Thursday, September 10, 2009

Recovery Will Mirror the Decline?

Treasury Secretary Timothy Geithner testified on Capitol Hill on Thursday before the Congressional Oversight Panel stating that confidence has returned to markets:
Citing emerging financial sector stability, Treasury Secretary Timothy Geithner said Thursday that a number of government rescue efforts in place since the Wall Street crisis are no longer needed and that banks will repay $50 billion in rescue funds over the next 18 months.

Geithner, testifying before a congressional watchdog panel, said the nation still has a ways to go before "true recovery takes hold." But he said improved conditions in the banking industry have prompted Treasury to begin winding down emergency support programs implemented after the collapse of Lehman Brothers last year.

"The financial system is showing very important signs of repair," Geithner said. He added later: "I would not want anyone to be left with the impression that we're not still facing really substantial enormous challenges throughout the US financial system."

The cautious but upbeat tone reflects a growing push by the administration to present the government financial rescue efforts as a success amid lingering public apprehension about the economy.

Earlier today, Federal Reserve Bank of Atlanta President Dennis Lockhart said the U.S. economic recovery will probably be “lackluster,” hobbled by strains in financial markets and weak consumer spending:

“Over the medium term, I see a slow recovery with ongoing repair of the financial sector,” Lockhart said today in remarks prepared for a speech in Jacksonville, Florida. “There are risks to even this lackluster outlook.”

The Fed said yesterday that 11 of its 12 regional banks, including Atlanta’s, reported signs of a stable or improving economy in July and August, adding anecdotal evidence that the worst U.S. recession in seven decades is over. The number of Americans filing first-time claims for jobless benefits dropped last week to the lowest level since July, the Labor Department reported today.

Policy makers said last month the economy appeared to be “leveling out,” with a “gradual” resumption in growth likely. Still, consumer spending was expected to be constrained by “job losses, sluggish income growth, lower housing wealth and tight credit.”

“Although consumer confidence is rising, actual consumption has remained muted overall,” Lockhart said. “Consumers remain cautious because of employment concerns and wealth loss. Households continue to deleverage, that is, pay down debt.”

Some market participants are much more optimistic about the recovery. Jeff Matthews of the hedge fund RAM Partners appeared on Tech Ticker stating that this is a normal cyclical recovery and in all recoveries, the recovery mirrors the decline:

The way to make big money on Wall Street is to stick your neck out and take a position when everyone else thinks you're a nutcase.

Our guest Jeff Matthews of hedge fund RAM Partners did just that earlier this year when he said the economy was headed for a standard cyclical recovery. At the time, most people thought the world was still on the verge of collapse.

Now the economy argument is usually between those who think we're headed for "double-dip" recovery (a short, happy boom followed by another bust) or a "square-root-shaped" recovery (a short, happy boom followed by years of treading water). Our guest Liz Ann Sonders of Schwab, who was also an early bull, made the latter case earlier this week.

Jeff Matthews thinks both views are wrong. He thinks this will be a "v-shaped" recovery, in which the economy recovers far more sharply than most people think. He thinks those who keep bleating about a "jobless" or "shallow" recovery like those in the early 1990s and 2000s are missing a key point:

The slope of the economic recovery, Jeff says, mirrors the slope of the economic drop. We had a sharp collapse. So we're going to have a sharp recovery.

I suggest you listen carefully to the interview (click here to watch it), especially when he talks about cognitive dissonance and taking the emotions out of it ("stock markets are not a reflection of your self-worth").

So is Mr. Matthews right or is he wearing some rosy glasses? The hardest thing for me to explain to people is that the stock market is a beast on its own. Right now, the market is pricing in a recovery. Whether it is a V-shaped or W-shaped recovery is immaterial, it's a recovery.

And as we head into the last quarter of the year, there are a lot of anxious portfolio managers who are suffering performance anxiety. What does that tell me? They're going to go long risk assets like high yield bonds, emerging market equities and bonds, commodity currencies, commodities and high beta stocks.

I have been writing and telling everyone to keep buying the dips. There is a lot of liquidity in the system and we have not seen anything yet. When things really take off, there will still be naysayers and skeptics out there, but even they will eventually throw in the towel.

Now, let me stop here for a second and talk about the economy. Unlike the markets, the recovery in the economy will not be V-shaped. In particular, those millions of job losses will not come roaring back. This will be another jobless recovery, just like the last recessions, but there are signs that the U.S. labor market is improving.

Importantly, companies managed to boost their workers' productivity and their own profits in the spring mainly by slashing costs and capping their employees' pay:

Productivity — the amount of output per hour of work — rose at an annual rate of 6.6 percent in the April-June quarter, the Labor Department said. That's the largest advance since the summer of 2003. And it's slightly better than the 6.4 percent productivity increase the government had estimated last month.

At the same time, labor costs fell at an annual rate of 5.9 percent — the sharpest drop since 2000 and slightly more than the 5.8 percent drop estimated a month ago.

Economists said the rising productivity and lower labor costs supported their view that the longest recession since World War II is coming to an end.

Mark Zandi, chief economist at Moody's, said it's "very typical" for productivity to surge at the end of a recession as businesses aggressively cut costs.

Economists say they don't expect productivity to keep surging. But they said the productivity jump in the second quarter, combined with falling labor costs, might persuade employers to slow their pace of layoffs and eventually resume hiring.

That is critical because until the labor market heals, consumers probably won't step up their spending. And consumer spending, which accounts for about 70 percent of economic activity, is a vital ingredient in any sustained rebound from the recession. A dismal job market makes that prospect uncertain.

Surging productivity means that Q3 and Q4 growth will surprise to the upside. As profits increase, stocks will head higher.

There are other signs of recovery worth mentioning here. The WSJ reported that the Man Group is launching an onshore version of its AHL product, one of the largest single hedge funds with some $20 billion assets under management, in a further sign of the company's confidence in boosting sales to private investors:

Man AHL Diversity is a managed-futures trading program, which means it follows and seeks to exploit persistent market trends. It will be managed by Man Investments, the asset management arm of Man Group, and marketed by hedge fund advisory company Dexion Capital Group.

The world's largest listed hedge fund aims to attract sophisticated investors who will be able to buy in with a minimum initial investment of just GBP100 from its launch in October.

"Historically, the performance of trend following managers has tended to be uncorrelated to traditional stock and bond markets," said Tim Wong, chief executive of AHL.

"We saw that with AHL's highly impressive performance last year when its best performing fund delivered 33% at the same time as some equity markets fell 40%," he added.

Man Group has successfully wooed private investors even as withdrawals by institutional investors have continued. In July the company reported strong sales to private individuals, posting a rebound to $3.4 billion in its first fiscal quarter to June 30.

The introduction of Man AHL Diversity onshore will give individuals exposure to more than 90 global markets and 29 international exchanges trading continuously which makes for a highly liquid product following trends in everything from currencies and interest rates to agricultural assets and metals.

But the London-based alternative investment manager is yet to be fully convinced about the early turnaround in the global economy, so it stays conservative on equity investments, said John Rowsell, managing director of Man Investments:

"We are still very cautious in terms of where we think the risks are and how much normalcy or rebound there has been in the economy," Rowsell told Reuters in an interview in Hong Kong.

"Earnings have not come back as strongly as expected. More importantly, consumer's access to credit has been severely curtailed and their appetite for credit has been affected."

Man's assets under management had dipped to $43.3 billion by the end of the June quarter.


Global hedge fund managers are still clawing back from a wave of redemptions which saw investors pull out more than $150 billion from funds of funds, amid the financial crisis, according to Hedge Fund Research.

Some fund managers started to put "risk on/risk off" trading strategies in practice this year as global markets recovered, but Rowsell said it was not yet a good time to leverage risks.

Among Man's fund strategies, convertible bond arbitrage has put up a strong showing for Man after its rocky performance in 2008, while its credit strategies have also done well but returns from macro have been subdued, Rowsell said.

"Commodities have also been making money without necessarily going long on them. Basically, you can make very attractive returns without having a lot of beta in your portfolio at this juncture," said Rowsell, a former director at the Chicago Mercantile Exchange.

Rowsell said Man preferred to invest in markets which have higher "dispersion" such as Japan and the Western markets over China, which many other asset managers regard a top pick.

In the wake of the Lehman Brothers debacle, Man has been adjusting its business model to better manage risks by transferring a part of its investments into managed accounts from co-mingled accounts.

In a managed account the hedge fund manager's role is limited to the right to make investment decisions while clients have control over the assets of the fund being managed.

"We are not doing this simply for transparency but for control over the assets. We also can then control the relationships with the prime brokers which is a potential area of risk," said Rowsell.

Rowsell said Man had been increasing the number of managed accounts as well as the proportion of its assets in these accounts and aims to move well over half its investments to managed accounts eventually.

Over half its investments to managed accounts? That means they will be focusing on liquid strategies that are easier to get out of if things blow up again. Institutions should be paying attention to what this giant in the hedge fund industry is doing because that is exactly what I wrote about in hedge fund heave-ho. Stick to liquid strategies using managed accounts and forget highly leveraged illiquid strategies.

Speaking of hedge funds, Bloomberg reports that according to Eurekahedge, hedge funds returned 1.1 percent in August, the sixth straight monthly gain, as managers investing in Europe and distressed debt outperformed:

The Eurekahedge Hedge Fund Index, tracking more than 2,000 funds, gained 13 percent this year, according to the Singapore- based data provider’s preliminary report based on 30 percent of the funds that reported August performances. Net inflows to the industry totaled $4.5 billion last month with over 50 percent of the reporting funds attracting capital, the report showed.

Hedge funds are benefiting as stock markets rebound on signs economies are recovering from the first global recession since World War II, and managers investing in distressed assets are finding opportunities in the wake of the financial crisis. The MSCI World Index of 23 developed nations jumped 3.9 percent in August, bringing its year-to-date advance to 18 percent.

“Hedge funds have benefited greatly from the global stock- market recovery,” said Masaharu Ito, a senior analyst at Daiwa Institute of Research Ltd.’s capital market research department in Tokyo. “Given how many of the funds still have some sort of exposure to the equity market, their performance going forward will largely depend on the direction of stock markets globally.”

More than 300 funds have started while 400 fund-closures were confirmed this year, Eurekahedge said.

Asia Underperforms

Six of Eurekahedge’s seven regional indexes rose last month. The measure tracking Asia-focused hedge funds declined.

The gauge tracking European managers advanced 2.6 percent, making it the best performer in August, as funds benefited from gains in regional equities, Eurekahedge said. Eurekahedge’s North American Hedge Fund Index climbed 1.8 percent as the Standard & Poor’s 500 Index rose for a sixth-straight month.

Managers in Asia excluding Japan underperformed, with the Eurekahedge Asian Hedge Fund Index losing 0.4 percent, as stocks in China, Hong Kong and Taiwan fell. China’s Shanghai Composite Index tumbled 22 percent in August, its biggest slide since October 2008, pushing the benchmark into a so-called bear market.

The measure tracking Japan’s hedge funds added 0.7 percent as the benchmark Nikkei 225 Stock Average rounded off a six-month, 39 percent advance.

All nine Eurekahedge measures tracking different hedge-fund strategies rose. An index of managers investing in distressed debt jumped 6.2 percent, making it the best performer, largely driven by a few emerging-market-focused funds, Eurekahedge said.

Distressed Securities

Distressed securities are mostly loans and low-rated, high- yield bonds of companies that have trouble meeting interest and principal payments. Investors can profit if prices rebound or the securities are swapped for equity in a restructuring. Distressed loans usually trade below 90 cents on the dollar and bonds below 70 cents.

Eurekahedge’s global index last year slid 11 percent, the most since the firm began tracking data in 2000. In July, hedge- fund assets increased by $10.6 billion, bringing total assets under management to $1.35 trillion, Eurekahedge said last month.

Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether asset prices will rise or fall.

Does all this mean the W-recovery is off the table? Not necessarily. What it means is that there is a lot of liquidity in the system that will spur another asset bubble. And we all know that asset bubbles do not end well.

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