Wednesday, September 1, 2010

Ripe for a Sustainable Bullish Turn?

It was a hot and beautiful day in Montreal. I met up with my former supervisor at the Caisse, Mario Therrien, who last year was appointed Senior Vice-President, Fund Management, with the Private Equity group.

It had been almost seven years since I last saw him, and I was glad to hook up with him again to talk markets, alpha, hedge funds and private equity. Mario is a smart guy who reads a lot on markets and politics. He understands alpha and he's very well connected with key players around the world. Talking markets with him is always fun.

Mario also offered me one of the most exciting jobs I've ever had. I was responsible for a portfolio of directional hedge funds (L/S Equity, global macros and CTAs) and learned a lot conducting investment, operational and risk management due diligence. But what I truly loved was sitting down one on one with top hedge fund managers and picking the minds on everything from which sectors they're investing in, to where they think bond yields are heading, to which trends they're following.

The toughest part of that job was the grueling travel schedule, not having full control of the portfolio, having to trust your managers when things were shaky, and knowing when to pull the plug when performance was simply not up to par. But it was an incredible experience and if I had to do all over again, I wouldn't think twice about it. Of course, with my MS progressing, crazy travel schedules are not easy. That part of it I don't miss.

Anyways, Mario gave me a lot of food for thought. We talked about how crazy things got in the last few years, the "new normal" and how the landscape has changed for hedge funds, private equity funds and pension funds.

On pension funds, I told him the Fed has no choice but to bail them out and he told me that the "trend towards immunization among G7 pension funds" has contributed to lowering bond yields to historic lows. "Pension funds are lowering their beta, cutting exposures to equities, shifting assets into bonds, liquid hedge funds, and some private equity."

[Note: I agree with Mario, illiquid, hard to understand hedge fund strategies, including black box, super funky quant strategies, are out. Investors are increasingly demanding that managers explain the rationale behind positions, and they're not going to pay 2 & 20 for leveraged beta.]

Why are pensions immunizing their portfolios? According to Mario, "Most mature pension plans are suffering severe pension shortfalls. They simply can't afford to be ravaged by another bear market which will force them to increase contribution rates. A lot of pension funds are now focusing more on protecting downside risk."

Post 2008, the mindset has changed and big players are focusing more on risk management, especially managing liquidity risk. Michael Sabia, the Caisse's President & CEO, talked a lot about risk management on numerous occasions and the Caisse devoted an entire section on it in its 2009 Annual Report.

Unfortunately, Mr. Sabia and his senior managers still have to deal with petty Quebec politics. The Caisse recently had to categorically deny misleading allegations by one of Quebec's powerful public sector unions who questioned the Caisse's mid-year stellar results.

But one thing that worries me is that all this focus on risk management, immunization, is leading pension funds to not take enough risk, and many of them will be caught off guard. Remember, when everyone is hunkering down, worried about the next Black Swan, then you have the potential for a sharp rally.

I am wondering if this is happening right now. Too many pension funds and other institutional investors underweight equities might suffer another bout of severe performance anxiety and are then going to scramble chasing stocks higher. I spent the last couple of weeks going over what the top hedge funds were buying and selling in Q2, and something tells me they're well positioned for any sharp, bullish reversal.

On this last point, read Chris Ciovacco's latest market comment, Markets Appear Ripe for a Sustainable Bullish Turn. I quote the following (but read his entire comment carefully):
Early September is very important for the financial markets; especially for the bulls. Numerous elements are in place for a rally to take hold now. The markets have been weak and the bears have been in control. If the bulls cannot make a stand soon, it will be a bad sign for risk assets. The good news for the bulls is several factors, across numerous markets and asset classes, are pointing to a possible rally in risk assets:

  • Bearish sentiment is high at the moment. Sentiment, especially as it approaches extremes, can serve as a contrary indicator.
  • The Fed has signaled they are willing to print more money if needed. Right, wrong, or indifferent, the markets are anticipating more quantitative easing from the Fed. The Fed's next meeting is only three weeks away. Markets look forward. A rally in risk assets for a few weeks is not out of the question.
  • Currency and interest rate markets are acknowledging the possibility of the Fed cranking up the printing presses. In recent weeks, the U.S. dollar and the 10-Year Treasury have been firmly in the bears' camp, but they are sitting near logical points of reversal. Recent rallies in the 10-Year Treasury have been showing signs of fatigue, which also points to a possible reversal in interest rates.
  • Better than expected manufacturing data from China and better than expected growth in Australia have been reflected in the copper market. Emerging market stocks closed yesterday at a logical point of reversal; this morning's news from China and Australia could spark a rally.
  • Despite weeks of disappointing news on economic progress in the United States, the S&P 500 and Dow have yet to revisit their June lows, which is hard to believe given the recent lack of interest from buyers. When markets do something you do not expect, it is time to pay attention.
  • Monday's sell-off appeared to be a win for the bears, but unlike recent down days for stocks, total market volume contracted relative to the volume during Friday's Fed-induced and broad-based rally. The S&P 500 and Dow have both held at logical reversal points.

Since a picture is worth a thousand words, we can show most of these concepts on the charts below. When you examine the charts, ask yourself, "Based on the actions in the past from market participants, is it logical for this market to reverse near current levels?" If the answer is yes, then the next thing to look for is some confirmation from the markets, which can come in the form of market breadth (advancing issues vs. declining issues), volume, and whether or not a broad cross section of markets are moving in the same direction (stocks, commodities, interest rates, currencies, etc). This analysis was completed after Tuesday's close (8/31); so none of Wednesday's (9/1) gains are reflected.

Finally, let me thank Mario again for lunch and his book recommendation, Steve Drobny's The Invisible Hands: Hedge Funds Off the Record. My recommendations to him and my readers are Yves Smith's ECONNED and Graham Turner's No Way to Run an Economy. Both books are excellent and well worth reading and they remind us that financial and economic risks don't just happen by accident - more often than not, they're the product of defunct economic theories.

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