Hedge fund shakeout continues

It all seemed so easy. If you had a decent record, all you had to hang out your shingle and start a hedge fund; charge 2% and 20%; and get enormously wealthy. Many did.

I have written in the past that the hedge fund industry didn’t make sense to me. Returns seemed too correlated to equities and they didn’t offer value given their fee structure.
Then the shakeout began. Hedge funds blew up or started to close left and right (see this).

There is a recent WSJ article about the continuing shakeout in the hedge fund industry. Key quote from one commentator: “We used to invest in hedge funds because we got stocklike returns with bondlike volatility. Now we're getting bondlike returns with stocklike volatility."

The problem was expectations were too high, hedge funds got over-sold and the field got too crowded. Here is a study of well-known managers (John Neff at Windsor Fund, Warren Buffett at Berkshire Hathaway, George Soros and Jimmy Rogers at Quantum, Julian Robertson at Tiger, Ford Foundation) showing the Sharpe ratio of these top investors were no better than 1.0. In retrospect, some of those hedge fund marketing claims of high returns with Sharpe ratios of 2.0 or more seem overblown.

Today, the justification for hedge fund investing continues to be out of whack. Note this quote from the WSJ article:

Overall, the $1.9 trillion hedge-fund industry is holding up. The average fund is flat this year, through May, according to Hedge Fund Research. That beats the decline of 3.80% in the Standard & Poor's 500 in that period, though it's below the gain of 0.94% in the Lehman Brothers bond index. Last year, the average hedge fund gained 10%, compared with returns of 5.5% for the S&P 500 and 7.8% for the Lehman index.

An institution invests in alternative vehicles because they offer attractive risk-return characteristics, usually returns that are similar to their other asset classes but at a lower level of correlation. Today we have an industry delivering returns that are highly correlated to equities, but their justification for keeping their jobs is that they outperformed the S&P500??? If that the case, how about institutional equity-like fees (say 50 basis points)?

Timing the rise of the Phoenix (and market)

Despite my recent bearish tone on I am no permabear. In fact, I am waiting for signs of a market bottom in order to buy Phoenix stocks, a strategy that has yielded some eye-popping returns in the past. Here are some of the different indicators of market direction I am looking at in watching for signs of a market bottom and their current readings:

• Valuation - neutral/slightly bullish
• Investor psychology - bearish
• Economic - bullish
• Technical - waiting for a capitulation bottom

Valuation: Neutral to mildly bullish
As I write this, the 10 year yield is about 4.2% and the S&P 500 is trading at 21.8 times reported earnings and 14.6 times forward earnings. In recessions, analysts cannot forecast forward earnings well so we’ll throw out the forward P/E. Using reported earnings and plugging the results into the Fed model, which has well documented problems, the market is slightly undervalued.

One of my other favorite rules of thumb in looking for a bottom is the valuation of the investment banks. The investment banks tend to bottom out at a price to book ratio of 1 during periods of economic stress. The major investment banks such as Morgan Stanley (MS) and Merrill Lynch (MER) are now trading at 1.3-1.4 times book, down from about 1.5-1.8 in late April. Lehman Brothers (LEH), which has had well publicized troubles, now trades at a discount to book value, as are some other brokers such as E-Trade (ETFC). The trouble is, of course, we don’t quite know how good the book value figure really is as there may be further write-offs coming down the road.

Despite these mixed signals, the market may not get screamingly cheap as we are likely in a period where the market moves sideways (see previous comment). Based on these considerations, I would rate the valuation metric as being neutral to mildly bullish.


Investor Psychology: Problem sectors not stabilizing yet
I like to keep an eye on the problem areas of the economy in order to time the turn in the market. The troubled industries in this recession are financials and real estate. Employment is another area that inevitably falls off in economic slowdowns. The financials and investment banks may be near levels where they stabilize but these stocks and the other problem groups are still underperforming with no end in sight.

The chart below shows the relative returns of the S&P 500 Capital Markets Index, which is comprised mainly of investment banks, against the S&P 500. The group has been in free fall against the S&P 500 but it is approaching a region that technical support has shown up in the past.

Similarly, the S&P 500 Financials has also been in a relative free fall against the S&P 500 but is nearing a relative support zone.
Other problem areas of the market aren’t so lucky. The chart below shows the S&P 500 Homebuilders relative to the S&P 500. The group is still falling and is has not yet declined to a relative technical support zone.

A similar picture holds for the relative chart of the S&P Supercomposite Human Resources and Employment Index (temp and employment agencies). Any improvement in employment should show up quickly in these stocks.

Economics: Conditions for market rebound present
The first step to recovery is recognition that there is a problem. This June 16, 2008 headline from Newsweek and front page story is an indication that the recession story is now in the public consciousness. There was a similar “Waking up to the Recession” cover in BusinessWeek on March 24, 2008. In the past, an excellent time to buy equities has been when the public recognizes that the economy is in a recession as most of the gloom and doom is already embedded in investor psychology.

Another economic signal I look for is an upward sloping yield curve. The current yield curve is indeed upward sloping, indicating that the central bank is in easing mode – a bullish sign for equities.


Technical: Timing the bottom
Given the current market backdrop, the S&P 500 is likely to decline and test the March low in the next few weeks. Would such a re-test be successful? For that I turn to the technicians. Most technical analysts identify intermediate term bottoms with two components: an emotional panic capitulation sell-off followed by confirmation that the bottom is in place in the ensuing rally.

A classic panic capitulation bottom would be a high volume day with the market trading down for most of the day and then closing near the highs of the day. The flamboyant technician Joe Granville, who correctly issued an all-out buy on the market in February 2003, has been quoted as focusing on parabolics to gauge these extreme moves.

After a capitulation bottom, technicians typically want to see some form of strength on the follow through. This Investors Business Daily article, written about two weeks after 9/11, is a good sample of what to look for at market bottoms.

When I see the panic bottom, the rally follow-through and the a majority of the other valuation, economic and psychology indicators flashing bullish, I plan to plunge ahead and buy the low-priced Phoenix stocks (with the appropriate stops of course) and hang on for the ride.

Demographics another bullish argument for commodities

Today I see another reason for the bullish argument for commodities: worldwide demographics. An article recounts analysts from Macquarie describe the demographics of rising demand from consumer in the emerging markets:

They may earn only about £2,000 a year but they are 400 million-strong, scattered across the globe and have just bought themselves a fridge.

Meet Generation A, who soon could become the most important economic force on Earth.

All those consumers will need more stuff, which will create enormous demands on commodities. This means that not only consumer non-durables (e.g. soap) will be areas of growth, but non-durables (furniture, cars) as well as services (telecom) in the emerging market countries. Jeremy Grantham of GMO also comments on this in his essay The Emerging Emerging Bubble (see page 9).

Key risk: Continued growth in the emerging markets depend continued open markets. If the developed trading blocs (US, EU) start to close their markets to the emerging market economies, then investors would have to re-assess the longevity of growth story in the emerging markets.

Put it another way, there is a joke in our household that Santa Claus comes from China as everything he brings is stamped with “Made in China”. Look at your shirts, your toys and your electronics. If they continue to be made in China, India, Turkey, Vietnam, Guatemala, etc. then the emerging markets should continue their long-term growth, which will also be bullish for commodities.

Bill Miller & Ken Heebner: A study in contrasts

Both Bill Miller’s Legg Mason Value Trust (LMVTX) and Ken Heebner’s CGM Focus Fund (CGMFX) have great long-term track record that would be the envy of most equity fund managers. While Miller has underperformed recently, he is still sticking to his guns in his latest commentary and he continues to focus on long-term value and a low-turnover philosophy. By contrast, Heebner has the hot hand right now (see Fortune article here) and runs a high-turnover portfolio.

Using the techniques shown in the sidebar titled Reverse engineering a manager's macro exposures, I estimated both Miller and Heebner’s sector and other exposures.


Miller is Value and Heebner Growth
I pointed out before that Bill Miller started to tilt towards Value in a significant way back in December 2007 and his bias is unchanged. As shown by the chart below, Bill Miller’s portfolio remains tilted towards Value, while Heebner is tilted towards Growth.

Miller buying Financials and Heebner owns Resources
Much of their style differences are attributable to sector weightings as the Russell 1000 Value Index is significantly overweight Financials compared to the Russell 1000 Growth. Bill Miller main overweight is in the beaten down financial sector of the market, while Heebner is underweight the sector.

Heebner, on the other hand, is still devoted to the resources sector with overweight positions in Energy…

…and Materials:

Both hold high beta portfolios
When considering these two managers one might be tempted to conclude that they are polar opposites of each other, they do agree on some points. Both managers’ portfolios have above average market betas, indicating that they expect the market to rise. Moreover, they are both underweight the traditional defensive sectors of the market such as Health Care and Consumer Staples.

Investment thesis and risks
Not to put words into each manager’s mouth, it seems that Bill Miller believes that despite the financial stresses evident in the system, the large financial franchises remain intact and have real lasting value. Miller’s investment thesis depends on no other hidden landmines blowing up in the financial sector.

By contrast, Ken Heebner believes that the commodity cycle is not over and is betting big on their continued rise. His thesis depends on continued US Dollar weakness and, to a lesser extent, that a US slowdown will not significantly drag down world growth. So far, he has been right, as evidenced by the new recovery high seen in the Baltic Dry Index. However, Heebner’s portfolio is a high-turnover portfolio and Heebner has shown himself to be flexible to reverse himself should the situation change.

The views of both of these investors deserve our respect.

A short term warning for gold bugs

Sentiment models are flashing caution for gold again. The Commitment of Traders data chart below shows the large speculator (hedge fund) net position in gold bullion, readings are moving into the crowded long zone despite the recent weakness in the gold price. This is a contrarian bearish reading.

Similar sentiment concerns were also raised by Mark Hulbert, who stated that gold timers were becoming more bullish on the yellow metal despite its decline. Other sentiment surveys also show the same rising bullishness.

Medium and longer term, I generally concur with the views of the Aden sisters who wrote in late April (italics are mine):

Gold's C rise is finally over. After rising 55% in nine months, in one of the best intermediate rises in the current seven year bull market, it signaled several things. Most important is the strength behind the bull market because new highs continued to be reached. Gold's next step is likely to be a good downward correction that could take several months to develop.

They concluded with:

Some worry that the March peak was THE peak for gold. This is very unlikely considering the world situation and the economic imbalances today.

Waiting for a ride on the Phoenix

As a follow up to my previous post on Altman Z score, investors who use solvency analysis to avoid bankrupt companies should beware of the effects of an economic recovery. The other side of the coin of solvency analysis is the Phoenix effect.

When the economy comes out of recession, shares of near-bankrupt companies see eye-popping returns as they rise Phoenix-like from the ashes of near insolvency. Examples include Chrysler moving from $2 to over $30 in the 1982-3 recovery; Magna International from under $2 to over $80 in 1991-2; and Akamai Technologies from under $2 to over $18 in 2003-4.

Buying shares of near bankrupt companies is a dangerous but exciting game. To be successful, an investor needs to identify the Phoenix candidates and correctly time the turn in the market. The rewards are can be big. Buying a basket Phoenix stocks can yield returns of 100-200% over a 12-18 month period.


Phoenix is partly a small cap effect
The Phoenix effect can be characterized partly as a small cap effect. The chart below shows the relative returns of the small cap Russell 1000 relative to the large cap S&P 500. I indexed the start value of 100, at dates representing stock market lows coinciding with economic slowdowns since 1980. On average, the Russell 1000 outperformed the S&P 500 by about 17% one year after the market low. The initial upward thrust in the market has always been marked by large cap outperformance.

Interestingly, the recent March 2008 low was characterized by small cap outperformance which leads me to conclude that this rally is just a bear market rally and the March low was probably not THE BOTTOM in this bear.







Looking for Phoenix candidates
Phoenix candidates are not just small cap stocks, but shares of companies that are at risk of insolvency and benefit from the tremendous positive operating leverage from an improving economy and high financial leverage which put them at risk of bankruptcy. The obvious quantitative way of finding Phoenix candidates is to screen the market for shares of companies that are at risk of insolvency. However, there is a simpler heuristic: low-priced stocks.

Stock price is a factor that’s not in most equity quants’ factor lists. However, it is a deceptively simple way of screening for Phoenix recovery candidates. I remember that Jeff deGraaf, who was at Lehman Brothers at the time, reported in late 2003 that the return spread between the lowest and highest decile of stock price was about 70% - an astounding return to a factor for less than one year.

I roughly confirmed these results by running a backtest using the current components of the Russell 1000. Had you bought the lowest decile by stock price in December 2002 and held them for a year, the median outperformance compared to the top decile was about 110%. This simple study has problems, mainly in the form of a survivorship bias. The use of a median return instead of an average return does mitigate some of the survivorship bias issues. Nevertheless, it does illustrate the magnitude of the effect. Using a long-only approach, this study over the 2003 and previous recovery period suggest that a basket of Phoenix stocks has the potential to rise by a factor of between 2 and 3 over a 12-18 month period.


Phoenix candidate = low stock price + dramatic fall + insider activity
Just buying low priced stocks gets you partly there but we should eliminate stocks that have always traded at low prices. Phoenix candidates are stocks that have taken a pounding, or stocks that have fallen dramatically (70-90%) from the 52-week high. This is a likely indication that it is at risk of insolvency.

These companies are on the verge of Chapter 11 so buying their shares is highly risky. To mitigate downside risk of possible bankruptcy, add an additional insider activity screen. Ideally I would like to see recent insider buying in Phoenix candidates, which indicates that the fundamentals may be turning. At the very least, I would like to see the lack of insider selling, a sign that the worst is may over for the company under consideration.


Timing: Be patient, the Phoenix will rise
Right now, the weight of the evidence suggests that the turn has not occurred yet. I am preparing a list of Phoenix candidates for my portfolio but waiting for signals of a bottom before buying. In a future post I will write about how I would time the buy decision of these stocks.

Oil overbought but no signs of excessive commodity speculation

As oil prices topped $130 and later $135 there was a cacophony of calls from market commentators that the parabolic rise in crude signaled a top in commodity prices and that this is a commodity bubble that would end badly soon.

Oil and Energy stocks overbought
The chart below shows the log price graph of crude oil futures. Prices moved to the top of the rising channel line, from which it has corrected in the past. So a pullback in oil prices in the next month or two would not be a surprise.

The relative return of Energy stocks tells a similar story. The chart below shows the returns of the Energy Select SPDR (XLE) compared to the S&P 500. The XLE moved to the top of the relative trendline against the S&P 500 and appears to be overbought. I would expect a near-term pullback but the relative uptrend would remain intact.

No sign of excessive speculation in resource stocks longer term
At the top of every mania, the junk starts to fly. Stupid deals get done. People start talking at parties about how they made a killing in this mining junior or that penny stock. Even here in Vancouver, one of the resource penny stock capitals of the world, there is no sign of that speculation.

The chart below shows the relative returns of the small cap speculative TSX Venture Index compared to the large cap S&P/TSX Index. Small caps have been underperforming large caps since the end of 2006. This is excessive speculation???

No sign of excessive speculation in gold stocks
If we were to look at the pure gold stocks, it appears that we are still early in the move. The chart below shows the relative returns of the equal weighted CBOE Gold Index (GOX), which gives bigger weight to smaller gold stocks, compared to the capitalization weighted PHLX Gold & Silver Index (XAU), which is more large cap oriented. After drastically underperforming the large cap gold stocks, small cap golds only caught up in mid-2006 and it wasn’t until October 2007 that they definitively began to outperform the bigger stocks.

Putting my technician’s hat on, this is a classic cup and handle formation. The breakout in October 2007 would yield a relative return target of roughly 70-80% outperformance of the GOX against the XAU. This suggests that small cap golds have much further to go against their large cap senior brethrens – indicating that this bull move in gold (and commodities) is nowhere close to being over.

A warning for Tech

The chart below shows that both smart and consensus mutual funds are both selling their Technology holdings. In the face of such selling pressure it will be difficult for the sector to make any headway in the medium term.

This concerted selling is occurring just as this Bloomberg story pointed out that Bank Stocks Cede Biggest S&P Weighting to Technology. Is the story the ultimate contrary indicator?

Uh oh!

The technicians aren't going to like this:

Consensus sentiment from AAII is on the bullish side so the market lacks buying support from an excessively bearish sentiment reading. If there is follow-through selling tomorrow it could portend more short-term weakness.

Will the real inflation rate please stand up?

Regular readers know that I am a long-term bull on commodities. Given all the problems for the US economy, the overall direction for the greenback is down which is conversely commodity bullish. Now rising concerns about CPI understating inflation is another nail in the coffin of the US Dollar.


CPI understating inflation
These concerns are showing up in the minds of the public. USA Today recently published a story entitled Inflation may be worse than consumer price index shows. Until recently, the debate over the problems of inflation measurement have been confined to academics and a few investors with snarks of inflation ex-inflation.

This article shows the history of how the CPI has evolved over the years. John Williams of Shadow Government Statistics indicated that if we measured CPI the way it was done in 1982 it would be 11.3% (in March 2008). Even if we accept the premise that we need to strip out the more volatile components of inflation rate, the Dallas Fed’s measure of trimmed mean PCE is consistently higher than core PCE, or PCE ex-food and energy.

My take: the chickens are coming home to roost. The public participation in inflation hedges is just starting and commodity prices are going to get really parabolic before this is all over.

A decade-long low return environment for equities?

The chart below shows the Dow Jones Industrials Average from 1947 to the present. This brief history of the Dow has been marked by two eras of rallying markets, followed by a long sideways market. We could be moving into another period of sideways markets for another decade or so.Poor macro-economic backdrop
There are valid fundamental reasons for these sideways markets. The last sideways pattern has been marked by rising inflationary expectations that begun with LBJ’s guns and butter policy in the Vietnam War. The macro-economic backdrop is not dissimilar to that of the late 1960s and 1970s. America is involved in a war with no end in sight, the fiscal deficit is spiraling out of control and the US Dollar is falling.


Excessive equity valuations
Some investors, like John Hussman, believe that the market is excessively priced. In a recent commentary he wrote that “the S&P 500 remains priced to deliver probable total returns of about 2-4% annually over the coming decade”. Using the methodology described here, Hussman indicates that the market’s cyclically adjusted P/E based on peak earnings is very high. Profit margins are elevated at this point of the cycle and there is the market is not pricing in any room for margin mean reversion (read analysis here).


Pension funds asset mixes likely to favor more bonds
Corporate treasurers are likely to move towards a asset-liability matching framework in defined benefits plans given the advent of changes in accounting policy such as FASB 158 and IAS 19. In Europe there are already suggestions to extend the Solvency II standard to corporate pension plans, which would further accelerate this trend (and has created scare stories like this).

We saw this effect in the UK a few years ago when companies moved towards an asset-liability matching framework. Investors drove the yield on the long-dated gilt to unbelievably low levels as they reached for duration in their portfolios. This asset shift came at the expense of equity weightings and other assets in the pension portfolio.

More upside in oil? NatGas climbing a “wall of worry”

As oil prices top $125 and take other energy prices higher, where do oil prices go from here?

Crude oil appears to be overbought in the short term but sentiment doesn’t seem to be at a bullish extreme indicating that there may be more upside in black gold. However, oil does seem to be extended relative to other commodities.


Fast money is in a natural gas crowded short
A look at the CFTC commitment of traders data shows two different faces of sentiment in the energy complex. While natural gas prices are nowhere near their all-time highs, large speculators (read: hedge funds) are showing record levels of skepticism in natural gas and they are net short the commodity. Readings are not only at a crowded short level but their bearish positions are off the charts.Hedge funds long crude but not excessively bullishness yet
By contrast, large speculators are net long crude oil but readings are not at an extreme level despite the record oil prices. This data from the CFTC, combined with public sentiment readings, suggests that in the absence of excessive bullishness in crude oil, the commodity does have room to move a bit higher given its positive price momentum.Buying natural gas seems less risky than buying oil right now
The contrast in sentiment readings suggests that natural gas prices have more upside potential than oil prices and could hold up better should the energy complex correct. The chart below shows the price ratio of natural gas to crude oil, along with its long-term average and the one standard deviation bands around the average. I highlighted the price divergence between these two commodities in December and again in February. The natgas/oil ratio bottomed out in late December and has since turned up but likely has more to go.A long natural gas/short crude oil position would have a potential upside of 15% today, based on the conservative target of reaching the lower one standard deviation band. If we assumed that the ratio moved up to its long term average, the position would have a profit potential of 50%.


Oil looks extended against gold too
Another way to look at oil is to look at its performance against gold. The chart below shows the price ratio of gold to oil since 2000. Gold prices topped out against oil prices in late December 2007 and the ratio reversed itself dramatically. Oil now appears quite extended relative to gold, as it does against natural gas.The commitment of traders report on gold (not shown) shows that sentiment readings are relatively neutral. As a result, I would prefer a long natural gas/short oil trade rather than a long gold/short oil trade.

Risk management is becoming an art (finally)

After my series of posts on Surviving as a quant here and here, I see that there is finally some calls for reality checks on models in this article (italics are mine):

Industry experts are now saying market participants shouldn’t rely exclusively on mathematical models but should also use the social sciences to understand behaviors—of home owners, for instance.

They’re also calling for more disclosure and more transparency from market participants.“It’s time perhaps to put aside mathematics and somehow find the right balance between qualitative, quantitative and sensitive risk management,” Philippe Carrel, global head of business development at Thomson Reuters, said Wednesday at a forum in New York on valuation risk.

“Risk management is becoming an art,” he said. “Risk starts to be managed now, as opposed to being merely quantified in the past.”

A model is just an approximation of reality. There is no substitute for experience and intuition in building models of the world, otherwise you wind up like this.

The limitations of Altman Z

As s we go through a period of economic stress, I thought that it would be timely to review the Altman Z formula as a predictor of bankruptcy. The formula is a function of liquidity, balance sheet strength and earnings power:

Altman Z =
1.2 X Working capital/Total assets +
1.4 X Retained earnings/Total assets +
3.3 X EBIT/Total assets +
0.6 X Market value of equity/Book value of debt +
0.999 X Sales/Total assets

The original Altman Z score assigned fixed weights to each of the components. Different ranges for Altman Z score represented different levels of risk of bankruptcy. Subsequent versions of the formula varied the weights depending on whether the analyzed company is public or private and also varied the cutoff ranges for bankruptcy risk.


Altman Z was formulated for operating industrial companies
The main problem with this formulation of solvency risk is that the formula is not suited for many industries. As an example, when I first tried to apply Altman Z I found that many regulated utilities showed up as having high bankruptcy risk.

I found that Altman Z was not industry specific enough to my liking. For instance, low or negative working capital doesn’t score well on Altman Z but some industries can operate with zero or negative working capital. For example, a restaurant gets paid in cash, but their suppliers will generally give them net 30 on their payables and the inventory (food) turns over very quickly.

Another sector that the Altman Z doesn’t analyze is the financial sector. What does “sales” mean for a bank? Financials tend to be highly levered and their operating risks and exposures are not well disclosed.


A heuristic for solvency analysis of non-financials
In a recession, the combination of high operating risk and excessive leverage combine to produce insolvency for non-financial company. A better way of forecasting solvency risk is to look for companies that show:

• High operating risk: The top two deciles of standard deviation of EBIT or EBITDA margin over the last 5 or 10 years (pick your horizon)
• High financial leverage: The top two deciles of financial leverage, by total debt to market equity or interest coverage. Normalized decile scores by sector.

I have found that this heuristic, or simple rule of thumb, serves as a better forecaster of solvency risk as it neutralizes many of the industry specific effects that Altman Z failed to address.

Solvency analysis of Financials is difficult
The problems of creating a solvency test for financials that operate in real-time or relative real-time is not easy. It’s not hard to do after the fact, but at any one time, no one – not even the directors of the company really know what is embedded on the books at a financial. Société Générale, Barings, Northern Rock, Bear Stearns – the list of blowup surprises go on and on.

I have had some successes with a solvency risk test for lending institutions based on the following two characteristics:

• Excessive lending growth as a sign of lending portfolio quality: In good economic times, a bank can produce earnings growth by growing its assets, or loan book. In the long run, not all banks can grow their loan books significantly in excess of GDP. High asset growth comes at a cost of lower asset quality.
• Loan loss provisions as a measure of the current level of stress: Instead of the standard ratio of loan loss provisions to total assets, I like to use loan loss provisions to assets three years ago. It’s not the loans that you make today that go sour, it’s the ones that you made two or three years ago that tend to get into trouble.
  
  

Economic storm clouds still gathering

With headlines like Buffett: Economy in a recession, will be worse than feared and McCain & Clinton Fail Economics 101, I thought that it is time to focus on the possible effects of the November presidential elections.


Clinton or Obama presidency = Double dip?
With the US fiscal situation as it is today, a Democrat in the White House, regardless of whether it is Clinton or Obama, would likely raise taxes to try to bring the budget more into balance. Can you say double dip recession?

It’s usually in the first two years a new administration will try to take its economic medicine and blame it on the previous president. Remember how the current Bush administration tried to position the post-Tech Bubble slowdown as the “Clinton recession”?


McCain presidency = ???
When John McCain was quoted in 2005 as “I'm going to be honest: I know a lot less about economics than I do about military and foreign policy issues. I still need to be educated” in that bastion of left wing politics, the Wall Street Journal, the country could be rudderless economically.

A more recent quote shows that he still has no economic direction: “The issue of economics is not something I’ve understood as well as I should. I’ve got Greenspan’s book.”

Still waiting for a market bottom

As the S&P 500 seems to have formed a double bottom in January and March, the question in many investors' minds must be "Have we seen the bottom?" My review of some of my market indicators indicate that it’s probably a little early to flash the all-clear signal for US equities.

In particular, the problem areas of the market, namely the investment banks, housing and employment, continue to struggle, suggesting that the worst may not be over for this bear market. Here are some of the indicators that I am watching:


Insiders are bullish
Mark Hulbert reports that insiders have been buying their own stock at levels that are comparable to other market bottoms. Insider signals tend to have a very long time horizon but their actions does have bullish implications.


Investment bank valuations - more downside?
Since much of the recent stresses that have shown up in the investment banks and brokers, I go back to my rule of thumb that I would like to see a price to book ratio of 1 for the investment banks. The P/B of 1x was a good signal of a market bottom in the 1974-5 and 1981-2 bear markets.

While Lehman (LEH) did reach a P/B of 1x for one day at the time of the Bear Stearns panic, other investment banks and brokers such as Morgan Stanley (MS), Merrill Lynch (MER) and Raymond James (RJF), which is an interesting bellwether as it has no significant prop trading operations, are trading at valuations of 1.5 to 1.8 times book. Goldman Sachs (GS) is trading at valuations that are even higher than that.

I could be wrong here but my guess is that there needs to be more pain in the brokerage stocks before the market bottoms.


Smart funds defensive while overall sentiment is bullish
A check in with my group of smart funds shows that their posture remains defensive. The accompanying chart shows the market beta of the “smart funds” compared to the “consensus funds”. Smart funds have a market beta, or implied market exposure, that is lower than the market while consensus funds are at or positive market exposure. Moreover, the recent Barron’s Big Money Poll shows 50% of their respondents to be bullish or very bullish, compared to 13% as bearish. This is a contrarian bearish reading.

Problem areas of the economy not stabilizing yet
This economic downturn was the result of overbuilt housing fueled by overly aggressive real estate lending. The chart below shows the S&P 500 Homebuilders relative to the S&P 500. The homebuilders remain in a relative downtrend and show no signs of stabilization, which is not a good sign for the health of the overall market.

Addendum: When you get stories like KB Home's Broad Says Home Prices May Drop Another 20%, it doesn't exactly inspire confidence that housing has bottomed.

Similarly, we have seen employment statistics starting to weaken, as is the case in any recession. Rather than looking at the payroll numbers, which are backward looking, I prefer to look at market discounting real-time statistics. My proxy is the price action of S&P Supercomposite Human Resources and Employment Services, consisting mainly of temp and employment agencies. The chart below of these stocks relative to the S&P 500 indicate that, like the Homebuilders, the Temp Agencies remain in a relative downtrend with no convincing signs of stabilization.

How far or how long before a bottom?
If my assessment is correct then the next question would be “how long or how far down before we see a bottom in the market?” William Hester at Hussman Funds, in his recent article Recessions and the Duration of Bad News, suggests that if this was an “average” recession we will likely see much more bad news in employment, housing, earnings, etc. If this was an “average” recession the chart he shows suggests that we are currently seeing a bear market rally but a more convincing market bottom is a few months off (see the last two charts in the article).

Is this an average recession? I have no idea. All I can do is keeping watching my indicators for signs of a market bottom.

A reprieve for hedge funds but challenges remain

We all know the story. The hedge fund industry grew from a handful of funds on a relatively small asset base in the early 1990s to over $2 trillion in assets today. What really spawned the explosive growth were hedge funds’ positive returns which were uncorrelated to the equity market in the post-2000 Tech Bubble bear market.

Since then, the chart below of the HFRX Global Hedge Fund Index and the S&P 500 shows that hedge funds returns have become highly correlated to the S&P 500. In the current equity market downturn, hedge fund returns has fallen with the S&P 500 but the level of correlation has decreased in the last few months.

Challenges remain for the hedge fund industry
Despite the near term recovery, several challenges remain for the hedge fund industry. Firstly, no doubt many hedge fund investors feel chastened by their experience and caution will be the watchword going forward. In addition, various studies have shown that hedge fund returns can be replicated using factor betas. Larger sponsors that I have spoken with echo the sentiments of Russell Read, chief investment officer of the $225 billion California Public Employees Retirement System: “We can get average market risk very cheaply. We hate paying a performance fee for something we can get very cheaply.”


The industry is getting more institutional
These problems are well known and many commentators have given their views on how the hedge fund business is likely to evolve so let me throw me my two cents worth.

• The industry needs to move away from a strict absolute return based focus and need to better understand clients and customize solutions
• Fee compression pressure will intensify as a result

Understanding the client
For most of their history, hedge fund managers have marketed themselves as absolute return vehicles, with low correlations to other asset classes. As returns came down, they clung to the low correlation idea but that line is wearing a little thin these days.

Low correlation, in of itself, has limited value. Supposing that I told you that I had access to a fair roulette game, i.e. the house didn’t have an edge. Returns would be uncorrelated to virtually any asset class that you could think of. Would you fund me on a 2% and 20% fee structure?

I believe that the key to surviving and prospering as an alternative asset manager is to learn to listen more to clients and understand how sponsors put together portfolios. You represent a piece of a jigsaw puzzle to them and know what the benefits you offer.

This William Mercer study for the State of Arizona is typical of the new thinking. Mercer suggests, among other things, that sponsor portfolios should be optimized to alpha exposure. Expected alpha, alpha volatility and alpha correlation all matter in how you pick managers. This is part of the move toward the “portable alpha” concept where a sponsor moves towards a liability driven investing framework. He builds a passive portfolio based on that benchmark and then overlays a “portable alpha” on top of the passive portfolio.


Fee compression pressures to rise
If the concepts in the Mercer study become accepted and widespread then fee compression pressures are likely to rise. Reading between the lines the terms of “expected alpha”, “alpha volatility” and especially “alpha correlation” sound suspiciously like the hedge fund factor betas concept that Bridgewater Associates and others have documented in their studies. The obvious conclusion is you shouldn’t be paying the same level of fees for beta as alpha.

Further fee pressures could come from portable alpha implementation. A sponsor can gain access to a portable alpha in two ways. The high cost route would be to buy it from a hedge fund or a hedge fund of funds. The cheaper way would be to synthetically create an alpha stream by hiring a traditional long-only manager and shorting the manager’s benchmark against the long portfolio. As an example, the sponsor could hire a small cap equity manager and then simultaneously short the Russell 2000 using derivatives. The hedge fund solution would cost 2% and 20% or more. The synthetic alpha solution would run around 0.5% and 1.0% for a reasonably large sponsor.

If you were a pension fund or endowment fund, what you choose?

The limits to China’s growth

I have a seven year old daughter. Despite her Chinese heritage I am not in a huge rush to enroll her in the Chinese Mandarin classes as many of the other parents have enrolled her peers. There are two reasons for this. First, Chinese is a difficult language (no alphabet, all characters must be learned by rote memorization) that is learned best in an immersion environment. Second, I believe that by the time she is ready to move into the working world China will no longer be ascendant the way it is now. The Chinese language courses that parents are rushing to put their children into now will turn out to be as useful as the Japanese courses in the late 1980s (anyone remember Theory Z?)

A bearish call with a very long term horizon
Before you start flaming me, note that I am talking about a very long term time horizon. While I believe that China will grow at very high rates in the next five to ten years, there are two main long-term problems with China which will limit her growth path:

• China is a nation of small business entrepreneurs but the small business model is not scalable
• Chinese age demographics are getting more unfavorable
  

First, some good news and bad news about China’s growth: From personal observation I have found the Chinese tend to be very entrepreneurial. This effect is demonstrated by the business dominance of the overseas Chinese in much of Southeast Asia, which has created friction in the past in countries such as Malaysia, Indonesia and the Philippines. This entrepreneurial spirit has created a nation of small businesses and an enormous dynamism which is fueling much the growth in China.

However, Chinese business culture has not fully developed a professional manager class (with some limited exception in Hong Kong and Singapore). The business model of much of these small businesses consists of a single person at the top with managers and workers below, most of whom have little or no authority. Small businesses are not scalable into large businesses if there are no professional managers. Such a culture can create a nation of shopkeepers but not a nation of industrialists. This will create barriers to further growth at some point in the future.


Demographics another headwind
China has undergone over a generation of the one-child policy, which has served to restrict her population growth. The law of unintended consequences raised its head along the way.

The population is aging rapidly. The accompanying chart shows that the UN projects the proportion of China’s elderly population, which is defined as those over age 65, will rise from 6.8% of the population in 2000 to an astounding 22.9% in 2050. China’s dependency ratio (ratio of non-working to working population) will rise from 10 per 100 workers in 2000 (19 for US in 2000) to 37 in 2050 (vs. 32 for US). The demographic bonus of a rising young, productive, working population will have been spent in the next 20-30 years.

Source: US GAO, The Future Sustainability of Social Insurance Programs

A nation of little emperors
Beyond the mere numbers of age demographics, the cultural effects of the one-child male-preferred policy may further inhibit the growth dynamism of China’s economy. The family pyramid has become inverted, with parents and grandparents doting on the single child. This has created a nation of spoiled “little emperors” many of whom have grown up with a sense of entitlement and may not have the same work ethic as older generations. Many of these “little emperors” are now in their 20s. Can we really expect the same entrepreneurial drive from this age cohort as from older cohorts? Culturally, this will further inhibit China’s growth potential in the future.


Too early to short China
I began this post by referring to my seven year old daughter. It is with that time horizon in mind that I refer to China’s longer term challenges. In the meantime, China remains a powerhouse of economic growth for the next 5-10 years. Shorting it now would be like standing in front of a speeding freight train.

Storm clouds starting to lift for commodities

I am on record as a long term bull on commodities. The near term risks that I see for this trade are:

• Cyclical: A US slowdown will spread to the rest of the world and reduce cyclical commodity demand
• US$ rally: A countertrend rally in the US$ will create headwinds for commodities

Cyclical risks are abating
A look at some real-time indicators for the world economy shows signs of stabilization and recovery. Dr. Copper, which is an indicator of world cyclical demand, is at or near new highs. The Baltic Dry Index, a shipping cost benchmark, fell from all-time highs in 3Q 2007 and has stabilized (see the chart here, click on the BDI & Copper link to see the two together).

While I continue to be concerned about a counter-trend rally in the US Dollar as the US economy shows signs of recovery later this year, the cyclical risk in the commodity trade is greatly lessened.

As an investor, I would be inclined to raise from an underweight to a neutral position in the commodity sensitive plays in my portfolio.

More on the secular pilot shortage

My recent post entitled a secular warning for the airlines elicited a lot of comments from the pilot community. The comments fall mainly into the category of “if there is a pilot shortage why am I so badly paid/poorly treated?”

Don't confuse secular with cyclical effects
My answers consist of several parts. First, don’t confuse the secular effect with the cyclical effect. With airlines from Aloha to Frontier going into Chapter 11, a possible Delta-Northwest merger in the works and the US economy in recession, there should be a surplus of pilots in the short term – that’s the cyclical effect. The longer term secular effect is found at the age demographics of most flying clubs that I have visited – there are few members in their 20s and 30s. Members below the age of 50 seem to be the “young pups”.

Some airlines have begun to address this problem by doing their own training, which takes a long time to pay off, or moving to the multi-crew pilot concept in which someone gets qualified as a member of a cockpit crew instead of a pilot. Under this scheme, it is possible to qualify as a member of a cockpit crew without being qualified as a private pilot. This solution seems to be just a case of the blind leading the blind.

Pilots reap what they sow
The history of poor pay for pilots is related to the number of people who love flying. There are many pilots who would still say that they have the greatest job in the world despite the mediocre pay scales, long hours away from home, etc. If you are willing to accept those conditions in exchange for the experience of flying for a living, who do you have to blame for that?

Still a lot of denial out there about the secular trend
Nevertheless, I continue to be disappointed by the reaction to this secular trend. A recent discussion of air travel in 10 years by a number of observers in the aviation industry was mostly a case of people talking their own “book”, an indication that the industry remain in denial over the looming pilot shortage.