Thursday, 30 December 2010

The January Effect v QE v Market Internals

December US equity markets have been typical in the shrinking of traded volume which makers them prone to being squeezed. At this point I hesitate calling it squeezing (hurting the shorts by mark-ups which forces closures (buying) of positions) as there have been 18 up-days out of 20 trading days in the MTD. Short squeezes are short-term phenomena. Although December began with a powerful rally, there has been anaemic follow-through as we near the end of 2010. As is common with the Christmas period, trade has been light, and price action muted. Based on market internals, institutional involvement has been clearly absent from the market over the past two weeks. In the last week or two of trading the broad market has exhibited indecision, and market internals (advancing volume to declining volume, for example) have differed between exchanges and indices. In addition there has been a noticeable flow of money into sectors that have significantly lagged the market over the past year (oil-related, homebuilders, banking, pharmaceuticals, and real estate). This is often a leading indicator that a rally may be nearing exhaustion. It is too early to definitively suggest that the market is about to change trend, but when laggards become leaders, caution is warranted.

There will likely be institutional buying early in the New Year as the whole staff comes back to work and markets are still hitting minor new highs. But will this persist? At this point the influence of QE on markets should be more important than calendar effects, but is the impact waning? Evidence from the bond markets suggests it may be.

As for the calendar effects I have reproduced below a long term study on the January effect. It comes from

Does long term data support belief in exceptionally strong performance by the U.S. stock market during the month of January? Could this conventional wisdom be an artifact of data snooping or a victim of market adaptation? Robert Shiller's long run sample, which calculates monthly levels of the S&P Composite Stock Index since 1871 as average daily closes during calendar months, offers data for testing. Using monthly levels of the S&P Composite Stock Index for January 1871 through November 2010 (nearly 140 years) and monthly closes of the S&P 500 Index for January 1950 through November 2010 (nearly 61 years), we find that:

The following chart shows the average return by calendar month for the S&P Composite Stock Index over the entire sample period, with one standard deviation variability ranges. The average return for all 1,678 months in the sample is 0.42%. At 1.51%, January has the highest average return of all months. January has the lowest standard deviation of returns (2.86%), so this high return is not compensation for high variability.

October is the only month with a negative average return (-0.39%).

Is this apparent January effect consistent across subsamples?

The next chart compares the average return by calendar month for the S&P Composite Stock Index over the entire sample period and three approximately equal subperiods (46-47 years each). The performance of the stock market is consistently strong on average during January, and January is the best month for two of three subperiods. However, there is generally substantial variation in average returns by calendar month over the three subperiods.

For greater granularity and trend analysis, we examine relative performance during January by decade.

The next chart shows the outperformance of the average return for January relative to the average monthly return by decade over the entire sample period, along with a best-fit linear trend line. The trend line indicates that the magnitude of any January effect is declining, but the sample size in terms of number of decades (14) is small.

For even greater granularity, we examine the effect by year.

The next chart shows the outperformance of the return for January relative to the average monthly return by year over the entire sample period, along with a best-fit linear trend line. The trend line again indicates that the magnitude of any January effect is declining. Outperformance appears to disappear, or even reverse, during the past two decades.

A plausible interpretation of the above results is that there used to be a somewhat reliable January effect, but the market has adapted to extinguish it.

Since the Shiller data calculates monthly index levels as average daily closes during months (perhaps representing typical investor experience) rather than monthly closes, we compare the above results to those for monthly closes of the S&P 500 Index.

The next chart shows the average return by calendar month for the S&P 500 Index during 1950-2010, with one standard deviation variability ranges. For this calculation, we approximate the January 1950 return using the opening level for that month (since the December 1949 close is not available). The average return for all 731 months in the sample is 0.69%. At 1.10%, January has the fifth highest average return of all months, behind December, November, April and March. January has the second highest standard deviation of returns (4.84%), trailing only October.

Is performance during January consistent across sub-samples?

The next chart compares the average return by calendar month for the S&P 500 Index during 1950-2010 and two approximately equal subperiods (30-31 years each). During the first (second) subperiod, the performance during January is tied for third (seventh) place among the 12 calendar months.

For greater granularity and trend analysis, we examine relative performance during January by year.

The final chart shows the outperformance of the return for January relative to the average monthly return by year during 1950-2010, along with a best-fit linear trend line. The trend line indicates that any outperformance during January disappears or reverses during the past two decades.

In summary, evidence from long run data suggests that the conventional wisdom regarding outperformance of the U.S. stock market during the month of January derives either from snooping of an insufficient sample of older data or a real effect that the market has recognized and extinguished. Recent January returns are relatively weak.

Friday, 24 December 2010

Heightened Uncertainty

All those who engage with markets always have to cope with uncertainty, and so it helps to have an over-arching investment thesis to put everything in context. I have particularly heightened uncertainty to cope with today as I don't know what I'm getting for Christmas. In that spirit I offer you some help with some appropriate research from "The Perfect Storm of Investment Theses" dates from 2008, but a good piece of research has some shelf life. Have a good Christmas - Simon Kerr

We are currently in the Perfect Storm of Perfect Storms. This has caused great loss in our imaginary investment portfolio on the gains we had generated by shorting mortgage-backed securities. The only way to counter a Perfect Storm of Perfect Storms is with the Perfect Storm of Investment Theses. Luckily, we have found it: The Four S's.

We have identified four trends that all start with S. They are also all compelling investment opportunities. Combined, they form the Perfect Storm Investment Thesis.
  • Solar power
  • Smartphones
  • Software…
  • …as a Service
Many people correctly believe that:
  • In the future, solar power will be the primary source of energy for the world economy. This power will be free, plentiful, and have no environmental impact. Except the unknown impact that results from taking massive amounts of energy that normally would have hit the Earth and shunting it into our cars and smartphones, and the related waste from producing solar paneling on an industrial scale, but other than that, we can assure there will be no environmental impact. As a side benefit, Al Gore will finally shut his piehole, since he will have made his billions from his green portfolio, you know, the book he talks everytime he opens his mouth.
  • Smartphones will achieve 207% penetration as most consumers choose to carry more than one smartphone in order to make themselves smarter. Smart people know that it is important to have a persistent buffer from the place you are actually in. That is to say, if I’m driving, I’d be better off talking to Sarah. If I’m on a date with Sarah, I’d probably be better off talking on the phone with Sonya. And if I’m at Sonya’s apartment watching Mad Men in the nude, I’d be better off playing the newest cool iPhone game. Smart people know this is the whole point of smartphones. Apple will have 35% share, RIMM will have 30% share, Palm will have 25% share, and Nokia will continue to be the market share leader with 40% (See, they’re all winners!)
  • No one will use antiquated sales programs like Siebel. Everyone will use online, automated sales programs like and Google Adwords. All sales will take place online. Brick & Mortar stores will be converted en masse into sales kiosk repositories and/or expensive condominiums communities where everyone feels like they know everyone else but in reality are too busy doing something with their smartphone to know anything about the people who breathe the same air as they do.
However, using our superior intellects, we realize all of this will converge. In the future, software as a service tools will be the exclusive sales channel for solar-powered smartphones. We expect they will be able to run all the most important applications including Call of Duty 8, Microsoft Excel, and YouTube. Additionally, by 2012 they will achieve grid parity pricing and begin contributing energy back to the grid. We calculate the total market size for this trend at $8 trillion.
Recommendation: Software as a Service Solar Smartphones will stave off the Perfect Storm of Perfect Storms.

Thursday, 23 December 2010

The Top Ten Hedge Fund Stories of 2010

The hedge fund industry is still dominated by America in terms of where the majority of assets are directed and invested. So I have given due weighting to U.S. focused stories in the top ten for the year – they are the first five stories, published by trade press in the States. My own viewpoint and concerns put global and regional stories into the top ten for the year – they are the second five stories here.

Expert Network Insider Trading

Hedge funds' use of so-called expert networks was called into question in late November when more than a dozen money managers were issued subpoenas for information related to a vast government investigation of insider trading.

Among those asked for information—but not accused of wrongdoing—were SAC Capital Advisors, Diamondback Capital Management, Level Global Investors and Loch Capital Management. All stressed they were subjects, not targets of the investigation (the latter, which means the government is likely to bring charges, would likely cause massive redemptions). Loch, which did not respond to a request for comment, is laying off most of its staff by year end, according to Hedge Fund Alert. Firms like Loch and Balyasny Asset Management, which was also subpoenaed, suspended their use of third party research firms as a result.

Drunkenmiller Quits but Team Lives On"I have had to recognize that competing in the markets over such a long time frame imposes heavy personal costs," Druckenmiller wrote in a one-page letter announcing his plans to retire and close the firm, also citing the challenges of running a large fund.
Duquesne was reportedly down 5% at the time, which would have been the fund's first losing year in 30 if it did not snap back by year end, having returned an average 30% annually since 1986. As of November, fund returns had indeed turned positive, according to Bloomberg.

A group of former Duquesne Capital Management managers prepared to start a new global macro fund, Point State Capital, which will oversee roughly $5 billion, one of the largest launches ever, Bloomberg reported in November. The funds come entirely from Druckenmiller ($1 billion) and former Duquesne investors. In addition Wojtek Uzdelewicz, a Duquesne managing director who ran a roughly $500 million technology focused fund at the firm, plans to launch a fund, Espalier Global Management in New York City.

The Goldman-Paulson CDO Scandal

Goldman settled with the SEC in July for $550 million, the largest ever penalty from Wall Street. John Paulson, for his part, was never dragged into the legal mess despite initial concerns that led him to let investors know that he was prepared for a possible legal battle and would personally cover any legal fees.

One of those key facts, the SEC said, was failing to disclose the role that Paulson & Co. played in the portfolio selection process and the fact that the hedge fund had taken a short position against the product (Paulson made about $1 billion on the bet).

In April, the Securities and Exchange Commission charged Goldman Sachs with defrauding investors by "misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter."

FrontPoint's Annus Horribilis

FrontPoint Partners, the once highly successful hedge fund firm, had a difficult year.

In October, FrontPoint announced it was spinning out from Morgan Stanley, which had acquired the firm in 2006 when it managed $5.5 billion but was concerned about new hedge fund investment restrictions under the Dodd-Frank Act. But as FrontPoint restructured, an insider trading scandal hit its healthcare hedge fund, causing the suspension of portfolio manager Chip Skowron and the liquidation of the fund.

FrontPoint faced large redemptions—reportedly as much as $3 billion of $7.5 billion, according to the Wall Street Journal—from skittish investors as the insider trading probe spread to more than a dozen hedge funds and put unwanted attention on the use of expert information networks.

Buffett's Hedgie Successor

Until late October, Todd Combs was a successful but largely unknown manager of a small Greenwich, Connecticut hedge fund. But Combs was thrust into the spotlight with the announcement that Warren Buffett has chosen him to manage a large chunk of Berkshire Hathaway's roughly $100 billion investment portfolio, one of the most high-profile money management positions in the world.

Combs, 39, ran Castle Point Capital Management, a financials-focused long/short equity fund launched in November 2005 that managed $405 million as of September. The fund was down 3.93% through September, with a net annualized performance since inception of 5.93%, unspectacular performance compared with its peers.

Hedge Fund UCITS Mushroom

Whilst service providers and some of the managers were over-excited about the prospects of UCITS versions of hedge funds last year, in 2010 there have been some strong growth trends. There are now around 350 UCITS hedge funds, most of which have mildly amended mandates of the mother (offshore) fund. There have been some UCITS only fund launches, but not many.

Early evidence is that UCITS provide a solution to the major drawback of hedge funds that was revealed in the Credit Crunch – the ability to deal in the funds at will. 76% of UCITS hedge funds offer daily liquidity, 21% offer weekly liquidity. The buyers of UCITS hedge funds are client types that put a premium on this positive feature – HNWIs that were much aggrieved at being locked into offshore hedge funds and are buying through wealth management networks; and insurance companies that have problems of admissability of assets when putting capital into offshore funds. UCITS hedge funds manage €27bn of capital.

JP Morgan takes a BRIC Hedge Fund Bias

JP Morgan's 2004 partial takeover of Highbridge Capital for $1.3bn was the deal which said that institutional flows into hedge funds were believed to be for real and for some time. Eventually Morgan bought all of Highbridge. In October this year JPMorgan Chase & Co. agreed to acquire a majority stake in Brazil's Gavea Investimentos Ltda., the fund manager founded by former Brazilian central banker Arminio Fraga.

Gávea Investimentos has $5.1bn AUM invested in hedge funds and illiquid investments, and has a staff of 103 people. The hedge fund industry in Brazil is dominated by bank-run domestic retail flows, but JP Morgan likes the international appeal of Brazilian hedge funds. There are many international investors who use Brazil as a proxy for the best of the BRICs – high employment and industrial production growth, an appreciating currency, a relatively sound fiscal position and a commodity play to boot.

One of the lessons of the post-Crunch period has been that the appeal of emerging markets to investors in developed markets has recovered as well as the prices of iron ore and coffee. Has the JP Morgan deal for Gavea confirmed that emerging market flows are for real and for some time?

Renaissance is Back

In 2006-7 there was a feeling abroad that Renaissance Technologies was going to eat the lunch of a lot of hedge funds by soaking up the flows into the industry as it looked to take in as much as $100bn into the Renaissance Institutional Equities Fund (RIEF). However the large capital inflows turned into outflows when RIEF was down 16% in 2008 and down 7% in 2009. The Renaissance Institutional Futures Fund (RIFF) fared no better in 2008 - it was down 12% when most CTAs were up on the year. The reverse happened last year – RIFF was up 5% and most CTAs were down. Overall firm assets were down 25% last year, and to cap it all founder James Simons retired as CEO at the end of 2009.

After successor co-CEOs Peter Brown and Robert Mercer considered closing the two institutional products, it as well they didn't. This year RIEF International - Series B is up 17.00% YTD, and the Renaissance Institutional Futures Fund is up 17.14%. The latter fund did well enough on a 12-month risk adjusted return basis to win the Best Managed Futures Fund at the AR Awards in November. Renaissance is back.

The Eurocrats Take a Grip

In America the intense interest of politicians, regulators and the media was such that Anthony Scaramucci, founder of fund of funds Skybridge Capital, said "We have felt like a piñata - We certainly felt like we've been whacked with a stick." But it is the European end of the industry that will suffer more from actual interference.

The politicians and Eurocrats have wilfully failed to understand the significance of their proposals, despite lobbying and submissions from the industry. The hedge fund industry gives employment, tax revenues and invisible export earnings – in return the industry got proposals treating all management companies as publicly quoted, regulations on how private companies should pay their employees, damaging increased disclosure of short positions, and little-island-thinking that would have created a fence around the European hedge fund industry. On top of that the UK, home to most of the European industry, increased tax rates to an extent that it has pushed some hedge fund companies and leaders into other tax jurisdictions. The country, continent and industry are not the lands of opportunity they were.

Recovery by Madoff Receiver

The story which has come back with new developments through the year is the efforts of receiver in the case of the Madoff ponzi scheme, Irving Picard, to recover cash from the 2,000 or so net beneficiaries of the scheme. These are the investors who withdrew more money than they invested with the fraudster, and around a thousand of them have been in the sights of the receiver.

The list of banks, intermediaries, investors, friends of Madoff and counterparties to receive suits form Picard is long. Some have been obvious targets, like the 34 affiliates with ties to Madoff feeder fund Fairfield Greenwich Group. But he has been very thorough and looked through to where the "profits" have been deployed. For example, in July the court-appointed trustee took aim at three Madoff family entities, a family fund, an oil and gas properties business and a trading business, seeking $30 million that the family had invested in them.

As the deadline approached for the receiver – he had until the 11th December, the two-year-anniversary of Madoff's arrest, to file the suits – activity accelerated. Picard reached a $625m settlement with Boston billionaire and philanthropist Carl Shapiro this month, and on the last day for possible filings, the receiver filed a suit against Austrian banker Sonja Kohn and dozens of firms linked to her for $19.6 billion—all of the principal he estimates was lost by Madoff's investors and more than twice as much as he has sought in any of the thousands of other lawsuits he has filed since Madoff's arrest two years ago. The single biggest settlement to date was $7.2 billion from the estate of Madoff investor Jeffry Picower.


Monday, 20 December 2010

Two Sides of a Short Position - A High Quality Argument on Netflix

During my time as an analyst of hedge funds in 2000-2002, and later as a consultant working on portfolio management and risk management issues with hedge fund portfolio managers, I have been granted the privilege to hear the fundamental cases for positions taken by very good managers. Hearing about a single position in detail gives a potential investor or investment advisor some insight into how managers think about their positions. When consulting I would always ask how typical the sort of position is, as there is no structural insight given in hearing about something that is outside the usual style for the manager.

I look for several key points during discussion – how did the idea arise; what made the manager devote the scarce resource of research time to the company/industry; did the manager procure or carry out primary research on the company; at what level of the company has the hedge fund manager met management and how often; what sort of catalysts does the PM like to see, and has the hedge fund manager identified a catalyst for a change in fundamentals or for a change in (stock) market perceptions? All of these points will enable an outsider to gauge whether there is an edge in research. Consideration of the edge (if there is one), along with the breadth and depth of human resources in analysis, and a view on the creativity/fertility of the manager's mind, will feed into an assessment of the quality of the manager's alpha source and the potential for consistency in the alpha stream.

So it is I read with interest the published debate about Netflix between Whitney Tilson, the value-oriented founder and Managing Partner of T2 Partners LLC (, and Reed Hastings, CEO of Netflix Inc. You can find Tilson's full rationale for his short position in Netflix at, and the response by the Netflix CEO at Most unusually for such a dialogue, it is a very high quality argument.

In this case the Netflix short is smaller than any of the top ten longs in the T2 portfolio. The fund manager does not have to be right on any one position, but how he (or she) deals with being right/or wrong in money management terms is important.

Friday, 17 December 2010

John Paulson on the Benefits of Activism

John  Paulson
John Paulson may have made been the subject of the book "The Greatest Trade Ever" about his shorting of (residential) mortgage-backed securities, but that trade was as typical for him as Michael Steinhardt going long U.S. Treasuries in 1981. Steinhardt was an analytical equity investor betting his reputation on an unfamiliar asset class in government bonds. Paulson's deep experience was in something else too*.

John Paulson's professional background is in mergers and acquisitions, and so it was natural that the investment strategy in which he came to specialise was risk arbitrage, first with Bear Stearns and then Gruss Partners, before he opened his eponymous firm. As with many practitioners who go on to play other stages of the event cycle, risk arbitrage led to exposure to distressed bonds, and eventually to the full panoply of event investing of divestitures, recapitalizations and other company reorganizations and financings.

So it is the associated specialism of activist investing that is covered here with John Paulson. This is a written form of a presentation
he made a few years ago on the topic . Whilst the principles of what John Paulson describes are still valid, the aftermath of the Credit Crunch makes comments on real estate and banking anachronistic in today's market conditions.

Simon Kerr, December 2010

Paulson & Company is an event arbitrage firm, and we have been in business 15 years and activist investing is not our only activity but is in an important part of our investment strategies. I'm going to talk today about the benefits of activism.

Activism is good for the stock market. It is good for investors and is also good for business and is good for corporate governance.

The Benefits of Activism

One: The first benefit, and primary benefit, of activism is to increase shareholder value. We get involved when a stock is trading at a discount to its true value. Through activist strategies we seek to realise that value.

Two: The second goal, and as important as realising shareholder value, is to improve corporate governance. Unfortunately there are situations where corporate Boards or managements don't always act in the best interests of the stockholders. Activists make sure that all shareholders are treated fairly and properly.

Three: Another benefit is that activist investing carries out a role on behalf of other investors. We might have to act alone, and we might own only 5 or 10% of a company, but when he share price goes up all investors in the company benefit. That helps individual investors who don't have the time or resources to act in this way. It also benefits pension funds and other institutional investors that can't get involved for political reasons or because it is outside their mandate. But I would say that in many if not most of the situations in which we get involved we are clearly getting the support of institutional investors. Even if they are somewhat constrained in coming out and saying so publicly, they are supportive of the goals we are trying to achieve.

Four: Activism keeps management and boards focussed on shareholders' interests. Prior to activist investing Boards acted in their own interests. It used to be that the only thing shareholders could do when they didn't agree with what was going was to sell the stock. Activism gives shareholders a voice, and makes management listen.

I believe it also creates companies stronger. Many times what leads to an activist situation is where a company management is pursuing a strategy that that they are reluctant to let go of. Shedding loss-making operations and merging with other companies to get to global scale, in the end, does result in stronger, more competitive and more profitable companies.

Five: Activist investing also removes inertia. You can't just accept the status quo. If management have been doing something for a long time and are happy with it, that is not good enough. Management have to be accountable and activist investors showing up forces management to be accountable.

Why is There a Need for Activism?

The primary reason for activism is that in public companies there can be divergent interests between owners of the business and management. In many public companies, particularly in cases of very old, established companies, the board members and management frequently own de minimis amounts of stock. So their decision-making criteria for running the company are other than those which are best for company shareholders. Frequently they are focussed on the perks of running a large public corporation. Many times they like their cushy jobs, they like all their perks and the prestige that go along with the positions they hold. Ideally the Boards want to be left to run the company - they view shareholders as bothersome.

In some of the old companies the Boards can become very insular. Many times the Boards don't have any stock at all. They are reluctant to incorporate change. Then there is a need for an activist to get involved.

The Criteria We Look for in an Activist Situation

  1. The company is trading at a deep discount to fair value
    If the company is doing the right thing, the shares are trading at a full value and the shares are trading at a high P/E, then there is no need for an activist to get involved. However if it is trading at 50% discount to fair value, if it is pursuing strategies that have failed, if it is under-performing and the sum-of-the-parts is at premium to current traded values then that attracts the activist investor.

  2. Strategic Initiatives Available
    There have to be readily implementable strategic alternatives to unlock that value (some examples will follow). So we look for a discount and a situation where if management took action that discount could be quickly eliminated. Typically the management has been reluctant to act, simply because they don't want to change things. The activist investor comes in and acts as a positive catalyst for positive change.

Why Would the Company be Under-valued?

Why would a company be undervalued to the extent that an activist could get involved? The most common reason is that the company is in disparate businesses. Some of the businesses are weaker than the others. The sum of parts is greater than the value of the whole, and the remedial strategies are not always seen as readily implementable.


The sum of the parts was greater than the whole. Take as an example Cadbury Schweppes. In the U.S. beverage business it was an also-ran in market share, but it had an attractive confectionary business. Combined as a public company they traded at a discount to the fair value.

Sainsbury's had very valuable real estate and the management was reluctant to separate that real estate element from the retail operations. It traded at a big discount to the asset value of the business. (Property investor) Robert Tchenguiz showed up on the share register and highlighted that differential, and the stock appreciated significantly.

In (Dutch company) Stork – another situation where they were in many disparate businesses - people that wanted the individual businesses didn't want the whole rag-bag of businesses, and as a consequence the shares traded at a very significant discount.

Then there are situations where the track-record of the management is poor. Though there are pieces of the company that are valuable, investors lose confidence in the management, and as a result don't attach a high multiple to the stock. Two situations come to mind – Ahold from Holland and ABN AMRO, the Dutch bank. Both companies, for different reasons, had underperformed in stock market. There were actions that could be taken to highlight the value, but the managements needed some pressure from shareholders to do something about it.

We also see situations where managements are not focussed on shareholder value. It could be through no fault of management, but that the private market value is very different from the public market value. A ready example is the real estate sector. Real estate can be capitalised at very high multiples of cash-flow, but generally the public market looks at multiples of earnings. You can't get full value for real estate assets in the public market.

So for example, Ahold had a fair amount of real estate and the shares traded at approximately 7 ½ x EBITDA. Yet real estate transactions are being done at over 20x EBITDA. So put the real estate in a public company and the market gives it 7 ½; separate the real estate, sell it to someone privately, and you can get 20x. Some deals were done recently at approaching 24x EBITDA. The latter deals had cap rates as low as three and a half percent. That is the incentive - the difference between public and private valuations. For the retailers it is not necessarily a problem of management, but a difference in value can be realised through re-structuring, tax treatments and other considerations.

Activism Need Not be Confrontational

Many people see that activism has to be confrontational. That is not the case - some of our best investments have been where we have been working together with management, outside of the public eye, to enhance value. For example, a fund was written up in the newspaper yesterday: Blue Harbour is an activist investor that only does friendly transactions. They buy a stake in situations which are under-valued, and where they believe strategic re-structuring will add value, and then they work with management collaboratively to achieve that goal.

We have worked with managements at Ahold and The Mirant Corporation constructively. Actions the management have taken have added value in both cases.

In Cadbury and Laidlaw we have worked in a non-confrontational manner. Generally it is important for management to listen to shareholder concerns: when investors make a point that is valid, it is up to management to respond to those concerns and help to realise that value.

But Management Can Defend Aggressively

In the ideal situation, you take a stake and management greet you with open arms, and you agree to enhance shareholder value, but sometimes management is very confrontational. Sometimes the Board and management don't like being told what to do, and the management take action which harms shareholder value. I will refer to two recent examples.

After ABN AMRO granted exclusive negotiating rights with Barclays, RBS indicated an interest to pursue an acquisition. ABN AMRO management said they couldn't negotiate with RBS because of the exclusivity agreement with Barclays. That exclusivity period expired, and even knowing the RBS interest, ABN AMRO management then extended that exclusivity period. They used that second period to negotiate what was effectively a poison pill: they arrange to sell the prize asset which RBS was after (LaSalle Bank) to Bank of America. This made it almost impossible for RBS to pursue the deal they wanted with ABN AMRO.

ABN AMRO was refusing a deal at a higher price so they could choose the buyer that they wanted to sell to. This was done though many shareholders in ABN AMRO did not want this to happen. This is thankfully rare, where management use scorched-earth tactics to destroy value in order to serve their own interests.

Thankfully ABN AMRO were taken to court by Dutch shareholder group, VEB, and the shareholder group won. In order to sell even some of the the assets ABN AMRO management needed shareholder approval. Without that activism on the part of the Dutch shareholders association the incremental value in the asset sale would not have been realized.

Another hostile situation where were involved was Stork – this was a deeply undervalued businesses on a sum-of-the-parts basis. It traded at a 50% discount to fair value of the component parts on a peer group public company basis. It was in chicken processing, aerospace, oil services, and believe it or not scores of other businesses at well. So there could no corporate buyers of the whole company, because buyers of oil services did not want a chicken business. We believed the best and most promising business in the group was aerospace. We suggested either splitting into three businesses or building the group around the core aerospace business.

The Board refused to listen to us, even though we owned up to 35% of the shares, and the Board owned no stock. We said that that was unfair, and let's put it to a shareholder vote. At the shareholder meeting 89% of the votes at that meeting were for the change in strategy. The Board refused to listen to the voice of the meeting and said the Board make strategy not shareholders. So we called another meeting to replace the Board. To deny our rights the Board then initiated a poison pill – issuing super voting preferred stock to themselves. The preferred would represent the majority of votes if the issue was allowed. We had to take the company court. We argued that the poison pill was originally put in place to stop an unwarranted takeover, not to prevent shareholders from voting. The court agreed with us and threw out the pill. We are now in the process of trying to negotiate something with Stork. Our preference is always to do something collaboratively rather than confrontationally, but unfortunately it doesn't always work out that way. And we have to act to protect our interests on those occasions.

Examples of Activist Positions of Paulson & Company

Cadbury – a great company. In two businesses: it is a world leader in confectionary, but also had a substantial but sub-scale drinks business. Everyone knew that it was in the interests of shareholders that the businesses split – the best strategy was thought to be to sell the drinks businesses and concentrate on confectionary. Once Nelson Peltz declared his stake management realized the logic and immediately announced they would consider separation of the businesses. The stock jumped almost 40% in a few months of the announcement of the split of the businesses. Incidentally Nelson Peltz had good knowledge of the situation as he had sold Snapple Beverages to Cadbury five years previously.

ABN AMRO – over the five years prior to the involvement of the The Childrens' Investment Fund the stock had moved sideways whilst the banking sector was up substantially. ABN AMRO share appreciated 40% in a few months after the TCI stake became public knowledge. This shows the benefit of an activist stirring the pot. Shareholders had been disgruntled with ABN AMRO management for some time. It was a big bank, but it had pursued a strategy of being a small player in a lot of different markets. It was one of the largest banks in the world, but it had a tiny operation in the U.S., it had small operations in Italy, in Brazil, and the Middle East. That situation does not create operational strength, or allow for synergies, or allow for expanded margins. Contrast that with those banks that had large shares of deposits in its markets. Large shares of deposits in a banking market leads to profitability, so although ABN AMRO had grown it had not created value.

Ahold – the re-structuring activity in Ahold took the shares up 50% at the same time that the retail index was up 5%. The company does well operationally in Holland and Sweden but poorly in the US. As a consequence the shares traded at a discount to the sum of the parts. We proposed selling off or spinning-out the under-performing US operations, to focus on the successful European operations. We believed that that would create shareholder value. They were responsive. They sold off the US food service operations, and received much more than anyone expected – some $7bn. They bought back stock with the proceeds. The story doesn't end there because management are considering other initiatives which came from the activist shareholders. We have met with management and they have listened.

The Mirant Corporation - a very successful situation as the shares are up over 100% in a year, and Paulson & Company was the largest shareholder. Mirant, an Atlanta-based power company, itself had come out of bankruptcy and had a new CEO. They announced that they wanted to buy another utility with stock, but their own shares were trading at a discount to the sum-of the-parts, and they were proposing to acquire the target company at a premium. It was a very dilutive acquisition proposal.

The proposal drew very sharp criticism from nearly all the existing Mirant shareholders. Ed Muller, the CEO, was surprised, but he listened to shareholders, and dropped the proposal within a week. He then reached out to shareholders, and met with us and other large shareholders individually. We explained that we thought they should do is sell off their non-core assets and concentrate on the Mid-Atlantic utility business. Rather like ABN AMRO they had bits of businesses all over the place. It had utilities in the Philippines, Jamaica, Trinidad and Tobago, and the Bahamas and in the U.S. in Texas, in California and in other states.

After meeting with us he realized that the best thing to do was to hire bankers and sell off the widespread operations, and concentrate on the core utility business. He sold the Philippines assets to Tokyo Electric; he sold the Caribbean assets to Marubeni; he sold the non-core US assets to a private equity group. It was our most successful activist position, and it was done with a collaborative approach to management.

Summary: Benefits of Activism

  • Activism Improves Valuation for Everyone
  • It Frequently Results in Better Governance
  • Activism Creates More Efficient Companies
  • It Removes Inertia
  • Activist Investing Holds Management Accountable

*Before he began his investment career, John Paulson accumulated academic distinctions. He was Valedictorian of his class at New York University's College of Business and Public Administration and received his MBA from Harvard Business School as a Baker Scholar, the school's distinction for the class' top students. After a stint as a management consultant with the Boston Consulting Group, he joined Odyssey Partners as an Associate and moved on to Bear Stearns in 1984 where he became a Managing Director in mergers and acquisitions. In 1988, he became a general partner of Gruss Partners. In 1994, he started Paulson Partners L.P., and in 1996, Paulson International Ltd., a companion offshore fund. In 2001, the firm launched a leveraged version of its funds. Based in New York, Paulson & Co. currently manages $33.6bn, up from $700 million in July 2003.

For a European take on activism read about Cevian Capital on this blog or at The Hedge Fund Journal

Wednesday, 15 December 2010

Long Gilt Future Confirms Downside Break - Increasing Position Conviction

A week ago I suggested that Gilts had broken down at the long end. The successful test of the resistance at 120 (overhead supply) increases confidence in the short position. The standard trader response is to increase the position size, as the hypothesis of a breakdown has been confirmed.

Today there is also cross-asset confirmation - Sterling has depreciation against the Euro and $ in a break of previous action. That Sterling is doing this independently of other currencies is significant. 

source:Bloomberg LLP

Friday, 10 December 2010

Bob Prince, Co CEO of Bridgewater, on Alpha and Beta in HF Portfolios

Bob Prince
Now, if you look back at the history of Bridgewater, for the average market that we trade, we made 1 percent return with 3 percent risk. We've had a .3 ratio for each market. Our overall ratio is about 1. The difference between these two is diversification and portfolio structuring. So, two thirds of our performance has come from balancing risks well, and only one third has come from trying to get the bets right. Of course, if you don't get the bets right, you don't have anything to balance, so you have to start there, right? Okay. So, that's point number one. You can get a lot more mileage out of risk reduction than return enhancement.

Number two is don't believe the numbers. Now, I'm going to make an assertion here. I don't know if you've ever heard this assertion before. My assertion is that correlation is unknowable. So, we talk about portfolio mean variance, about, correlation. My assertion is that correlation is unknowable. I'm talking about the correlation of any two assets – it is unknowable. Now, I'm going to try to prove that to you on a chalkboard.

So, let's just say that I have stocks and I have bonds. Okay? And the question is, what is the correlation between stocks and bonds? Well, correlation is the way that the returns co-relate. It's how the returns relate to one another. In order to understand how the returns relate to one another, you have to really understand something about what drives returns. Okay? Well, there is more than one thing typically driving the return of any one asset. Let's just say I've got economic growth here as a factor that drives the return of stocks and bonds. Now, if the economy is strong, that will be good for stocks - generally speaking if the economy is stronger than expected. If the economy is strong, it will generally be bad for bonds. But the economy's not the only thing that drives their returns. Let's say I've got inflation here as the factor that drives their returns. If inflation falls, that will generally be good for stocks. If inflation falls, that will generally be good for bonds. So, inflation is working the same direction for stocks and bonds. Economic growth is working opposite directions for stocks and bonds.

So, now the question is, what is going to be the correlation of stocks to bonds? I don't think you can possibly know. You can't know unless you know what kind of environment you're going to be in. Will I be in an environment that's dominated by inflation? If I am, they'll probably have a positive correlation. If I'm in an environment that's dominated by economic growth, they'll probably have a negative correlation. But if I knew what kind of environment I was going to be in, I'd just go bet on that. But if I'm trying to passively structure a portfolio that's balanced, I don't have any idea what the correlation between stocks and bonds is going to be. And what it was in the past really has no bearing on what it will be in the future. So, now what do you do? How do we do mean variance optimization when you can't possibly know the correlation of two assets?

So, what I'm saying is you can't do this. So, what we try to do is we don't pay any attention to the numbers. We never try to look at the correlation between any two assets. What we try to do is balance our exposure to economic growth and inflation. So, given the structural characteristics of assets, they will perform a certain way given a certain economic environment. And you can look across your assets and start to think about how you're balanced against the economic environment through your asset holdings.

The last point is that you need to understand the fundamental characteristics of the returns that you're operating with. And the most important characteristic of those returns is the derivation of the return: is the return derived from beta or from alpha? Beta means the return is derived from the risk premium embedded in the asset. Risk premiums over time will be positive in order for the capital system to function. Risk premiums will be positive over a very long period of time, but it's very easy to buy a risk premium, so it's not a really good returning source of return. It's not a very consistent source of return because it's very attractive. A lot of people buy it and they bid up the prices, maybe has a ratio of .25 return to risk ratio. So, beta is one kind of return. It's one type or category of return. There are lots of betas.


Alpha is totally different. Alpha is a bet. I've got a view. There's timing involved. I'm long. Now I'm short. Now over time, people might make bets, but they might on average be long. Then on average they have a beta in their return, right? But ... so the question is, are you generating your return through beta or through alpha, through risk premiums or through timing of bets? Because the characteristics of those is radically different, and the ability to produce a very high return is inherently limited if you're basically holding betas because betas tend to be pretty expensive. You've only got about a .25 ratio. No matter what the historical numbers are ... don't believe the numbers. No matter what the historical numbers are, the return to risk ratio of a beta is probably not above .3. It may have an option characteristic that makes it look that way, but it's not above a .3.

And they tend to be very highly correlated because betas are all related to the same economic environment, so it's hard to get a lot of diversification in betas. Therefore, it's hard to get a really high ratio -- high consistent return -- from betas. On the other hand, alphas are very uncorrelated, but you never know if you're going to make or lose money because alpha is a zero sum game. So, it's entirely a bet of can you bet on and find the right manager who can take money from somebody else. And if you know ... if you think you can, you probably should ... as a test, you might want to think about who they're taking money from as a cross check on your process because somebody's got to take money from somebody else when it comes to alpha. For every winner there's got to be a loser.

Beta in Hedge Fund Returns

Now, I just want to show you a quick example of the importance of understanding the composition of beta in the returns of a manager that you might hire. One of the things that we did was that we looked at our database of 2,700 hedge fund managers - we ran the calculations for how much beta is approximately in the returns of these various managers. Well, we did that up to the beginning of the crisis in July 2007, quantified how much beta was in every single one of these 2700 managers. And then, we looked at how those managers then performed over the crisis period.

And so, what this work shows is the managers with more beta lost a lot of money, and that those with not very much beta in their portfolio up to July 2007 lost less. Hardly anybody made money. And the observations are right on the line of best fit (though you should also look at their return to risk ratio).

So, the amount of beta in a hedge fund's portfolio was something like, 96 percent correlated to what their performance has been since July 2007. So, if you just knew that one thing -- how much beta is in their portfolio -- you would have been able to identify with a 96 percent correlation how they would have done it through the financial crisis. The same thing is happening going forward because if you actually monitor this through the crisis for those managers, that beta hasn't changed. They still have that beta.

Now, so if their particular beta does well now, they are going to look good. But it's because that beta is in there. So, are you betting on the manager or are you betting on the market that they're involved in? It's absolutely crucial for you to understand that. And if you're betting on the market they're involved in, no matter what their historical ratio is, the beta ... the ratio of the beta is inherently limited, so something like .25, .3.

So if you look at what Bridgewater does, right now we're long bonds. There's risk premium there that we're earning today by being in a long bond position. But if you look back at what we've done historically, we're long half the time and we're short half the time. There's no systematic bias to be long bonds. And if you understood our process, you would know how hard we try to make sure we don't have that in there, right? So, literally indicator by indicator, market by market, we are approaching it with an expressed purpose of not having beta in our alpha. And we try hard to not let it get in there.

At any point in time, we could be long or short a market. Funds don't have to always be market neutral. But what I'm referring to is a systematic orientation toward beta. What I'm saying is that the amount of beta that was in those 2700 manager's returns was measured by a statistic, that a static holding of asset classes over many years was 80 percent correlated to their return, so that they are, over time, largely in a beta position.

Bridgewater Equity Mandates

I think the question of relative versus absolute is always trying to get at the real question of "what is value added?". And there's a lot focus on the industry on the quest for alpha, so to speak. But I think if you were to ask three people in a room of experts what the definition of alpha is, you'd probably get about four answers.

So, the real question is, what are you trying to do in getting value add other than exceed a simple passive benchmark? And, secondly, how is that going to influence people behaviorally?

That tend to lead you in a couple of directions, one in terms of more complexity -- I'll give you an example of that- our equity mandates. Our benchmark not against an overall equity index, but every security selection decision is against a sector in a country. So, you get six major countries, ten S&P sectors. So, we have something called a 60 cell matrix; you can imagine the operational complexity behind that. But every active choice is done against a very specific subsector so that the sector's taken out.

The question is, though -- and it gets back to that behavioral one -- how is that going to influence people, and can you even think intuitively about that when you're in 60 different dimensions? And so, there is something to be said for simplicity because the reality is that the very best tech fund manager in 2002 might have exceeded his peer group by 5 percent, but that meant they were only down 90 percent as opposed to 95 percent. And that's not going to solve anybody's problem.

Edited Transcript from The Greenwich Roundtable

Wednesday, 8 December 2010

Chart of the Day - The Long Gilt Future

source: Bloomberg LLP

  Is this what Hugh Hendry was looking for?

Hugh Hendry on Debt Deflation

At one time Hugh Hendry, manager of the Eclectica Fund, used to write monthly commentary and distribute a full attribution for fund returns at the same time. Now he writes manager letters of some length periodically, but still informs his investors about risks assumed and how the P&L  has been shaped on a monthly cycle. This month he has returned to his great theme of the last few years in writing about the Great Debt Deflation he sees.  Whilst a substantial minority of the manager commentary is on Japan, this extract is about the situations elsewhere.

There Are No Policy Remedies for Debt Deflation

I fear that a later generation might see the Fed’s initial stab at quantitative easing as tame in contrast to our squeamish reaction to it. They might guffaw, “two trillion dollars, how quaint. And they thought that might produce inflation!?” For a not so distant future generation may bear witness to far greater monetary debauchery.

This has been my argument in April 2009. Given the impediment of such a large quantity of private sector indebtedness, I speculated that should the global economy suffer a further debilitating setback over the course of the next two years, the Fed and especially its acolytes at the Bank of Japan would print much, much more paper money. And only under such dramatic economic circumstances would we establish the pretext for a truly gigantic monetary intervention which would surely undermine the fiat system. 

Today, however, we are learning that additional money, perhaps $600bn, is to be printed even without the occurrence of a serious crisis. This has come as something of a surprise to me. I had thought that intense scrutiny and political discontent from the US Congress would have tempered the ardour for such intervention. The QE announcement has also produced a rise in the risk premium associated with term structure. The yield on the ten year Treasury has shot up from just under 2.5% in August to almost 3% in November. Yields on government bonds with shorter tenors (where we have directional exposure) have also been dragged up as the market factors in a heightened probability that QE2 will lead to a rise in policy rates sooner than had the Fed shown greater restraint. This has proven detrimental to the Fund's short term performance. Yet despite it all, I remain persuaded by the argument that the additional proposed easing is not a tipping point and accordingly on its own is unlikely to do much to alter the course of US or western inflation. Perhaps I have some explaining to do.


Evidently there is an all-out war being waged between what we might refer to as the Fed’s fiat money (the ability to increase dollar banking liabilities), and the private sector’s debt-based money (the willingness of the private sector to hold dollar banking assets). The market favours the prospect of fiat printing winning. Perhaps the outcome is a foregone conclusion. However, I continue to argue that the odds seem stacked against this outcome occurring in the short term. 

Consider that the US authorities are battling against the $34trn of gross debt added by the private sector since the start of Greenspan's tenure as Fed chairman in 1987. This is a formidable obstacle to quantitative easing as it added only $9trn to income and has therefore left the private sector with misgivings as to its on-going ability to service such a huge quantum of liabilities, never mind add to such exposure. The crucial question is how much of this lift in income is a recurring flow, a product of wise investment spending, and how much was debt fuelled asset speculation with little capability of servicing interest payments and principal repayment.  This is especially pertinent because, as the chart reveals, despite the helicopter money drop of last year, the ratio of private sector liabilities to Fed-induced base or fiat money (M2) remains elevated by historic standards. For instance, it is twice the level that prevailed in the 1960s and three times the level of the 1950s.

No one has really addressed this issue except Professor Steve Keen in Australia, who is starting to win much justified acclaim. He compellingly argues that some form of aggregate demand analysis is especially apt in describing why the Fed’s initial dalliance with $2trn was insufficient. Defining demand, or total spending in the economy, as nominal GDP plus the change in gross public and private sector debt, total spending in the US shrunk from $18.2trn in the year concluding in the summer of 2007 to just $13.9trn this year. Effectively, the US economy has spent $4.3trn less on the purchase of goods, services and assets (houses, shares, hedge funds, private equity investments, etc.) despite the rise in gross debt from $47.5trn to $52trn. In other words, monetary and fiscal accommodation have been overwhelmed by the 10% contraction (much of it involuntary and taking the form of default) in the private sector’s debt-to-GDP ratio from its peak of 3x in early 2009. 

Recognising this vulnerability, the actions of the Fed since the onset of the crisis are easier to comprehend. With such a large quantum of debt it was imperative to reduce the cost of servicing it. Policy rates were cut to zero. However, the Fed’s aggressive interest rate cuts had only a mild impact on the servicing of household debt in America with its preponderance of callable fixed rate mortgages.  The effect was more pronounced in the UK where mortgage lending was predominantly variable and rates were previously priced off the one-year swap with only modest additional term and counterparty premium. Arguably, the institutional differences between the two countries’ mortgage markets made QE almost inevitable, in the US at least. Last year the Fed bid for probably a third of the outstanding stock of ten year Treasuries; the Fed’s holdings climbed from $450bn in early 2008 to $767bn at present day. But they had to concentrate the majority of their ammunition on purchasing mortgage backed securities, buying over a trillion dollars’ worth, to ensure that the cost of servicing the household sector’s debt would not rise on the back of elevated risk aversion in the banking sector. I salute this round of easing.

Fooling All of the People, All of the Time

Unfortunately, in my humble opinion, the additional monetary stimulus, takes the Fed back to dancing around a bubbling cauldron rubbing two chicken bones together. For flush with their success in having reversed the negative trend in nominal GDP, the Fed’s ambitions seem to have soared. Bernanke has publicly reasoned that they should go further and boost the economy’s animal spirits in order to increase aggregate demand in the economy. The implicit thought process is that if they could only encourage the private sector to believe that the trend in rising asset prices will endure then perhaps speculators will once more volunteer to risk taking on more debt, secure [?!] in the belief that higher future asset prices will allow for it to be repaid in full. This reasoning, whereby the stock market acts as a contributory factor to GDP growth, invokes parallels with Thomas Huxley's The Principal Subjects of Education. Sometimes it seems that next to being unequivocally correct in this world, the Fed has concluded that the next best of all things is to be clearly and definitely wrong. 

Capturing this unrepetentantly bullish autumnal mood, the Greek finance minister, in Washington for the annual IMF meeting, opined that, "smart money is realising Greek bonds are a good investment." Remember this is the same guy who said, and I quote, “we are deluding ourselves as a country in thinking we have a tax system!” Politicians and their central banking cousins are of course the ultimate expression of the prevailing consensus. The finance minister had no doubt been buoyed by the decline in Greek ten-year bond yields from 11.7% at the end of August to just below 9% and the FOMC’s confidence was likewise lifted by the slide in the ten-year yield from 4% in April 2009 to less than 2.5% in the weeks preceding their last meeting. But with Greek yields back at their highs, Ireland sinking into the mire, the solvency of the entire European banking sector in question and Treasury ten-year yields challenging 3%, it makes me think that the character Vernon God Little, from DBC Pierre’s novel had it right when he said:
     What I’m learning is the world laughs through its ass every day,
     Then just lies double time when the sh*t goes down…

The Rule of Society by the Wealthy

My greatest complaint however is that the Fed is producing a plutocracy by demonstrating that they are willing to go to all lengths to prevent a market inspired liquidation of the economy’s bad debts. This is what happened in Weimar Germany. Huge private fortunes were amassed during a time of little economic prosperity, exactly what has transpired in recent years in Britain and America with the rise of hedge funds and private equity firms. Success with money has become intimately connected with inflation – people have got rich not through productive, wealth-creating activity, but because they bought a house or stock at a time when general asset prices were rising. We have confused talent with being bullish.

Into this fray stepped a prominent and hugely successful (if somewhat uncomfortably brash) hedge fund manager who proclaimed himself the leader of this red-light gang. In his call to arms he claimed that making money was "so easy" and “you can’t lose.” You see, he has influential friends at the Fed, at the People’s’ Bank of China, at the Bank of Japan, at the Bank of England, the IMF and the ECB. He has so many friends...if the economy improves from this uncertain economic patch, supposedly a mid-cycle breather, then equities will make him money. But if it reverses back into its torpor, and he gets caught on CCTV in places he shouldn’t be, then don't worry. His friends will bail him out with their monetary largess; heads he wins, tails he wins. I believe his swagger and confidence moved the market (the global MSCI jumped 9.1% in dollar terms in September). But what is good for my exceptionally talented hedge fund friend is not necessarily good for the rest of us. Let us consider the malady afflicting Europe.

Angela of the North

The euro project has not gone according to plan. It reminds me of the story of the James Bond character Q, based on the British intelligence officer Charles Fraser-Smith. It was he who invented a compass for spies hidden in a button that unscrewed clockwise. The contraption was based on the simple yet brilliant theory that the unswerving logic of the German mind would never guess that something might unscrew the wrong way. This is really what happened with the Euro. New member states were supposed to take lower interest rates and invest their resources wisely to improve and deepen their productive capacity. Instead, they used the advantage to finance speculative asset bubbles. The world screwed them the wrong way. The Germans are unhappy.

But, desperate to cling to the euro project, the other European sovereigns have opted to default on their spending promises to voters rather than impose a haircut on their financial creditors. In the 1920s the payoff structure had been very different. The First World War took an intolerable toll on the typical household both in terms of the loss of life and financial well-being; everyone had become poorer. Accordingly there was little willingness on the part of the ruling political class to force austerity measures to redress the fiscal imbalances. The people had suffered long enough. Consequently, there was much procrastination and fiscal deficits persisted way beyond the end of the War, making capital markets reluctant to accept government paper and forcing the sovereign to rely on the central bank’s printing press.

              “Working people are not about to be used to allow passage of policies that will bring the worst barbarity we’ve seen in the past thirty-five years.
              Aleka Papariga, Head of Communist Party of Greece

This time around however the political class has concluded that the Greeks (especially the Greeks!) and the other peripheral states have done so well on the back of the euro project that it is their turn to shoulder the burden. They  calculate that the social pain would be less severe than the financial costs of a debt default and/or a euro exit. Of course this is to neglect the financial consequences of bailing out the banks in 2008 and the ensuing impact on the ordinary household. Can an analogy be drawn between war and the banking bailout? Certainly both events had a disastrous impact on the sovereign fiscal balance and consequently the social mood darkened considerably. Emotions clearly run high and the term speculator has become pejorative. 

Ireland is indicative of the social pain. Nominal incomes in that country have already fallen 14% and the working population has endured job losses and wage cuts. Their reward for all this is a second austerity package. The average household is now being asked to pay a new property tax and an additional $4.1k annually in income tax (that’s 7% of per capita income), plus minimum wages are to be slashed and further job losses are a virtual certainty. The country itself is only held together by the unintelligible premise that the economy will grow by 2.75% per annum for the next four years. Dream on. I believe the European bureaucrats have badly misjudged the public mood. 

Perhaps they are too closely aligned with the plutocracy of the financial and banking sector. Contrast the mood of the ordinary household with that of my hedge fund billionaire friend. Today the average European long/short fund is running its most bullish risk exposure in many years and is feeling ebullient regarding the rising tide of corporate profitability as businesses pare back employment levels. My grumble is that I suspect the omnipotent powers of my  peers’ central bankers might be found wanting just when they are needed most. 

I have always held the view that Europe will have its Asian Crisis moment when the popular mood in Germany rejects any further bail-outs and concludes that it is every one for themselves.  And with the precedent of Germany, quite rightly in my opinion, of insisting on the imposition of financial creditor haircuts, I believe the “sunny” monetary prophecies of such hedge fund inflationistas could be held in check over the course of the next two years by significant deflationary risk emanating especially out of Europe but also out of Japan. I’m especially positioned for the latter. But before exploring what that might entail, I need to comment on the current inflation debate.

Psychic Blindness
Let me be succinct: QE1 succeeded. In combination with the largest fiscal stimulus in sixty years, the economy reversed its freefall. If there was any failure it rests squarely with investors’ fear that the rate of price inflation would accelerate; it has not. For just as Jesus failed to turn up on the 22nd of October 1844, a modern generation of Millerites has had to bear witness to another dramatic and troubling no-show. The Fed's hotly contested money printing scheme has failed to generate the prerequisite rate of inflation, never mind the hyper-inflation expected by some market seers and academics. Indeed, despite the hysteria, core prices in the US economy are rising at their lowest year-on-year rate since the series began in 1957. Inflation, at least as measured by central bankers, has not proven to be a monetary phenomenon so far. 

Elvis Lives!

Unabashed still, our contemporary Millerites admonish inflation’s refusal to return by arguing that it is with us if not physically then certainly in spirit and point to the rise in commodity and asset prices and the simultaneous weakness of QE currencies such as the dollar and Sterling. But are they not confusing a rise in relative prices with a rise in general prices? The British experience is especially confusing: in March 2009 year on year retail price changes fell below zero for the first time in 50 years but today they are rising by almost 5% year-on-year. Which is the more telling figure?

I am sympathetic with the central bank argument that the weakness in the currency has raised the price of imports, which represent a third of total spending, and that food and energy price hikes, as well as the increase in VAT, are deflationary. And, with no evident monetary expansion in the UK, these relative price hikes serve only to moderate the demand for domestic goods and services. This proved to be the British experience following the pound’s ERM eviction in 1992; why should it prove any different in 2011 with such on-going paralysis in the banking sector and the most severe public-sector squeeze in fifty years?

Nevertheless I am acutely aware of my contentious posturing. I accept the inevitability of inflation. Indeed I refuse to acknowledge its presence in the UK price series, and I stick doggedly to fixed income strategies that assume no change in central bank target rates. Furthermore, I do not disagree with the prevalent Friedman logic that, “inflation is always and everywhere a monetary phenomenon.” So what gives?

Quantum physics

Consider the quantum theorist and Nobel Prize winner Niels Bohr, who noted that the opposite of a profound truth might well be another profound truth. Could it be that applying the logic found in Bohr’s quantum physics, one can suggest another profound truth? With the prevailing level of private sector debt many times greater than historic norms, sustained de-leveraging by corporations and households necessitates that the amount of public sector fiat money printing is so huge that the required inflation is always and everywhere a political phenomenon resulting from a serious economic malfunction in order to legitimise the actions of the central bank? That is to say that without a further economic crisis, the central bank never gains the political goodwill necessary to intervene sufficiently to reverse the decline in the rate of general price increases across the economy.

Goethe apparently wrote that Hamlet was a man asked to do something that seemed impossible for him to accomplish. The Fed’s mission seems equally intolerable. They have printed $2trn and yet the US is close to outright deflation on the core CPI measure. Does this institution truly have the mandate to print the necessary quantum of money necessary to change the course of prices?


The truth is I couldn’t guarantee it…Neither of us should have tried to predict the future.
Tony Blair, A Journey (2010)

The world of investment has parallels with theology. Repetition and the passage of many years, especially a decade, can transform the rational into the fanatical. I think we are approaching the end of a chapter that began with much cynicism directed towards China and commodities and is closing with fervent devotion. As an example, the gold price has risen more than fourfold since 2002 and has climbed every single calendar year for the past decade; only the twelve year sequence of consecutive up years from 1978 to 1989 in the Nikkei can beat it. I have no beef about gold, but how likely is it to be the next big trade?  

Of course I’m still on the dark side. A number of western economies have yet to surpass their nominal GDP highs of 2007 and I am not persuaded that this is a typical economic recovery that requires double-dip considerations; it feels like a mild depression to me. The debt of the private sector remains too high and as the events in Ireland highlight it can even hobble the security of the sovereign. Why is it so contentious therefore to declare oneself cautious if not downright pessimistic? Could the next great trade be a bear trade?

We have a number of such trades that all have asymmetric payoffs and are largely predicated on the notion that there are no policy prescriptions for a debt deflation. Accordingly the astonishing profits of the carry down trade in Japan in the 1990s remain our fascination and focal point for our rate trades. Simply put, we think the market is overstating the risk premium of the term structure. That official policy rates are unlikely to rise for some time in Europe and the US.

But I also cannot completely shake off the analogue of the 1920s/30s. In 1929, global economic growth was to be found almost exclusively in the creditor country, America. From 1927 to 1929 the debtor countries of Europe struggled to reconcile the savagery of austerity cuts without having recourse to a weaker currency. The fixed gold standard offered no redemption to soften the tremendous social costs of unemployment. And when domestic demand finally faltered stateside, the decline was made more dramatic by this lack of offsetting economic growth elsewhere. 

Today of course the analogy runs true with the Asian countries, especially China, representing the only story in town. But the comparison breaks down when it comes to assessing how pro-cyclical the Chinese have been in thwarting the steep recession of late 2008. According to the thirties analogue the Chinese should have displayed monetary hawkishness concerning their domestic speculation and soaring asset prices. But this time around, the dominant creditor has shown great monetary extravagance and as a result global GDP growth is bounding back.
The only hope for my analogue comparison is the recent Chinese hysteria concerning the Fed’s QE2 program. I find the very vocal Chinese admonishment of the Americans strange. Sure they own over a trillion dollars of US short dated Treasuries and the value of this asset is vulnerable to inflation. But so what? The Chinese are not running a fixed income hedge fund; there is no consideration of two and twenty. Indeed I would happily wager that they would accept an almighty paper loss on such securities should it underwrite a robust cyclical economic recovery for their largest customer, the US. Remember all economic policies in China are predicated on maintaining the Communist Party’s hold on power. The true nightmare for the Chinese has to be a prolonged Japanese style recovery in the west where US nominal GDP fails to grow beyond its debt fuelled peak of 2007/8.

Arguably their QE2 misgivings say more about their anxiety of food price inflation taking root and threatening their precious social cohesiveness. As other interventionists have learnt much to their chagrin, you can game the monetary system but you cannot beat it. China’s insistence on undervaluing and managing its currency whilst capital flight to its shores pushes more freshly printed renminbi back into its expanding banking system is evidence of the international economic order seeking equilibrium if not through the external value of the renminbi then through higher domestic Chinese prices. 

The Chinese have been the global economy’s magic tooth fairy these last two years, absolving us from our economic sins and making the fallout from the crisis of 2008 more manageable than bears like myself thought possible. But it is just about possible that their benevolence is changing as they seek to rein in their own domestic price inflation. Charity to strangers has come with a cost and their bureaucrats are frantically twiddling their knobs to cool the monetary system down. The danger is that a credit bubble when starved of its marginal credit soon exhibits a sudden and sharp reversal in asset prices. So the time is nearing when we might experience the world’s two most successful creditor nations (Germany and China), seeking, if not a purge of the rottenness, then certainly its moderation. This is an environment rich in policy error contingencies and justifies, I believe, your ongoing and much appreciated investment in the Fund.

This extract appears with the kind permission of the author.