Wednesday, December 30, 2009

Leverage is Back in the Credit Markets

Last night I had dinner with a friend who works as a bank loan trader for a large and distinguished credit-focused hedge fund. We were chatting about the wild ride the credit market has taken over the last two years and commiserating how difficult it will be to make money in 2010 given how much spreads have narrowed since the depths of the market swoon last December.

In casually noting how difficult it is to get excited about bank debt trading at close to par (vs. 40-60% of par one year ago) with skimpy spreads and LIBOR close to zero, my friend told me his fund is now employing what is called a Total Return Swap (“TRS”) to juice their returns. Essentially, a TRS is a form of financing provided by an investment bank that allows an investor to lever their returns (i.e. if a security is trading at 80 cents on the dollar a hedge fund could finance some portion of this purchase to turn a low return investment into one with a mid to upper teen yield).

At the height of the credit bubble in 2007, levered purchases of bank debt were fairly common and contributed to the madness. However, this mountain of leverage came crashing down in 2008 when the trading levels of most securities fell below the face value of the debt issued to finance their purchase (akin to the price of a home falling substantially below the value of its mortgage).

As my very crude example below demonstrates, the use of a TRS can help juice a security with an otherwise paltry 5% current yield into a highly attractive 15% clipper (admittedly, the use of 80% leverage is probably high, but certainly existed at the height of the credit bubble). Since my firm never employs leverage in any of our purchases, much of the bank loan market has now been rendered off-limits to us.

Should liquidity in the credit markets remain robust and the economy continue to heal, many of these investments will pay off handsomely. However, it’s quite disconcerting to me that not only is leverage quickly coming back into the system, but that it is the leveraged buyer is who driving the sharp rebound in asset prices. Does the memory of investors extend beyond one year or is 2008 sufficiently in the past that we are ready to go back to our old ways?

Another somewhat related point – how perplexing is it that investment banks are willing to lend to hedge funds (who are using the cash to drive asset prices higher), but most Main Street businesses who operate in the real economy still can’t get a loan.

Wednesday, December 23, 2009

Investing Outlook and Strategy for 2010

Here is an article from the FT confirming that large hedge funds are betting on inflation. Obviously, there is nothing earth shattering in this article since Robertson has been touting his “steepner trade” since Jan 2008 and Paulson is the largest holder of the GLD (in addition to marketing a new gold focused fund), but thought it was interesting to point out how funds are positioning themselves to make money in 2010.

In reflecting on the market bottom that we hit in March 2009, if you had told me that the high yield index would be up 55% this year, leveraged bank loans up a similar amount, the Nasdaq up 40+%, the S&P up 60% from its March lows, gold at $1100 (having crossed $1200 along the way), I would have thought it nuts to see the 10-year at only 3.7% (and around 3% for much of this rally!). This goes to show you the incredible effectiveness of the monetary experiment initiated by the Fed. Essentially, quantitative easing (primarily through the Fed’s $300 billion treasury purchase program and $1.25bn agency-backed mortgage program), has kept the back end of the curve fairly low, even with a powerful rally in risky assets. One can chastise the Fed for its involvement in the financial system and dispute the long-term merits of such action, but in no way can one debate how successful it has been in the short-term. The ponzi-esque nature of the Fed’s actions are legendary (i.e. buying unwanted assets in the open market to keep their yields low and allow the treasury to fund our fiscal deficits at rock bottom rates), but even Madoff’s investors felt great in the beginning years. However, based on the recent rise in the long end of the curve it’s unclear that our creditors will remain as committed to us as Madoff’s unwitting investors were to him.

Rapped up in this “inflation” trade is actually a very bullish view on the economy. Assuming the Fed keeps rates negligible for some time, which is my own personal opinion (hardly differentiated, but certainly confirmed by Bernake’s extensive work on the failings of the Fed during the Great Depression), we could see a fairly powerful rally in the stock market for the early part of 2009. As forceful as the rebound has been off the March lows, the individual investor has remained almost entirely on the sidelines. This is confirmed by the persistent negative fund flows into equity mutual funds. March represented a capitalization of sorts on the downside; the pervasive skepticism that has greeted the current rally is hardly reflective of market tops.

I routinely like to call a bunch of friends in the industry to take a very informal poll of their mood and that of their firms. I like to say that everyone was a micro bottoms up investor in 2004-early 2007 and ignored (except John Paulson and a few other astute investors) the macro clouds hanging over the global economy in 2005/2006. Well in October 2008 to March 2009, everyone all of a sudden became a “macro investor.” Concerns over the systemic risk of the banking system, the Fed’s irresponsible involvement in the financial markets, and the death of capitalism dominated the conversation. Such “boring” things as single digit PE multiples off of cyclically depressed earnings and free cash margins in the double digits (for even unlevered companies) all of sudden became irrelevant in the context of the impending doom of the financial system.

As we emerged from the depths of the March lows, massive amounts of skepticism greeted the market rally. People conceded that asset prices were extremely cheap, regretted that they hadn’t bought more, but also doubted the sustainability of the rally. The “green shoots” sprouting in the economy (i.e. house price stabilizing in California, inventory liquidations abating at most large companies, credit worthy borrowers accessing cheap credit) were either ignored or outright dismissed by those seeking confirmation of their bearish bias.

As I stand here now in December 2009, I can sense a clear shift in the mood of my fellow investors. Skepticism is melting away as people are simply tired of being bearish. The macroeconomic concerns that dominated the conversation over the last twelve months are being replaced by “M&A is back”, “companies still look reasonably priced on historical metrics”, “which companies stand to benefit from China growing 10% next year.” In short, all the discussion topics that would have served investors well in March; ones that I found so hard to engage people in less than a year ago, are only now beginning to resurface.

While the individual investor still remains on the sidelines, the hedge fund community has clearly embraced this rally. Until the former joins the party, I think we could see a continued rally in the market, perhaps materially so. Improving economic data that will most surely surface in the early part of 2009 will only confirm this increasingly bullish disposition. However, as an unrepentant contrarian, I think investors should not so easily dismiss the “macroeconomic” views they so diligently added to their investing toolkit at the bottom of the market. An improving economy will have the perverse effect of encouraging the Fed to extricate itself from the economy. This is particularly the case as it relates to housing, which I have repeatedly pointed out since starting this blog, has been on an improving trend for much of 2009 (do in no small part to the strong hand of our government).

The Fed’s decision on whether or not to extend the $1.25 trillion mortgage-backed security market (set to expire at the end of Q1) will serve as the seminal data point on the sustainability of the market rally. Should they let this program expire, the impact on mortgage rates, housing, and the banking system will be immediate. The reverberations of this in the overall economy could take a few quarters, but under such a scenario I think 2010 could end up disappointing a lot of investors as we exit the year. On the flip side, should the Fed maintain its overall accommodative stance by keeping rates low and extending many of its liquidity programs, we could see a sustained rally for some time. At some point, the reckoning will have to come, but I doubt it will happen in 2010. If 2009 has taught me anything, it’s to never doubt the short-term impact of a massive Fed-induced monetary experiment.

Bernake and Co. unleashed every weapon in their arsenal to prevent another Great Depression. As long as they continue their fight, and Bernake’s academic background leaves little doubt that he remains committed for the long haul, it remains pointless to fight the Fed. The ramifications of sustained monetary stimulus will be inflation, which underpins the short treasuries/long gold thesis dominating the investing strategies of many hedge funds going into 2010. I remain in this camp, though I concede I derive little comfort from the growing consensus forming around this thesis. A sharp reversal in Fed policy will warrant a reassessment of this investing strategy, though I think investors will be well-served by maintaining a strong bias to equities and gold as we enter 2010.

Sunday, December 20, 2009

Job Openings - Leading Indicator of Job Growth?

While the employment picture remains grim in the United States, the number of job openings has increased by over 4% since bottoming in July 2009. As a leading indicator, this provides a bullish data point for the employment situation as we close the books on 2009.

A few points explain the spike in job openings. Firstly, the increase in listings reflects the normal frictions that occur in the labor market as companies prepare for an increase in employment. After all, you need to post a job offering before actually hiring someone. Secondly, with the pool of unemployed workers in excess of 15 million, companies are rightfully being very discriminating in who they seek to hire. Most executives remain suspicious of the apparent rebound in the economy and want to make especially sure they have a need for additional workers before adding to their payrolls.

However, I believe a third factor is having the greatest influence on job openings without a commensurate increase in employment. Simply put, the administration's repeated extension of unemployment insurance is making out of work Americans more selective in what jobs they are willing to settle for. As explained in this very enlightening NY Post article ("The Stimulus for Unemployment") if you subsidize something (i.e. unemployment) you get more of it. Extending unemployment benefits from 26 to 79 weeks has removed the ballast of necessity for many unemployed folks. Why settle for anything less than ideal when the unemployment check keeps rolling in?

With the benefit of hindsight, the administrations's worst case assumption of 9% peak unemployment used in the bank "stress tests" seems patently laughable. This has been the source of much ribbing by investors and economists alike. Ironically, it may be the administration's actions regarding unemployment insurance that resulted in such a sizable divergence from their original estimates. As suggested in the referenced NY Post, the government's forecast may not have been too far off if it left the labor market to its own devices.

Friday, December 18, 2009

China's Empty Cities

A good friend alerted me to the video below, which demonstrates the incredibly inefficient capital investment taking place in China as a result of its 4 trillion yuan stimulus program (~US$600bn). The video features the city of Ordos, intended to hold over 1 million people, but which remains virtually uninhabited.

The story of Ordos reminds me of the unoccupied homes on Dubai's palm-shaped islands. 60 Minutes did a great two-part segment on the country in August 2008. Here is a link to the video: A Visit To Dubai Inc.

While I remain convinced of China's long-term growth potential, there is little question that the government has fomented a massive investment bubble that will undoubtedly end very badly. While there are innumerable data points to support this view, a few stand out. Firstly, average Chinese home prices are nine times median household income, on par with the peak levels reached at the top of the US housing market in even the most speculative cities (more normalized levels should be ~2.5-3x income). Secondly, the volume of property sales has risen by 85% in 2009 and prices of new apartments in Shanghai have risen by nearly 30%.

While concerns over Dubai and Europe's "PIGS" dominate headlines, China scares me infinitely more. Dubai has public and private market debt of approximately $60-$80 billion depending on which source you believe (Dubai World, where much of the troubled debt resides, comprises just $25 billion of this total). On the other hand, Chinese banks unleashed over $1 trillion into their domestic economy in the first six months of 2009 alone! On an annualized basis this equals approximately 50% of GDP. After forcing them to aggressively lend earlier this year, the Chinese government is now encouraging banks to shore up their capital bases. Such a dramatic change in direction should not be dismissed lightly. (see: Chinese Banks Study Plans to Boost Capital).

Lending by government decree has undoubtedly contributed to the country's 8-9% GDP growth, but one has to question how efficiently such capital was invested. While there is little tangible data to support this assertion, most pundits speculate that a good chunk of this lending (perhaps a 1/3) was directed to real estate and stock market speculation. The video below provides some convincing anecdotal evidence to support this claim.

Wednesday, December 16, 2009

More Evidence of a Bottom in Housing

While housing activity will likely remain subdued over the next year as inventory in the existing home market gets whittled down, the data below provides convincing evidence that the new home market bottomed earlier this year. From the peak in September 2005, housing starts hit a trough in April 2009, some 79% below its peak levels. Subsequent to that time period, total starts have risen a healthy 19.8% and single family starts an even more robust 35.0%. While permits and housing starts have firmly rebounded, homes under construction continue to hit new lows in November 2009, suggesting the new home market could experience a rebound in pricing over the next year, particularly if mortgage rates remain at rock bottom levels.

Tuesday, December 1, 2009

Is Gold a Good Long-Term Investment?

Here is my response to a friend’s comment that “gold is a good long-term investment”.
I am not sure I would ever hold a commodity “forever” and I disagree vehemently with your statement that gold is a good “long-term” investment. The nature of commodities is that high prices ultimately choke off demand and/or result in increased supply. Gold seems to be in the sweet spot of the cycle since annual supply continues to decline (despite the higher prices) and demand remains very strong among investors and central banks. However, nothing suggests that this dynamic will last indefinitely.

Remember gold was in a secular decline from 1980 to 1999 so while it has risen a lot since 1999, it will come back down hard at some point. It could take 5-10 years (frankly, I have no idea), but there is little doubt that it could come crashing down. The near consensus global view forming around gold's preeminence as a store of value should only serve to spark your interest in how best to short it. There is still much skepticism around its recent run; as such it could continue going higher (hopefully, materially so since I remain long through the GLD and options on the GLD). However, there will come a time where even the most ardent skeptics throw in the towel and the most strident bulls bask in their fleeting fame as TV personalities (many of which are already coming to the fore). At that point, I hope I am smart enough to spot the cracks in the bull case. Usually, it’s the most levered buyers who serve as the canary in the coal mine. To the best of my knowledge (albeit limited), I don’t think the current bull market in gold is being driven by the leveraged speculator and so the “foolishness” that characterizes most bubbles has yet to surface.

Every time a speculative bubble gets underway, I always try and call the top and every time I am always way too early. However, without fail no matter how high things go they always end up materially lower than ever I thought possible. So my point is that even if gold goes to $2,000, $5,000 or whatever, once investors’ faith is restored in paper currency, gold will decline precipitously. It is hard to imagine a world where paper currency reclaims its spot as a favored store of wealth; then again, it’s always difficult being a contrarian when others are getting rich riding a speculative wave. While the comment that investors will one day come to value paper currency again seems asinine given the ubiquitous money printing and fiscal deficits being run by nearly every developed economy; I can assure you that asserting in 1999 that gold would breach the $1,000 level seemed equally as preposterous.

The only thing I would blindly hold forever is the equity of an excellent company. Give me an early stage Coke, Disney or Microsoft and I will give you every ounce of gold residing in my portfolio (no matter what the concerns surrounding inflation are). There is absolutely no better way to generate long-term wealth than buying and holding the stock of great companies residing in countries undergoing secular growth. No matter how high gold goes, nothing will shake my conviction that equities remain a far superior long-term investment.