors through lower fees.”

Another warns that competition is likely to increase, prompting fee cuts, as funds struggle to survive. Many funds are well below previous highs, known as high-water marks, meaning they face no prospect of earning performance fees this year or next.

“People who are down 20 per cent are so far below their high-water marks that they have to get in new money just to pay the bills,” says the founder of one of London’s largest funds. “So they are offering lower fees.”

This is already visible in the fund of hedge fund business, where some recent mandates have been awarded at less than half the fees usually charged, according to managers.

Other managers and investors are discussing whether funds should charge fees only on realised profits, the standard practice in private equity, not paper profits.

Some new funds also have been offering surprisingly low fees, investors say. For example, a new fund from London-based Ferox, designed to capitalise on the crisis in convertible bonds by taking directional positions, has a fixed two-year life and fees of either 1 per cent a year and 10 per cent of profits or just 15 per cent of profits on returns above an annual 10 per cent.

“A lot of the corruption of the [hedge fund] proposition is being laid bare and will be eradicated,” Mr Engineer says.

The change to a new model is happening fastest at funds that have hit problems or been faced by very large withdrawals.

Mike Novogratz and Adam Levinson, managers of Fortress’s Drawbridge fund, for example, told investors last week they planned to “offer an opportunity for reduced fees” on the fund, as well as focusing on highly liquid trading strategies.

The $7.2bn Drawbridge faces $3.51bn of redemptions, which it has suspended, after falling almost 23 per cent in the year to the end of November.

It is Darwinism in the hedge fund industry as most are scrambling to survive. I have mixed feelings, however, about locking up money for lower fees. It sounds to me like they are just trying to buy time, hoping the good times will come back.

But as I already alluded to in "R.I.P. Good Times?", this is an unprecedented shock to the global financial system and it is wreaking havoc on the real economy. It will take years to clear this mess up so forget about the old mantras like "stocks for the long-run". In a deflationary environment, it's going to be "bonds for the long-run", pick your sectors based on energy and demographic themes, and trade in and out of bear market rallies to capture some gains.

Finally, take the time to read Absolute Return Partners' December letter. It raises many excellent points that every single investor needs to understand. Importantly, read what they say about leverage in the system, deflationary headwinds and opportunities in credit markets (their advice is to stick with senior secured loans - first lien only).

Yes, denial is a terrible thing but sooner or later you have to wake up and face reality. Unfortunately for most pension funds, hedge funds, mutual funds and individual investors, it's already too late.

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