Toro's Running of the Bulls Market Blog

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.

Alternative Assets on Sale

Just like everything else.

From the New York Times.

Some of the nation’s universities are trying to sell chunks of their portfolios privately as their endowments swoon with the markets.

Among institutional investors, school endowments aggressively embraced private equity, real estate partnerships, venture capital, commodities, hedge funds and other so-called alternative investments over the last few years. Endowments with more than $1 billion in assets reported 35 percent of their holdings in these types of investments on average last year, a much greater portion than big public pension funds, for example. ...

Last year, the average seller got $1.04 for every dollar of face value, according to a report by Cogent Partners, an investment bank for institutions looking to sell such holdings in the secondary market. Since June, sellers have been getting 50 cents or less on the dollar, said Colin S. McGrady, a managing director at Cogent.

I love markets (though admittedly, I have not been so much in love with markets over the past few weeks).  The psychology of herds as manifested in financial markets fascinates me. 

Over the past several years, the herd had been stampeding into alternative assets as institutions all tried to emulate Harvard and Yale, which put up some gaudy numbers when markets were getting creamed.

Now, unsurprisingly, after pouring an ocean of liquidity into alternatives, which lead to many really stupid deals, pieces are being sold off at 50 cents on the dollar.

We all can't be Harvard and Yale.

The cycle of greed and fear never ends.

Pirates v. Private Equity

Amusing article at Deal Journal.  I especially liked

Start-up costs

Piracy: Gun, boats, a handful of men, rocket-propelled grenades.

Private equity: Office on Park Avenue.

Jargon

Private equity: “Internal rate of return,” called IRR.

Piracy: Eerily similar: “Aaar.”

How to Earn 40% Per Year Returns Like a Private Equity Fund

Are you jealous of Blackstone?  Have a hankering to be like KKR?

No problem, dear readers.  We at Running of the Bulls are here to enlighten you on how to make 40% a year, just like the private equity funds, without having to pay the extortionary fees just to have the privilege of participating in a pool of capital in which you are not allowed to withdraw any money until your first born is in college.

First, one must understand how a private equity firm generates such magnificent returns. 

Its easy!  It goes something like this.

1. Find a publicly traded company that has a ton of cash on its balance sheet, is magnificently free cash flow positive and is being ignored by the stock market.
2. Offer to buy said company at 30% above the market price.  The stock market - which has the attention span of a hummingbird - will be thrilled.
3. Once you own it, gut the company of all its cash, paying yourself a ridiculously handsome dividend, using gianormous amounts of debt to pay yourself that dividend.  You deserve it.
4. Fire half the employees.  
5. A few years later, when the stock market has finally turned its attention to the industry in which the company you just hallowed out and gutted the balance sheet operates, take the company public at a higher price at which you bought it.  Emphasize the efficiency gains and much higher return on equity of the company that you generously imbued your business acumen upon.
6. Convince Congress that secretaries and hamburger flippers should be taxed at a higher rate than you.

Voila!  You're a billionaire! 

But since you - the average Joe who didn't go to Harvard and spend the first two years of your post-MBA career photocopying for 120 hours a week deep in the bowels of an investment bank - can't do that, here's a way for you to generate similar returns in a similar manner.

Pleas send me $249 for a copy of my software which will tell you how you can...

Haha! No, just kidding.

Here's how you do it.

1. Go open a margin account.
2. Buy one of these ultra floating ETFs which return two times the market rate, such as the ProShares Ultra S&P 500 fund, ticker SSO.  Use maximum leverage.
3. Sit back, relax and watch the money roll in.

If you are a money manager, stick the money offshore.  Hire a New York valuation firm to tell you what your account should be worth.  Ignore what is happening in the stock market.  Charge your clients high fees.
...............................

Satirical commentary aside, much of private equity returns come from increasing the leverage they own.  The PE funds have the luxury of not marking their investment to market, thus are not bound by current market valuation as market movements are often considered transitory.  They also choose when to sell their company back to the public markets.  PE funds are able to exploit this "asset class structure arbitrage" quite profitably.

In our example, if one can stomach the volatility and can put up extra cash for margin calls during downdrafts, over time, one would earn similar returns.  The average return of stocks has historically been 10%.  Buying a double floater ETF increases the historical return to 20%.  Buying the ETF on maximum margin generates average returns of 40% per year.

Of course, even the casual investor can see the inherent dangers of such a strategy.  However, initiating such a position in 1982 and removing it in 1999 would have made one very wealthy.

It goes without saying that it would be enormously stupid to do this now.  Bear markets are not a good time to lever up positions in stocks with everything you have.

But you get the idea.

REITs - What are Institutional CIOs Thinking?

Last week, I read a report by Citigroup on intended three-year asset allocations of 50 CIOs who control $1 trillion in assets.  The survey was the subject of a piece in The New York Times.

During the last two weeks of July and the first week of August, amid a widespread market meltdown, Citigroup surveyed close to 50 pension managers from the United States and Europe who collectively manage over $1 trillion in assets.

The survey showed they would, on average, raise their allocation in alternative investments to nearly 20 percent by 2010 from 14 percent today. In all, that would mean another $1.2 trillion flowing into alternatives over the next two years.

That money is coming out of traditional stock and bond investments.

So I went back and looked at the price indices for both the S&P 500 and the Dow Jones US Real Estate Index.  On December 31, 1999, the S&P 500 closed at 1469.25.  Yesterday, it was at 1564.05.  The Dow Jones US Real Estate index was at 125.77 on the last day of the 1990s.  Yesterday, it closed at 313.68.  Thus, in the past seven and three-quarters years, stocks have risen 6.5% in total whereas REITs have risen 149.4%.

Not only that, but at the start of the decade, REITs were cheap, trading at ~7x funds from operations (FFO), whereas stocks were nose-bleed expensive, trading at ~30x trailing earnings.  Today, REITs are 14x FFO - sky-high expensive - and stocks are 18x trailing earnings - not cheap but not expensive either.  (At least on current profit margins.)  On FFO, REITs are trading at a 40% premium to equities and nearly 100% on forward estimates. 

All this while at least one category of commercial real estate is at the highest vacancy rates in 5.5 years.

U.S. strip-mall vacancies only inched up in the third quarter, but still hit a 5½-year high, spurring concerns about cutbacks in consumer spending. Rentals of retail space in weak housing markets are getting hit disproportionately hard, as consumers rein in their purchases.

The retail sector has been a pillar of the commercial real-estate industry -- and the overall economy -- for the last seven years, riding out economic downturns on steady consumer spending strengthened by soaring housing prices and easy credit. The end of the housing boom and the current credit crunch have analysts and investors watching for signs of weakness. ...

The strip-mall vacancy rate rose to 7.4% in the third quarter, from 7.3% in the second quarter and 7% in the year-earlier period. Along with the first quarter of 2002, when the vacancy rate was also 7.4%, that level was the highest in 11 years, according to a survey of 76 U.S. retail markets by Reis.

And CIOs want to put more money into commercial real estate?

Is reversion to the mean and the value effect dead?

It would be interesting to know what this survey looked like at the end of 1999, when investors were tossing money at the technology venture capitalists like it was going out of style. 

(Paradoxically, a former intern of mine went to work in the energy department of a private equity firm in Dallas in the late 1990s.  He called me shortly after he arrived and told me they could not raise money for their fund.  Nobody wanted to invest in energy.)

Pension recipients are going to be sorely disappointed in their CIOs a decade hence.

I am short REITs.

Too Much Debt?

Breakingviews, via Naked Capitalism, posits that corporate deleveraging has been over-exaggerated.

Smithers noticed that the trend {of falling corporate debt ratios] was different in the UK....When the assets are valued at replacement cost, the debt-asset ratio has actually increased, from 45% to 52%.

The US statistics measured replacement costs, but with a large "statistical discrepancy" that seemed to be used to reconcile top-down calculations with individual corporate accounts. Take away that adjustment, and the decrease in US corporate debt burdens was cut by more than half - from 70% to 55% of equity.

As a check, Smithers compared the ratio of corporate debt to domestic output. That has also declined, but only from 100% to 90%. That's the same level as at the last peak, in 1990. In the 1970s, the ratio was mostly in the 60-70% range. Similarly, the ratio of financial debt to GDP has increased from 96% to 107% since 2002. Some of that additional financial debt may actually be non-financial corporate debt in disguise.

What's going on, precisely? It seems that higher asset prices have made their way onto company balance sheets. There are many possible mechanisms, including asset sale-leasebacks and accounting for financial portfolios at market values.

If the rise in asset prices does indeed account for a big part of the decline in reported corporate leverage, then companies could be more vulnerable than investors think to an economic decline, especially if it were accompanied by weak financial markets.

Its easy to see the effect of debt over-abundance in the private equity markets.

...self-proclaimed pieties seem to be evaporating across the Street. That's especially true with private-equity firms, which regard their work as the vanguard of economic progress.

The idea at the heart of their business -- that paying down debt instills managerial discipline -- became subverted over the past 18 months. As one leading private-equity player put it a few months ago, some buyout shops began "solving backwards."

By that he means they first calculated how much money they could raise to finance a purchase, rather than first calculating a target's intrinsic worth. This meant debt markets were doing the exact opposite of disciplining -- they were enabling ever-steeper prices.

Deal values climbed accordingly, according to data compiled by FactSet MergerStat. In 2004, for instance, private-equity firms paid nine times cash flow for their targets, a number that climbed to 12.4 times this year.

Private-equity firms have been selling companies they own "to people who could borrow even more, and that's not going to happen now. They're going to be stuck with a lot of deals for a long time," said Michael Weisbach, a finance professor at the University of Illinois who just released a study of 153 private-equity buyouts.

And how will the buyout firms rectify things two to three years from now, when some of their investments are still losers?

The most direct path will be to cover the overpayment by slashing costs. That means greater chances for the things that private-equity groups insist don't much exist: job cuts, factory closings, offshoring.

Though I'm somewhat bearish on the market, I am not uber-bearish because, despite the problems in the economy, as long as employment holds up, it is unlikely we will enter a recession.  But I spend time thinking about what could increase unemployment, and one driver of higher unemployment may be the recent orgy of private equity activity.

I believe private equity returns will be substantially lower over the next 10 years compared to the past 10 as private equity firms are over-paying for public companies in aggregate.   A way to offset over-payment is cost reductions, i.e. job cuts.  If future returns are disappointing - as I believe they will be - then private equity may initiate a wave of job losses that would increase unemployment and slow the economy. 

By how much, however, I don't know.  Perhaps private equity layoffs will be inconsequential to the economy.

Or perhaps it will not be.   

Blackstone Stuffs Lawmakers!

Kudos to Blackstone for coming to market.  Now we know why the pricing was moved up from Tuesday to tonight - because grand-standing politicians were engaging in class-baiting politics by pressuring the SEC to hold up the issue.

In a letter to SEC Chairman Christopher Cox, Waxman said Blackstone's IPO may present potential investors and the public with new and undisclosed risks, while stripping them of necessary protections.

"For this reason, we urge you to refrain from accelerating the IPO until Congress has had a chance to hold hearings on this matter," wrote Waxman. The letter was also signed by Rep. Dennis Kucinich, an Ohio Democrat and chairman of the panel's domestic policy subcommittee. ...

In the letter, Waxman said the value of investors' interests in Blackstone would be tied to the performance of its underlying hedge and private equity funds. Such funds have not been considered suitable investments for the general public because of their high risks and speculative nature, he said. 

"While exposing unsophisticated investors to new risks, the Blackstone IPO would also apparently deprive them of control over the management of the funds and of many of the protections provided by fiduciary duties typically owed to them by management," Waxman and Kucinich wrote.

What utter nonsense. 

This has nothing to do with risk and protecting investors ("protecting" them from a firm, by the way, that has compounded annual net returns in its private equity fund 22% over two decades and 30% in its real estate fund since the beginning the 1990s).

This is about sticking it to rich guys who pay low taxes!

Now, I'm not saying profits generated by Blackstone shouldn't be taxed at 35% instead of the current 15%.  Frankly, I don't know why one type of corporate organization should pay a different tax rate than another, though DealBreaker makes the argument.  However, attempting to halt the Backstone IPO is pure political theater for the liberal politicians in the Democratic party who are playing to their base, especially for serial Presidential candidate Kucinich. 

I'm appalled at the sleazy opportunism of the politicians who are attempting to interfere with an independent government regulatory agency to blatantly advance a political agenda, using the guise of investor's stupidity and gullibility as cover. 

They presume that investors are morons who don't know what they're doing, witnessed by the open on Friday, which will surely be in the high-$30s / low-$40s.  Instead, we should trust the political representatives of the American left, who are often openly hostile towards American corporations and suspicious of markets, to protect us from what we don't understand!

And they wonder why they're at 23% in the polls.

Disclosure - the firm in which I am employed has a relationship with Blackstone.  I personally will not participate in the IPO.

Private Equity Deal Interest Coverage at Decade Lows

From the Fox Street Journal

 

Not everyone's making money hand-over-fist doing leveraged buyouts lately.

Even as the buyout boom rolls on, a number of recent high-profile deals are already showing signs of strain. Among them: the $1.3 billion purchase of retailer Linens 'n Things Inc. by a group led by Apollo Management LP; Avista Capital Partners' $530 million buyout of the Star Tribune newspaper in Minneapolis; and the $17.6 billion deal for Freescale Semiconductor Holdings by several buyout specialists. Apollo's $6.7 billion purchase of Realogy Corp. also is raising questions among some investors.

For now, those deals are the exceptions -- most of the recent private-equity buyouts have held up nicely or are at stages where it is too early to judge them, analysts and traders say.

"I think these are one-off problems and not a signal of problems to come," says Victor Consoli, co-head of corporate-credit strategy at Bear Stearns. "The economy is still fairly strong, the dollar is weak, [which] makes our exports more attractive, and the consumer is employed and still spending."

But others are more cautious, noting that recent LBOs have included heavy dollops of debt, potentially causing problems as bond yields climb and the U.S. economy runs into new obstacles.

Companies that have gone private in buyouts are generating cash that exceeds their debt interest payments by just 1.7 times, versus 2.4 times last year and 3.4 times in 2004, according to Standard & Poor's Leveraged Commentary & Data. The ratio is at a 10-year low and shows how the margin for error for companies is shrinking as their profit growth is slowing.

Still, it is striking how quickly a few of the deals have run into problems. The stumbles from LBO firms with impressive track records are a reminder that these deals can be challenging, especially when they take place in cyclical or struggling industries where cash flows aren't very stable.

"Our concern is if there is more of a slowdown in the economy in the second half," more companies that have been taken private will run into trouble because of the significant debt they have taken on as part of the deals, says Jeffrey Rosenberg, head of credit strategy at Banc of America Securities.

Tick, tick, tick...

Market Experts Becoming More Cautious

Aside from the Jim Cramers of the world - who has been right so far, I might add - it seems I am reading more and more bearish commentary from market experts.  Perhaps that's because of the media I frequent, I don't know, but it seems to me to be the case.

From The Financial Times

Anthony Bolton, Britain's most feted fund manager, has fired a message of doom and gloom as his parting shot to the industry as his sparkling career spanning more than quarter of a century draws to a close.

Speaking at a dinner marking the appointment of Sanjeev Shah as his successor to manage Fidelity's flagship Special Situations fund, Mr Bolton warned that he was fearful of a stock market slump.

"We've got a bull market that is four years old now," he said. "I find it difficult to find cheap shares. The low risk and high risk [shares] have gone up together. That spells danger. You are seeing mergers and acquisitions' tittle tattle that makes me concerned."

His views will be closely watched by financial advisers and rival investment professionals, not least because Mr Bolton has displayed a canny ability in the past for predicting stock market corrections. ...

Stressing that these were his personal views, Mr Bolton said much of the boom in mergers and acquisitions - and also risks in markets - were being driven by a dramatic weakening of the legal covenants that have traditionally protected investors holding syndicated bank loans.

"The comments that we get in private from private equity is that they can't believe some of the covenant-light deals they are getting," he said. "It is only a question of when rather than if [things go wrong]. I can't tell you when it's coming. I can tell you the pressures are there."

More on private equity, easy credit and the potential effects on the market

Steve Rattner, managing principal of the Quadrangle Partners, has a blunt warning for those riding the wave of easy credit in the private equity industry. It won’t last.

On FT.com’s View from the Top video, he says:”Those of us who are in private equity think we are unbelievably talented investors, masters of the universe, whatever you want to describe ourselves as, and many private equity guys are extremely talented investors, extremely talented managers. But when you cut though it all, what’s really going on here is that you have a credit-fuelled bubble driving private equity deals that would not happen in a normal credit market.

“You can borrow more money today, at lower rates relative to risk-free rate – the treasury rate – than ever before in history. And that has taken deals that would not have made any sense for private equity, and made them into very economically attractive private equity deals.

“Unless you believe that there is a new paradigm: that somehow we’ve reinvented the rules of history, and of finance, the music is going to stop…Once the default rate starts to rise, the lenders, who are now throwing money at all of us private equity guys at these incredibly low spreads, say, “What was I thinking? Why was I lending to this particular creditor at 296 basis points over treasuries? I wasn’t getting paid for the risk I’m taking.” And then we will go back to some sort of normalised existence.”

Tobias Levkovich, strategist for Citigroup and fellow Canadian, wrote a piece entitled Monday Morning Musings, The Angle from Armonk, dated, I believe, May 18, highlighting Robert Rubin's thoughts on the market in a speech he gave at a Citigroup conference

Mr. Rubin raised the issue of the political risks of trade protectionism, the need for more comprehensive investment in education, infrastructure and training, the challenges of burdensome regulation and litigation, and the emergence of China and India as global competitors to the United States, plus large cash pools coming from outside the US like petrodollars. Indeed, he highlighted that the uncertainties around the world today are the most testing that he could recall in his adult life, while admitting that he has a bias towards risk aversion. His most interesting comment though, quoting Alan Greenspan, was that so-called excess liquidity is more a function of confidence than just cash swirling around and that it could dissipate quickly if that confidence was broken.

A few weeks ago, Jeremy Grantham let his thoughts be known.

[Jeremy] Grantham, chairman of Boston firm Grantham Mayo Van Otterloo, has been a voice of caution for years. But he has upped his concerns in his latest letter to shareholders. Grantham says we are now seeing the first worldwide bubble in history covering all asset classes.

Everything is in bubble territory, he says.

Everything.

"From Indian antiquities to modern Chinese art," he wrote in a letter to clients this week following a six-week world tour, "from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it's bubble time!"

"Everyone, everywhere is reinforcing one another," he wrote. "Wherever you travel you will hear it confirmed that 'they don't make any more land,' and that 'with these growth rates and low interest rates, equity markets must keep rising,' and 'private equity will continue to drive the markets.' " ...

Grantham concludes that every asset class is expensive today compared with historic averages and compared with the cost of replacing it. By his calculations, the only assets likely to beat inflation by any significant margin if you hold them for the next seven years are managed timber, "high-quality" U.S. stocks, and bonds.

"The bursting of [this] bubble will be across all countries and all assets, with the probable exception of high-grade bonds," Grantham warned. "Since no similar global event has occurred before, the stresses to the system are likely to be unexpected. All of this is likely to depress confidence and lower economic activity."

I agree.

Grantham talks about the stampede into private equity and the effects on the market.

In fact, the new global money flows have probably created the first truly global bubble, almost everywhere in almost everything. Particularly noteworthy and the beneficiary of our twin forces are small caps everywhere which on our data are more overpriced, driven by private equity deals, than an overpriced market.

But private equity itself is the star and indeed in future years may give its name to this bubble, the Private Equity Bubble. Potential private equity deals have been efficiently exploited by other investors, in the process creating odd cross currents like the out-performance of inefficient companies that are conducive to improvement by the acquirers. ...

An ominous recent survey confirms just how powerful this asset movement still is: 24 per cent of institutions expect to lower their allocation to US active equity portfolios versus only 4 per cent that intend increases.

But for private equity 34 per cent are intending to increase and only 2 per cent to decrease. It almost doesn't compute but it will be interesting trying. The new assets will be looking for excuses to be overpriced for they will, more often than not, be on the right side of supply/demand imbalances.

Conversely, the sources of funds, US blue chips and US bonds will be in the reverse position and will mostly be lower priced relative to fair value than the newer favourites. ...

So we are probably in for an extended period of mispricing usually in favour of the trendy assets, but with reactions towards fair value that will sometimes likely be dramatic.

What could trigger a "dramatic reaction?"  Charles Kindleberger, in his classic Manias, Panics and Crashes, argues that the end of bubbles often occur due to unexpected extraneous events outside the financial system.  Such an example was the sharp sell-off last February and March triggered by the Chinese government, a sell-off I believe was a warning shot to the global financial system.

David Andrew Taylor over at Dismally expects the end of the yen carry trade to signal the end of the bull market.

First, where is all of this money coming from? Japan and the carry. The carry doesn't like instability. If world equity markets start to shake, the carry will roll. Hard. We saw a taste of this in late February when the Chinese bourses tripped up, and the carry got whacked. This will very likely be the domino effect that pushes all, as in every single one, equity market in the world to take the necessary tumble back into normalcy. At the same time, the ramifications are going to metastasize around the global financial system. The money that's been accumulating in the carry will head right back to Japan, providing a liquidity crunch.

Finally, when short funds start shutting down, red flags start flying for me

Greg Newton at Naked Shorts relays the tale of Keel Capital, a US hedge fund that once managed $175m in assets. But reports on Monday said that the fund had decided to close down because of a lack of attractive short-selling opportunities and a strategy that it described as too restrictive.

The long/short equity hedge fund focused on companies undergoing disruptive change and started trading in early 2005. They chose to liquidate because a strategy shift would have taken too much time and money, co-founder Jeff Bernstein said in an interview.

As more hedge funds have started and others have grown into giants, trading opportunities have become scarcer and volatility has declined, he said: “It has become somewhat systemic: With the growth of hedge funds, short interest is higher and that has dampened volatility and could lead to long periods of lower volatility in future,” according to Bernstein. “To compound this with a low-volatility fund was difficult.”

They are not alone. Cantillon Capital Management in January used a similar line when they decided to call it a day.

I am becoming more selective.  I have been buying recently, last week adding to my coal position. However, I have also been selling technology, and plan to sell more.  The game has changed in tech.  Volatility has left the building, or at least relative volatility has.

I continue to look at what is going on in emerging market with great skepticism.  I wrote last month I was  pondering a small, speculative position in long-dated deep out of the money iShares China 25 ETF, ticker FXI.  In actuality, I was considering the position in March when it looked like the market was bottoming.  Since then, the value of those calls have risen 600%.  I don't kick myself, though, because I know there will be another opportunity in the not to distant future to take the opposite position.  At some point, I will start buying long-dated, deep out of the money puts on the same ETF.  I hope I'm smart to recognize the top and have the guts to go in hard.  Or maybe I'll scale in as the market keeps rising.  We'll see.  That's the great thing about Bubbles - there will always be opportunities to make a lot of money. 

China trades for about 50x earnings.  I wonder if it will get to 100x?  It got to something like 60x or 80x - I can't remember - several years ago.  This nutty action seems to have stronger foundations than the previous run-up.  But not strong enough. 

Finally, a comment on the DJ Real Estate ETF, ticker IYR, of which I own long-dated now at or near the money puts. A REIT analyst - whose name I cannot remember at the moment - left a voiceblast this morning stating that the reason why the REITs were breaking down was because CMBS spreads were widening.  (He then argued that he wouldn't have to cut numbers because the cap rates in his models were 6%, not the 5%-5.25% currently implied in the group.  But that doesn't matter to me.)  Remember that the spreads were widening in the residential mortgage backed securities last year as the subprime market began falling apart, and was presaged by a top in the homebuilders a few months earlier.  I believe a similar scenario will play out in commercial real estate, which has become over-extended.  A return to historical valuations would plunge the IYR back into the $30s - today it is $82.  I have a hard time fathoming the ETF will fall that far - I would be very happy if it did - but I can see it falling to $70 or even into the $60s. 

Of course, markets can do anything. 

Private Equity Biggest Risk to Global Economy - IMF

According to the IMF, a collapse in the private equity market is becoming more and more possible.

The International Monetary Fund has issued an unprecedented warning to the private equity industry, saying that a large-scale collapse in the sector is increasingly possible and that many of the major deals currently being mulled could prove a disappointment.

It said that potential problems with the buy-out industry were among the biggest risks facing the global economy in its latest survey of the financial system. The warning comes at a time when the appetite for private equity deals is at an all-time high. ...

it is the IMF's warning on private equity that will strike a particular chord in the City, where the industry has become a formidable part of the financial landscape.

In the Global Financial Stability Report, the fund said: "Financial market investors may be giving insufficient weight to downside risks [to private equity deals], assuming that low-risk premia and low volatility are a more permanent feature of the financial market landscape. The situation bears careful attention, especially if a large high-profile deal runs into difficulty, as this could trigger a wider reappraisal of the risks involved."

The size of the industry has increased rapidly in recent years, and it is expected to raise $500bn (£253bn) this year, compared with $430bn in 2006.

But the IMF warned that this is largely because conditions are particularly kind at the moment, with money cheap and the economy strong. If these circumstances deteriorated, it added, "deals that looked promising in a benign environment could suddenly appear much less attractive. It is therefore likely that some private equity deals will fail to live up to expectations."

And certainly, private equity firms had no problem raising money in the first quarter.

Private equity's record fund-raising in 2006 continued unabated in the first quarter, according to Dow Jones Private Equity Analyst.

U.S. private equity firms have raised $44.3 billion among 68 funds in the first quarter of 2007, according to the newsletter. That's up 67 percent from the 46 funds that raised $26.6 billion in the first quarter of last year.

In 2006, private equity firms raised $246.3 billion in 359 funds.

In addition to the $44.3 billion raised in the first quarter of this year, some 400 other funds are known to be raising at least another $130 billion, the newsletter said.

Private equity includes buyout and corporate finance funds, venture capital, mezzanine funds and funds of funds.

But the buyout side of the private equity industry continues to be the primary focus, representing $35.2 billion of the total raised in the first quarter.