Toro's Running of the Bulls Market Blog

Articles and Commentary on This and That

The following are links to several articles I found interesting over the past week or so.

First, a comment on the market. 

I am still substantially net long but have not bought or sold anything over the past while. However, I am more of a seller than a buyer at these levels.

The trend is still up, though with the S&P 500 trading at about 14x normalized earnings of $68 a share, the market is more than fairly valued.  Economic and financial apocalypse is off the table but the economy still has structural problems such that earnings and equities returns will be capped for some time.

I believe that today's market most closely mirrors the latter half of the 1970s or the late-1930s to early-1940s when the market bounced hard off the bottom then meandered for several years.  We are currently in the bounce phase, and my playbook is for the S&P 500 to get over 1,000, but I am more than willing to change my mind if it appears the market is rolling over.  However, the market is showing no signs of turning, so the trend remains up.  It gets tricky when the uptrend ends.

I rely primarily on fundamental analysis when investing but I also use technical analysis as a tool for entry and exit points.  Paul Tudor Jones - perhaps the greatest hedge fund manager of all time - explains why technical analysis is important.

The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade.  ...

Today there are young men and women graduating from college who have a tremendous work ethic, but they get lost trying to understand the logic behind a whole variety of market moves. While I’m a staunch advocate of higher education, there is no training — classroom or otherwise — that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. There’s typically no logic to it; irrationality reigns supreme, and no class can teach what to do during that brief, volatile reign. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it — a sort of baptism by fire. One has to experience both the elation and fear as markets move five and six standard deviations from conventional definitions of value.

The OECD believes the global economy is approaching a low.

Most of the world’s big economies are close to emerging from recession, according to data published on Monday by the Organisation for Economic Co-operation and Development that pointed to a possible recovery by the end of the year.

The Paris-based organisation reported in its latest monthly analysis of forward-looking indicators that a “possible trough” had been reached in April in more developed countries that make up almost three quarters of the world’s gross domestic product.

The composite index for 30 economies rose 0.5 points in April, the second monthly rise in a row, after falling for the previous 21 months. The index seeks to identify turning points in the cycle about six months in advance.

The OECD said its overall measure of advanced member countries – ranging from the eurozone and the UK to the US, Mexico and Japan – now pointed to “recovery” instead of the “strong slowdown” they had been suffering since last August.

Good news!  Fewer and fewer Harvard grads are going into financial services.  Generally, tops are marked by more grads going into financial services and bottoms by less grads going to Wall Street.

The number of graduating Harvard seniors entering finance and consulting has fallen by half in the past year, the Harvard Crimson’s annual survey found. About one fifth of all seniors seeking full-time employment are taking jobs in one of the two sectors.

The number of seniors entering finance and consulting has fallen from 47% in 2007 to 39% in 2008 to 20% for the current Class of 2009. The financial sector saw the largest reduction, falling from 23% to 11.5%, while the share of seniors entering consulting fell from 16% to 8.5%.

Sam Zell says that commercial real estate is far from dead.

While it is true that there will be a few implosions, a housing style bust may not be in the offing. A simple reason may be the string of payments. Unlike a homeowner who loses their job then their home, the owner of CRE has a buffer. First the rents of the tenants pay the loans, and only when they are not enough to cover, do the owner then dip into their own pockets.

In short, the risk/payment responsibility is dispersed among several parties. Again, this is not to say that there will not be defaults, many of them or that REIT's will not suffer, it is just the widespread and pervasive losses we are seeing in RRE may not be in the cards (losses here are defined foreclosures on CRE).

Tobin's Q may be signaling a low in the market.

Finally, hedge funds still have too much cash, which could power the market higher as lagging hedge fund managers put cash to work.

The fast money is proving slow to jump on the market's bandwagon.

Hedge funds, decried by many as quick traders, have played catch-up during the market rally since March. The average fund was 45% "net long" as of May 19, or had investment holdings valued at 45% more than its bearish "short" positions, according to Hedge Fund Research.

That figure is up from 33% earlier this year, but still is far below its 55% level a year ago. Funds are less bullish now than they were just before the market crumbled last fall.

Hedge-fund managers, and their investors, said many remain in a neutral position. Hedge funds tend to underperform stock-market averages at inflection points, in part because they aim to create a "hedged" performance, rather than ape the market.

Reasons to be Bullish

Frankly, I am having a hard time being bullish because everything feels so bad.

I was in the office on President's Day and watched the S&P 500 futures tick down to near-term support at 806, such that futures are indicating a 20 point decline at the open on Tuesday.  Now, it appears the market has formed a short-term double-top, and with stocks continuing to reach lower highs, it feels like we are about to break to the downside and re-test the November lows.

Emotionally, selling feels like the right thing to do.  However, cerebrally, since I have a time frame longer than my nose, there are many reasons not to sell at these levels, and to in fact buy stocks.  But it is difficult not to walk away in disgust, especially after last week's action, which was just horrible.

Everyone knows why you should be bearish - the credit crunch continues, the economy is terrible and earnings estimates continue to come down.  The reasons to hate stocks are very well known.  So I made a list of reasons why stocks could be substantially higher within the next year or so.

• Credit spreads have improved.  Credit remains tight, but spreads have come in.  Over the past 50 years, the average gain to stocks has been 18% when credit spreads are falling.

 

• Cash spreads are improving.  The TED spread and swap spreads are at levels last seen before the crisis began last fall.
• Treasuries are backing up and yields are rising.  The bond market has experienced a violent sell-off in the long end of the curve, while short-term T-bills - which were yielding negative returns a few months ago - have seen rising yields.
• The yield curve is steep.  When the curve is this steep, it almost always signal economic expansion over the next 12 months.
• Corporations issued the highest volume of debt in January than in any month since May.  In fact, debt issuance was greater than the last four months of 2008 combined.
• The dollar may be topping.  Some may argue that this is because of all the debt that the Treasury will flood onto the market.  However, a rising dollar has also been indicative of fear and a flight to safety.  A falling dollar may indicate that fear is seeping out of the market.

• The euro/yen cross has been moving sideways for months and may be basing.  The euro/yen carry trade had been popular over the past several years as investors bought higher-yielding euro-denominated bonds and financed the purchases by borrowing in lower-yielding yen.  This carry trade has been seen as a proxy for risk appetite in the global capital markets.  It may be signaling that investors are becoming less fearful.

• The gold/silver ratio has fallen below 70.  The ratio was as high as 80 a few months ago.  Both gold and silver have been rising the past few months, but silver has been rising faster than gold.  From September through November, silver fell 30% to the trough whereas gold fell 10%.  Silver is a thinner market but it is also an industrial metal and more exposed to the general economy than gold.  Gold is a haven during crises.  Silver prices rising faster than gold prices may be signaling that the economy is going to get better in the future and/or investors are less fearful about financial markets.
• Metal prices may be bottoming. Though it is still early, a bottom in stocks is sometimes presaged by a bottom in metals and commodity prices. 
• Commodities may be bottoming.  Oil may be putting in a bottom as well.

 

• Canadian stocks may be bottoming.  Energy and metals comprise roughly half of the total market capitalization of the Toronto Stock Exchange.  Materials stocks in Canada have been performing fairly well.

• Chinese stocks may be bottoming.  Stocks in China have been acting well as of late.  I am long the FXI.

• Semiconductor stocks have been outperforming and may be in the beginning of an uptrend.  Semiconductors are often an early indicator of the health of the technology industry.  I am long a basket of semiconductor and semiconductor equipment stocks.

• The VIX is acting like it wants to break below 40.  On Thursday's intra-day reversal, the VIX closed sharply down.  On Friday, when the market sold off during the last 20 minutes of the day, the VIX gave up less than half the decline of the prior session.  This may be a sign that investors are getting more confident of the future.

• Asset allocation by individuals towards equities is at or near all-time lows whereas allocations towards cash is at or near all-time highs.  The public is generally positioned like this at bottoms.
• Cash levels are at multi-decade highs.  There is nearly $9 trillion in cash on the sidelines currently.
• Hedge funds are heavily in cash.  There are very few hedge funds that are bullish now.
• Private equity investors are sitting on their hands.  After incurring large losses in their portfolios and wary of the cash crunch of their limited partners, private equity funds are doing little.  It seems that everyone is waiting for a turn before investing.
• Everybody whom I talk to is negative.  I have had in depth discussions with two dozen highly knowledgeable investors this month, and they are all overwhelmingly and uniformly bearish.  Every.  Single.  One.  Even those who are buying because they see value in the market are bearish on the market and the economy as a whole.  I had to talk a friend and a 20-year veteran of the business off the proverbial window ledge last week.
• Reversion to the mean suggests at least a bounce.  Last year was one of the worst years on record.  Tremendous selling usually begets a significant rally.
• Stocks are cheap.  Whether you want to measure by the 10-year moving average of earnings, Tobin's Q, or measures of book, sales and normalized earnings, stocks are inexpensive.

Now, as I tell you all this, I think there is a fairly good chance - 60% or 70% perhaps - that the market is about to re-test the lows over the next week or two.

Even after I listed all those points above, I cannot tell you that I feel bullish.

Maybe that is a sign a bottom is near.

Hedge Fund AUM Halved in 2008, $150 Billion of Withdrawals in December

Hedge fund assets under management declined by nearly a trillion dollars last year while $150 billion was withdrawn from hedge funds in December. 

From The Financial Times

Investors pulled close to a net $150bn from hedge funds last month in spite of moves by dozens of funds to halt or suspend redemptions.

The record December figure, equivalent to about 10 per cent of industry assets, extends the run of outflows to four consecutive months and has increased the total net outflow for 2008 to $200bn.

The size of the once lucrative industry has almost halved in the past year, to $1,000bn under management, according to data from TrimTabs Investment Research and Barclay Hedge.

Conrad Gann, chief operating officer of TrimTabs, said he foresaw more redemptions in the first quarter of 2009.

"We expected December hedge fund redemptions to be significant, but the results are still surprising . . . twice the peak equity mutual fund outflows in September at $72bn," he said.

The hedge fund industry was clearly "under duress", Mr Gann said. "Approximately two-thirds of industry revenues comes from performance fees and we estimate that 81 per cent of hedge funds were underwater [reported negative returns] last year . . . Managers have half the assets to work with and remaining assets need to fully recover prior losses before they can earn performance fees." ...

The size of the industry has fallen because of performance losses as well as investor redemptions. The average fund lost 21.7 per cent in 2008, according to Morningstar 1000 index. That is based on the 1,000 largest funds, which account for 90 per cent of industry assets.

And given the way markets have been behaving the past week, I imagine that more assets are being liquidated as the financial system continues to de-lever.

Hedge Fund Withdrawals, $63 Billion in October

From Bloomberg

The $1.65 trillion hedge fund industry is enduring its worst period in at least eight years as global declines in stocks and commodity prices led to investment losses and customers withdrew a net $62.7 billion from the funds last month, Singapore-based Eurekahedge reported. Assets may fall to about $1 trillion by the middle of next year, analysts at New York-based Citigroup Inc. estimated in a report published earlier this week.

Barton Biggs, however, says the fears of hedge fund withdrawals are overblown.

There is no question that a lot of money is coming out of the hedge fund space. Let's look at the $1.9 trillion. Losses have probably reduced it by 25%, to $1.4 trillion. Based on what I see and hear, $350 billion to $420 billion will be withdrawn by the middle of next year. Probably about $150 billion has already gone.

That means that there is about $250 billion to go (again, I am talking worldwide). That's not a huge amount, but what the bears are terribly worried about is that presumably this money is leveraged, and so to raise the cash, hedge funds will have to sell two to three times that much.

In fact, at least one huge fund has been liquidating leveraged positions. But I don't think that's the start of a wave. First, the prime brokers for the industry report that the hedge fund industry's net long position is now around 20% of their equity, an all-time low.

Hedge funds have heard the redemption footsteps: They have already sold down their long portfolios and tremendously reduced their gross book and leverage. It is a fact that hedge fund margin debt has been declining since July 2007, and prime brokers report massive hedge fund cash holdings.

Biggs also notes the following, of which I agree.

In every bear market I have seen, the doomsayers concoct a statistical argument that the glory days for stocks are over, because a flood of selling by brutalized investors is inevitable, and the buyers have no money. This case always seems most compelling close to the end of the declines and is always marked by a wave of media pronouncements. Remember Business Week's "The Death of Equities" cover in 1980? Recent covers from Business Week and The Economist have had similarly dire alarms.

Peter Schiff was on Fast Money this evening talking about the collapse of the economy.  He may be right but I suspect the uber-bears will overplay their hand as they did in 2002 when they called for the Dow to go to 5000. 

Hedge Fund Selling has been Intense

From Vince Farrell at RealMoney.

A report making the rounds today detailed managers' Form 13-F filings. This report shows what managers own. Their holdings of U.S. stocks by and large plummeted. The decline in the size of the positions could be from market share losses or the sale of a position, or most likely, both.

Atticus Capital reduced its holdings from $8.1 billion to $510 million. Tudor Investment from $5.7 billion to $453 million. SAC Capital Advisors said its holdings of U.S.-based stocks (and options and converts) were $7.7 billion vs. $14.4 billion last quarter. Moore Capital said the "value of its 13-F securities fell 69% to $1.4 billion." And on and on.

Those are astonishing numbers.

If you are a bear and are short, you must be cognizant that there is a tremendous amount of firepower on the sidelines.

Much of the proceeds from the intense selling is sitting in cash.  Yields on one month and three month Treasury bills were as low as 0.04% and 0.07% a few days ago.

Some of this cash has been earmarked for redemptions but some is because hedge funds are sitting on their hands.  Many of these hedge funds are down 15%, 20%, even 40%.  Hedge funds are not paid unless they earn a positive absolute return.  More poignantly, their business model is threatened by such bad numbers because they are not paid egregious fees to lose people money. 

What I think is going to happen is that when the market moves higher, it will do so in a tremendously violent way, with perhaps a move of as much as 1000 points on the Dow in a day and maybe 2000 points over a few days. 

This will be caused both by short covering and also by hedge funds rapidly pouring money back into the market.  A fund's viability is threatened if it is down 20% or 30%.  It is far more viable if it is down only 5% or 10%.  If the hedge funds sniff out that the market is moving up, an avalanche of cash will come back into the market, causing the market to soar.

This is why I have been scaling in.  I do not think that we will see a classical bottom, at least in the near-term.  This has not been a classical sell-off so it is unlikely to be a classical trough.  The rally will be red hot and waiting for an all clear signal means you will miss it.

At least that is my opinion.

Hedge Fund Leverage

From Paul Kedrosky

The hedge funds de-leveraging at least partially explaining the tremendous volatility and random moves in the market.

Hedge Funds - Yeah, They are Worth 2 & 20

Hedge fund performance has, for the most part, sucked this year.  Read this article to see how the compensation schemes have done.

The standard fee schedule for a top shelf fund is 2% of the assets and 20% of the profits.  Over time, the stock market returns about 10% per year.  Under a typical fee structure for a hedge fund, to generate a 10% return after fees, the hedge fund has to return nearly 15% before fees to attain the long-run average return of stocks after fees.

For example, let's say you have $100 to invest.  On average, that $100 will be worth $110 investing in a passive stock index fund after one year.

If you are in a hedge fund that charges 2 & 20, then the fund takes 2% of your assets leaving you with $98 net of fees to invest.  To generate $10 in profits after fees, the hedge fund taking 20% of the profits has to earn a return of 12.5% for a total of 14.5% in gross return before the manager earns the 10% one can earn investing in a passive equities fund.  Thus, to add any value, the hedge fund manager has to earn at least 15% to justify your investment.

How easy is that? Warren Buffett - one of the world's greatest investors - has compounded his equity at just over 20% per year.   The average mutual fund earns 8%-9% per year.  Consistently earning more than 15% per year is extremely difficult. 

How does the hedge fund manager get to 15% or more?  A few do it by skill.  Most do it with leverage.

And we have seen how well leverage has worked in the investment business over the past few months, eh? 

You can use leverage too if you want, either through the futures market or with leveraged ETFs, as long as you can stomach the volatility.  Hedge funds used to be about not losing money.  But as the article above notes, that is certainly not the case.

September Hedge Fund Withdrawals, $43 Billion

From The Financial Times

Investors pulled at least $43bn from US hedge funds in September as market turmoil led to unprecedented withdrawals, an analysis by a leading research house shows.

The data from TrimTabs Investment Research – which was to be sent to clients late on Wednesday – come as hedge funds are working to prevent far bigger redemptions by the end of the year, when many funds give investors a chance to take out money.

Withdrawals can lead to a vicious circle in the markets, as funds sell holdings to return money to clients, depressing prices and prompting further redemptions. ...

The chief executive of a leading alternative investment manager said he expected the hedge fund industry to shrink by 50 per cent in coming months – with half the decline coming from withdrawals and half coming from investment losses.

Conrad Gunn, chief operating officer of TrimTabs, said the $43bn in September withdrawals would mark “the beginning of what we expect to be a series of outflows for the remainder of the year. We expect October outflows to be larger”.

The industry, which manages close to $2,000bn, has experienced outflows during only a handful of months previously, including a small outflow in April of this year.

If you ask me what makes me most bearish, what makes me think that the S&P 500 could go to 600, it is not the recession.  We have gone through recessions before, even credit-induced ones. 

No, what makes me very worried and why I am not deploying capital just yet, even though the market is  getting cheap, is the tsunami of hedge fund sales that may be on the horizon. 

Recessions we have seen before.  Highly leveraged fund liquidation by over-compensated money managers in an industry that gets paid not to take losses whose time horizon is next quarter and whose clients thought they would earn money in any market environment we have not seen before.

That is what worries me.

Hedge Fund Liquidation $400 Billion?

If so, the decline in stocks is not over.

From Free Exchange

JPMorgan Chase has estimated that hedge fund outflows could total up to $150bn over the coming year. As investors take their money out of hedge funds, the funds have to sell assets.

But because they use so much borrowed money, the amount of potential asset sales is far larger. For example, JPMorgan expects that an outflow of $150bn will lead to sales of about $400bn.

Well, I @%^%^$)( Hope Not!

Let the 2 & 20 Masters of the Universe burn.

U.S. Treasury Secretary Henry Paulson said his plan to inject capital into financial companies is focused on banks and thrifts, indicating unregulated firms such as hedge funds won't initially get government aid.

I'm troubled by the word "initially."

How about "never."