Elliott Management: We Make This Recommendation To Our Friends: If You Own US Debt Sell It Now

Wednesday, August 8th, 2012

Every now and then we prefer to sit back and let some of the smartest money speak, especially when said smart money agrees with us. In this case, we hand the podium over to none other than Paul Singer’s Elliott Management, which after starting with $1.3 million in 1977 was at $19.8 billion most recently. No expert networks, no high frequency trading, no “information arbitrage”, no crony capitalism and pseudo monopolies of scale, and most certainly no bailouts: Singer did it all the old fashioned way: by picking undervalued assets and watching them appreciate. The timing is opportune because while Elliott has much to say about virtually everything in their latest 20 pages Q2 letter, it is the billionaire’s sentiment vis-a-vis US Treasury debt that may be most critical, and may be the catalyst that resulted in today’s abysmal 10 Year bond auction. To wit: “long-term government debt of the U.S., U.K., Europe and Japan probably will be the worst-performing asset class over the next ten to twenty years. We make this recommendation to our friends: if you own such debt, sell it now. You’ve had a great ride, don’t press your luck. From here it is basically all risk, with very little reward.” There is little that can be misinterpreted in the bolded statement. And while many have taken the other side of the Fed over the past 3 years, few have dared to stand against Paul Singer because if there is one person whose opinion matters above most, certainly above that of the Chairsatan, it is his.

More deep thoughts from Elliott:

On QE and the nanny state:

• Printing money and overstaffing government offices may look like growth for a period of time, but it is actually the road to poverty, corruption and, ultimately, political upheaval.

On regulation:

• Opaque, overleveraged and vulnerable Financial Institutions which need to be propped up by the implicit or explicit guarantee of sovereigns does not make for a solid financial plumbing system for the global economy…this is a formula for power entrenchment, favoritism and shady deals behind closed doors.

On Dodd-Frank:

• Not only will it fail to make the system safer, but we believe it will likely be an actual accelerant of the next financial crisis
• Dodd-Frank was supposed to “fix” the American financial system and end “too big to fail.” Unfortunately, the law, born in a political steamroller, does the exact opposite: it will be the accelerant of the next crisis.
• The 2008 crisis was episodic and took a while to get rolling. The next one could well be a black hole, and Dodd-Frank will bear responsibility for that.

On why Americans are angry:

• The government, lacking deep understanding of these firms, wants to pretend that their gigantic efforts (most notably Dodd-Frank) actually fixed the situation. But we believe that citizens are angry at what their guts tell them (correctly, basically) about the special treatment and riskiness of Financial Institutions.

On public data reporting:

• Decades ago, the balance sheets of the Financial Institutions contained most of the information you needed to know to understand their risks. Today the picture is profoundly different, predominantly due to the growth of leverage through derivatives….As a result, there is no major Financial Institution today whose financial statements provide a meaningful clue about the risks of the firm’s entire panoply of assets and liabilities including derivatives, nor how the firm’s performance, or even survival, will be affected by market movements in the future.

On leverage:

• Including derivatives, nearly all the world’s largest Financial Institutions are levered 50-100 times (not 10-20 as reflected on their balance sheets), so the exact composition of their derivatives books is essential to an understanding of their risks and stability….no hedge fund is remotely as leveraged as the Financial Institutions, and no hedge fund actually had to be rescued during the crisis.

On European banks:

• European institutions are in worse shape than before. Not only is their leverage (including derivatives) still at pre-crash levels, but they are choking on vast holdings of questionable sovereign debt which regulators more or less forced on them with lenient risk-weightings.
• These banks are stuffed with paper that private investors would not buy, as part of the “three-card Monte” shuffle that characterizes the European banking/sovereign system today.

On “peak fragility” in the bond and stock market:

• People are still buying bonds despite pitifully low yields because, well, they continue to go up in price, albeit in a self-reinforcing process goosed by central bank and momentum buying. When these forces exhaust themselves, the reversal could and should be swift and large.
• A decade ago, stocks were overpriced, but institutions who owned them were generally happy… Stocks looked predictable and safe at the very moment that they were maximally unsafe. That is where long-term bonds of these four currency blocs (euro, U.S., U.K. and Japan) now stand.

On “safety”:

• “Safe haven” could be the two most expensive and painful words for investors in the financial lexicon this year.

On market sentiment:

• Global financial markets currently feel like they are in a period of calm before a storm, possibly centered on the European situation. The problem is that no one can foresee when the storm will make landfall, or how severe it will be.

On why Europe is making one wrong decision after another:

• Raising taxes to confiscatory levels (75% top rates are absurd and self-defeating), lowering already-too-low retirement ages, making it hard or impossible to fire people (which obviously discourages hiring them in the first place), increasing the scope of regulation and making it more complicated and subject to greater discretion by hostile, inadequately informed regulators, and making threatening noises at every turn about “the rich”, are the precise opposite of the actions and statements that policymakers should make to attract businesses and encourage expansions of existing businesses.
• Nobody is forced to locate a business in Europe, and in fact capital flight today from several countries is already large and relentless.

On the future of Europe:

• Since all of the euro bloc surprises in the last couple of years have been negative, and since the answer to every question about the ultimate cost of preserving the euro is “more than you thought yesterday,” the metaphor of a slow-motion train wreck seems quite appropriate.
• The overall situation is not going sideways or up. It is drifting down.

On Socialists – in this case in France, but applicable everywhere:

• The Socialists are unlikely to be terribly successful at preventing the destruction of jobs, but they may be all too effective, however unintentionally, at stifling job creation.

On tax policy:

• Dramatic increases in taxes and regulation, together with a repeatedly punitive tone, are understandably extrapolated by capitalists and investors as indicators of hostility toward business and profits. The societal loss from the business decisions occasioned by such signals is self-reinforcing. Businesspeople sitting on their hands leads to lower growth and more angry rhetoric and hostile actions by government.

On the lack of job creation:

• Since the top 20% of taxpayers (which includes a great number of people making less than billions and even millions) pay the overwhelming bulk of taxes, this promise to raise taxes has not exactly generated enthusiasm or jobs.

On US (small) business uncertainty:

• Under ACA and the scheduled rise in overall federal income tax rates, one of the largest aggregate tax increases in American history is scheduled for five months from now. This is occurring at the same time that several strapped large states are also raising their top tax brackets.

On shifts in paradigms:

• Businessmen are inherently optimistic, typically always looking for reasons to do business, expand and innovate.
• Historical experience shows that when established perceptions are wrong, it can take a long time for contradictory data points to accumulate before such perceptions start to adjust and to cause alterations of behavior. However, at a certain moment, shifts in perceptions and trends could be abrupt, especially given modern tools of instant communication.
• Today the hostility of the American and European governments to private enterprise, wealth and profits is used by those governments as  vote-buying tactics. The impact on growth and jobs is already visible, and capital flight (already seemingly underway in France) may accelerate unless the policies, and tone, change.

On the US welfare state:

• If [Social Security, Medicare, Medicaid and government pensions] are not reformed, such entitlements simply cannot be paid as promised, regardless of the levels of future growth or taxes on “the rich” or anyone else.
• The numbers are just too big, the result of a form of corruption: politicians made big promises in exchange for votes, not worrying about whether the promises could be fulfilled.

On the US “recovery”

• Three and a half years after the bust, the massive spending, guarantees and money printing have left America with 8.2% unemployment (which vastly understates the actual level, since millions of people have simply left the workforce, while others have migrated from receiving unemployment benefits to getting long-term disability payments), sluggish growth, $5 trillion in additional federal debt, and $3 trillion of freshly-printed dollars on the Fed’s balance sheet. This is not a success. This is a national tragedy, in a society in which the world’s greatest engine of prosperity has  historically been fueled by innovation, optimism, entrepreneurship, flexibility and opportunity.

On Congress handing over the decisionmaking process to the Fed:

• We believe that relying on monetary authorities to pick up the considerable slack in growth by printing money by the boatload is completely wrongheaded. It distorts both the price of money and the risks of holding long-term claims denominated in paper money, builds a future risk of large inflation, supports economic activity only in an oblique and unfair way, and creates something that is going to be very hard to unwind.

On the consequences of the printing money “alchemy”:

• Somehow many policymakers and citizens have come to believe that money printing is some kind of magical process, that good things can be produced literally out of thin air, and that if leaders don’t create growth from obviously-needed changes in wrongheaded policies, then poof!… printing more money will solve it. This is pathetic.
• The range of inevitable costs to societies practicing such alchemy is somewhere between “a lot” and “utterly catastrophic.” The damage is already becoming evident, particularly in the distortion between the rise in financial asset prices and the sluggishness of the real economy. When consumer prices soar across the board or there are other painful consequences, we wonder what excuses the blameworthy policymakers will make to deny their responsibility.

Finally, on what nobody wants to discuss, but could very easily be the final outcome:

• A loss of confidence in paper money could result in searing and startling inflation, evaporating life savings and turning every stolid worker into a frantic speculator.
• If that were to occur, nobody could possibly say in hindsight that the conditions for such a sorry state of affairs were not in place.
• The people who are telling us now that inflation is impossible because there is slack in the global economy, and that central banks can print trillions of dollars more without a significant risk of inflation, are the same folks who not only failed to predict the financial crisis, they did not even have a clue that a crisis of such kind was possible.

Indeed the “smartest money” is just that because it calls it how it is.

Tags: 10 Year Treasury, Arbitrage, asset class, Billionaire, Bond Auction, Crony Capitalism, Deep Thoughts, Expert Networks, Financial Institutions, Government Debt, Government Offices, Monopolies, Nanny State, Paul Singer, Political Upheaval, Printing Money, Qe, Smart Money, Sovereigns, State Printing
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CASSH-ing In

Wednesday, August 8th, 2012

Last fall, I introduced the concept of investing in the CASSH countries– Canada, Australia, Switzerland, Singapore and Hong Kong. This theme has played out well year-to-date, and I still believe these smaller countries are likely to outperform broader global benchmarks over the long term. Let me explain why.

First, while larger developed countries have struggled with anemic growth and high debt burdens, the CASSH countries are in much better condition with relatively low debt, small deficits, and less traumatized labor markets.

Despite the outperformance, the CASSH countries still exhibit valuations generally below the larger developed regions. On both a price-to-book and price-to-earnings basis, the CASSH countries are, on average, about 10% cheaper than the average valuation of the United States, Europe, and Japan.

In addition, for investors looking for income, a basket of CASSH countries provides a respectable dividend yield. The average dividend yield on the CASSH countries – which is an equal weighted average of all the CASSH countries — is roughly 3.50% based on Bloomberg data as of July 31. That is about 1% higher than the average rate on the larger developed regions.

One objection we sometimes hear is the assertion that the CASSH countries are just a commodity play. However, while Canada and Australia both have large weights to commodity-driven sectors, this does not hold true for the group as a whole. Hong Kong and Singapore are largely driven by financials, and Switzerland has a significant weight to defensive sectors, specifically pharmaceuticals and consumer staples.

A strategy that I like to use is to underweight some of the larger developed regions, particularly southern Europe, and use that to fund a long-term overweight to the CASSH countries.

For investors seeking exposure to these countries, I would suggest looking at the iShares MSCI Australia Index Fund (NYSEARCA:EWA), or the iShares MSCI Canada Index Fund (NYSEARCA:EWC), the iShares MSCI Hong Kong Index Fund (NYSEARCA:EWH), the iShares MSCI Singapore Index Fund (NYSEARCA:EWS) or the iShares MSCI Switzerland Index Fund (NYSEARCA:EWL).

Source: Bloomberg

The author is long EWA, EWC, EWH, EWS and EWL

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Securities focusing on a single country may be subject to higher volatility.

Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. For actual iShares Fund performance, please visit www.iShares.com or request a prospectus by calling 1-800-iShares (1-800-474-2737).

There is no guarantee that dividends will be paid in the future.

Tags: Assertion, Australia Index, Canada Australia, Canada Index, Consumer Staples, Debt Burdens, Developed Countries, Dividend Yield, Ewa, Ewc, Global Benchmarks, Index Fund, Ishares Msci, Koesterich, Labor Markets, Outperformance, Southern Europe, Switzerland Singapore, Valuations, Weighted Average, Year To Date
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Is Dodd-Frank the Death of Preferreds?

Wednesday, August 8th, 2012

by Mariela Jobson, iShares

Investors typically don’t like uncertainty, and regulatory uncertainty is no exception. So it’s not surprising that our sales team has been fielding a lot of questions from clients about the iShares S&P US Preferred Stock Index Fund (PFF). Clients are wondering what impact regulations put in place after the 2008 financial crisis might have on PFF specifically and preferred securities in general.

As the portfolio manager for our preferred stock ETFs, I spend a lot of time with our sales team and clients, helping them to understand the complexities of these products. Here, I’ve recapped the two main conversations I’ve been having with investors about the effects of these regulations on preferreds:

Q: Will regulatory changes deplete the supply of preferred stocks?

A: First, it’s important to understand what the regulatory changes are, and how they assumedly will affect preferreds. The preferred market is going through a significant transition driven by the Dodd-Frank (D-F) legislation. Under D-F, the Tier 1 capital treatment of hybrid and trust preferreds from bank holding companies will be phased out at 25% per year from 2013 until 2016. The fear is that the law will change the preferred market and could shrink the market size over the next few years. As of 8/4/12 approximately 22% of PFF’s holdings were trust preferreds that would be affected.

So what does this change really mean for preferred stocks? First, it helps to remember that the change does not actually forbid the issuance of trust preferred securities. Even after D-F goes into effect, banks may still choose to issue trust preferred shares, and they can simply opt to exclude them as part of their Tier 1 capital calculation. One reason they may choose to do this is because the interest is tax deductible.

In addition, this change is only aimed at hybrid and trust preferred securities — not the entire asset class. Companies are still issuing and should continue to issue perpetual preferred securities (see chart below). Preferreds are typically a more cost-efficient cost of capital than common equity, and as such they have been an attractive source of financing for companies.

Q: With the onset of the Dodd-Frank Act, will large volumes of preferreds be called?

A: In response to the new rules, banks can either call their preferred securities and replace them with another form of capital if needed, or they can let them continue to mature. The current low rate environment is increasing the possibility of securities of being called similar to any other security that has a call option, and in some cases, banks have the option of calling the securities even prior to normal five-year call protection.

But at this point, we believe it is highly unlikely that banks would call all of their trust preferred securities. Many of them have publicly stated their intention not to – for example, JP Morgan only plans to call half of their trust preferred issues. Instead, we believe banks will call their preferreds over time. While it is always difficult to predict what decisions management will make, we believe the chart below – which illustrates expected call dates for preferreds within PFF if prices remained at current levels and issuers were solely motivated to call based on trading prices – shows a more likely scenario.

The bottom line is that despite these regulatory changes, investors can still consider using preferred stock as part of a diversified income-oriented portfolio. While Dodd-Frank may change the treatment of trust preferred securities, we do not believe it will curtail the supply of preferreds, and as new preferreds are offered, they should continue to make their way in to PFF.

Sources: BlackRock, Bloomberg as of 6/30/12

Mariela Jobson, Vice President and portfolio manager in BlackRock’s iShares Index Equity Portfolio Management Group.

Ms. Jobson’s service with the firm dates back to 2006, including her years with Barclays Global Investors (BGI), which merged with BlackRock in 2009. At BGI, she was a portfolio manager for the index equity team, focusing on iShares and taxable accounts. She was responsible for managing U.S. and global portfolios, including preferred equity. Prior to joining BGI, Ms. Jobson worked as an equity research analyst in the asset management group at ING Investments in New York and at Wedbush Morgan Securities in Los Angeles.

 
Diversification may not protect against market risk. In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Preferred stocks are not necessarily correlated with securities markets generally. Rising interest rates may cause the value of the Fund’s investments to decline significantly. Payment of dividends is not guaranteed. Removal of stocks from the index due to maturity, redemption, call features or conversion may cause a decrease in the yield of the index and the Fund.

Tags: asset class, Bank Holding Companies, Complexities, Dodd, Financial Crisis, Ishares, Issuance, Jobson, Mariela, Pff, Portfolio Manager, Preferred Market, Preferred Shares, Preferred Stocks, Regulatory Changes, Regulatory Uncertainty, Stock Index Fund, Tier 1 Capital, Trust Preferred Securities, Trust Preferreds
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Time for More Investment Risk?

Wednesday, August 8th, 2012

“An improvement in the global economic outlook is the key fundamental reason to take on more risk in an investment portfolio,” said BCA Research in a recent commentary. “The U.S. payroll report was positive relative to expectations, but rather weak in absolute terms. Moreover, last week’s Fed and ECB meetings did little to lift our optimism. Several indicators continue to suggest it is too early to add to pro-cyclical currency trades.

• For example, the global leading economic indicator is still pointing down. More importantly, with no new stimulus measures announced this week, it is difficult to see the global LEIs inflect upwards.
• In addition, gold is a real-time monetary indicator and the peak in March 2008 correctly warned that deflation risks were escalating. Gold’s recovery in early 2009 (ahead of the bottom in equities) then accurately indicated that reflationary policies were finally gaining traction. Gold prices slipped back below $1,600/oz following this week’s Fed and ECB meetings. This suggests that major central banks are still behind the curve.  As in early 2009, a sustained rally in gold will signal that the forces of reflation are starting to win out.
• Finally, an uptrend in Chinese stocks and an acceleration in Chinese money supply growth will be bullish signs for Chinese growth and the commodity complex.”

BCA concludes that “it will take further proof that the global economy is stabilizing before augmenting a pro-cyclical currency investment stance.”

Source: BCA Research, August 7, 2012.

Tags: Absolute Terms, Central Banks, Chinese Growth, Chinese Money, Chinese Stocks, Currency Investment, Currency Trades, ECB, Fundamental Reason, Global Economic Outlook, Global Economy, Gold Prices, Investment Portfolio, Investment Risk, Leading Economic Indicator, Monetary Indicator, Money Supply Growth, Payroll Report, Reflation, Uptrend
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Recession Generation Turns into Rental Generation

Wednesday, August 8th, 2012

by Mark Hanna, Market Montage

No surprise that we are seeing a big change in attitudes towards housing ownership among the younger generation.  There are a lot of things stacked against them – global wage arbitrage has pushed down wages for many, new college grads who enter the job market tend to have lower wages then those who do not [May 9, 2009: The Curse of the Class of 2009 - Lower Wages for Up to a Decade], and they are graduating with far more debt then their parents [Oct 19, 2011: Student Loan Debt Continues to Hit New Records].  Not to mention many see what happened to their parents in the “can’t lose” housing market during the past half decade.  That said, it appears renting is going far beyond just housing (furniture, clothing) as lower wages conspire with the American need/desire to consume.

Bloomberg takes a closer look:

• Anselmo and many of his peers are wary about making large purchases after entering adulthood in the deepest recession and weakest recovery since World War II. Confronting a jobless rate above 8 percent since 2009 and student-loan debt hitting about $1 trillion, 20-to-34-year-olds are renting apartments, cars and even clothing to save money and stay flexible.
• As the Great Depression shaped the attitudes of a generation from 1929 until the early years of World War II, so have the financial crisis and its aftermath affected the outlook of young consumers like Anselmo, said Cliff Zukin, a professor of public policy and political science at the Edward J. Bloustein School of Planning and Public Policy at Rutgers.  “This is a generation that is scared of commitment, wants to be light on their feet and needs to adjust to whatever happens,” said Zukin, who’s researched the effects of the recession on recent college graduates. “What once was seen as a solid investment, like a house or a car, is now seen as a ball and chain with a lot of risk to it.”
• Enterprise Holdings Inc. and Hertz Global Holdings Inc. (HTZ) are expanding in …the $1.8 billion hourly car- rental business, a segment dominated by younger drivers and made popular by Zipcar Inc. (ZIP).  The by-the-hour segment accounts for about 6 percent of the $30.5 billion U.S. car-rental market, a share that is forecast to rise to about 10 percent in five years, according to IBISWorld.   Those 34 and younger make up 84 percent of Hertz’s by-the-hour customer base.
• Startups such as Rent the Runway Inc. are supplying high-fashion apparel to satisfy those who want to wear, not own. CORT, a unit of Berkshire Hathaway Inc. (BRK/A), is increasing its furniture-rental marketing efforts to college students and fledgling households, said Mark Koepsell, CORT’s senior vice president.
• “Renting makes a lot of sense,” said David Blanchflower, professor of economics at Dartmouth College in New Hampshire and a Bloomberg Television contributing editor. “They have no money and they are not buying fridges and they are not buying the things they normally buy when they set up homes. Their incomes are a lot lower.”
• College graduates earned less coming out of the recession, according to a May study by the John J. Heldrich Center for Workforce Development at Rutgers. Those graduating during 2009 to 2011 earned a median salary in their starting job $3,000 less than the $30,000 seen in 2007.
• The majority of students owed $20,000 to pay off their education, and 40 percent of the 444 college graduates surveyed said their loan debt is causing them to delay major purchases such as a house or a car. The U.S. Consumer Financial Protection Bureau said in March it appeared student loans had reached $1 trillion “several months” earlier.
• The shifting attitudes also pose a threat to retail sales, said Candace Corlett, president of New York-based retail- strategy firm WSL Strategic Retail. Younger consumers are already comfortable buying used items and borrowing from friends. Renting will only reinforce their tendency not to buy new.

Tags: Adulthood, Arbitrage, Bloustein School, Class Of 2009, Cliff Zukin, Closer Look, College Grads, Great Depression, Hertz, Housing Market, Jobless Rate, Mark Hanna, Political Science, Recent College Graduates, Recession, Renting Apartments, Solid Investment, Student Loan Debt, World War Ii, Younger Generation
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Knight’s Berserk Algo Bought $2.6 Million Worth Of Stock Every Second

Wednesday, August 8th, 2012

While we already presented, courtesy of Nanex, the modus operandi of the Knight berserker algo, there was one outstanding question. What was the bottom line. And no, not how much the loss on Knight’s Income Statement would be as a result of this glimpse into what really happens in the market: we already knew that would be $440 million. The question is what is the notional amount of stock that this algo bought in the 45 minutes in which it was operational. We now know: $7 billion. Or $155 million per minute. Or $2.6 million per second. Or, assuming the algo impacted just 150 stocks as previously reported, it was buying on average $17,333 in each name every second. Or, assuming an average stock price of the universe of 150 stocks of $30/share, the Knight algo lifted the offer roughly 600 times each second. For 45 minutes straight! That’s right – the market making algorithm of a designated market maker which is responsible for 10% of the order flow in the US stock market, entered a pre-programmed mode (because the computer was told to do whatever it did by someone, and not without reason) that saw it buy up $2.6 million worth of stock every second.

Now there has long been speculation that HFTs are a central planner’s best friend because they traditionally provide not only a floor to the stock market, but a gradual levitation bias especially in a low volume environment (as well as liquidity its advocates claim, but that is total BS – HFT only provides volume and churn – liquidity disappears at the drop of a bat when real selling pressure appears). They do this not because they are evil instruments of Bernanke collusion (although who knows) but simply because they accelerate and accentuate legacy momentum bias, which at least historically, has been up. Now in the aftermath of the Knight debacle we can also extrapolate what would happen if, say, reality were to creep in one day, and all those mutual and hedge funds which have carbon-based life forms making the buy and sell decisions suddenly decided to sell. Well, at $7 billion in 45 minutes, or 1/10th of the trading day, this means that had the Knight algo been running all day, it could have bought $70 billion worth of stock. Throw in the remaining flow routers, aka DMMs in the market which account for the remaining 90% of order flow, and we get a total of $700 billion in vacuum tube mediated purchasing power.

In other words, this is the market “worst case” shock absorber, or inverse escape velocity, that Bernanke has at his disposal if things turn sour. That said, with hedge funds, aka fast money, holding about $3 trillion in unlevered assets, and about $6-9 trillion with leverage (ignoring plain vanilla slow mutual funds), and one can see why not even the HFT levitation bid would be sufficient to offset a wholesale market dump.

There is one last open question remaining on Knight: what discount did Goldman extract out of the firm to rid it of its residual position which as the WSj explains declined slightly from its peak as “traders worked frantically Aug. 1 to sell shares while trying to minimize losses due to a software problem, ultimately paring the total position to about $4.6 billion by the end of the trading day” (one wonders if the market would have just blown up if the Knight algo were to run in reverse, and just take out layer after layer of bids to unwind the inventory asap). We now know thanks to the WSJ:

Knight avoided that scenario by agreeing in the early morning hours last Thursday to sell the portfolio to Goldman Sachs Group Inc.,  after rejecting an offer from UBS.

 

The terms sought by the banks reflected how dire Knight’s situation was: UBS wanted an 8% to 9% discount on the position, according to people familiar with the matter.

 

The equities trading desk at UBS, headed by Mike Stewart, bid for the portfolio around 6:30 p.m. Wednesday, people familiar with the discussions said. Mr. Stewart was a former colleague of Knight Chief Executive Thomas Joyce’s at Merrill Lynch. The talks with UBS fell apart later that night.

 

Goldman ultimately negotiated buying the portfolio at a 5% discount, or about $230 million less than the value of the stocks, the people said. That amount, not previously reported, represents more than half the loss Knight disclosed on Thursday that it incurred as a result of the technology errors.

 

The deal with Goldman allowed Knight to move ahead. Last weekend, Knight negotiated a rescue package with six financial firms that injected $400 million in capital in exchange for securities that can convert to ownership of 73% of the trading firm.

And now you know why having cash on your balance sheet in a ZIRP environment may well be the best investment, because just like Goldman, one never knows just where a slam dunk distressed opportunity could come from in exchange for an immediate 5% pick up.

More importantly, the Goldman deal demonstrates what the true liquidity cost is in this market when one wishes to do a wholesale stock transaction (either BWIC or OWIC): it is not less than 5% and tops out at 9%.

Keep that in mind, because if and when the day when VWAPing in and out of positions is no longer possible, each and every fund will have no choice but to assume a guaranteed 5% minimum (up to 9%) haircut on one’s entire portfolio of allegedly liquid stocks.

We dread to think what the wholesale implied liquidity premium is on less liquid products than stocks, which nowadays is virtually everything…

* * *

Finally, we leave readers with yet another transformative animation from Nanex, after our first rendition of the “rise of the machines” back in February left many speechless, and which recently appears to have been rediscovered by some of the slower elements in the blogosphere. Why: because it’s pretty, and we feel like it. And because it once again confirms that only vacuum tubes with infinite balance sheets should be gambling in this loaded market.

Tags: 6 Million, Advocates, Algorithm, Berserk, Bias, Central Planner, Collusion, Debacle, Glimpse, Hedge Funds, Hft, Income Statement, Levitation, liquidity, Notional Amount, Programmed Mode, Speculation, Stock Price, Us Stock Market, Volume Environment
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Rosenberg On The Pending Trade Shock and Q4′s GDP Growth Outlook

Wednesday, August 8th, 2012

It would appear that the dilemma of the world exporting more than it imports (that we initially pointed out here) is starting to come to a head in reality with a negative export trade shock. As Gluskin Sheff’s David Rosenberg notes, since the recovery began three years ago, over 70% of the real GDP growth we have seen was concentrated in export volumes and inventory investment; and recent data from the ISM (here and here) points to a dramatic slowdown in both. Compounding this weakness is the fact that the remaining growth was from Capex – which is now likely to slow given the weakening trend in corporate profits – and will more than offset any nascent turnaround in the housing sector – if that is to be believed. The consumer has all but stalled and adding up all these effects and there is a high probability of a 0% GDP growth print as early as Q4.

Macro Risks Squarely To The Downside

I think that there may be a time, before too long, when we will walk into the office to find that the US prints a negative GDP reading on the back of a negative export trade shock that does not appear to be in any forecast – let alone consensus.

Look at the pattern of ISM export orders:

• April: 59.0
• May: 53.5
• June: 47.5
• July: 46.5

That is called a pattern. And this is a level that coincided with the prior two recession. As the chart below vividly illustrates, there is a significant 81% correlation between annual growth in total US exports and the ISM new orders index (with a four month lag). So either the market has already priced this in or it is going to end up coming as a very big surprise. We are already seeing the lagged effects of the spreading and deepening European recession hit Asian trade-flows: Korean exports sagged 4.1% in July after a 3.7% slide in June and are down 9% on a YoY basis. Industrial production there edged lower by 0.4% as well last month – I like to look at Korea since it is a real global ‘play’ on the economic cycle.

There is likely going to be another surprise, which is inventory destocking. How do I know that? Because the share of ISM industries polled in July reported that customer inventories were excessively high soared to 33% in July from 11% a year ago (because this metric is not seasonally adjusted it can only be assessed year-on-year), the highest ever for any July in the historical database.

Add to that what is happening to order books – the share of the manufacturers reporting expanded orders sank to 17% in July from 50% a year ago and again – the worst July showing on record.

The food price situation is another major wild card, especially since whatever relief we enjoyed from lower gasoline prices is now behind us. At a 14% share of the consumer spending pie, only shelter is more important than food. And when you go back to the last food cost surge, in the first quarter of 2011 when the grocery bill soared at a punishing 10% annual rate, real GDP growth slowed to a 0.0% annual rate that quarter, which arguably was the big surprise of the year (up until the dent downgrade, that is).

In the final analysis, since the ‘recovery’ began three years ago, over 70% of real GDP growth we have seen was concentrated in these two areas: export volumes and inventory investment. The rest was in capex which is now likely to slow along with the weakening trend in corporate profits, more than offsetting the nascent turnaround in the housing sector. Also keep in mind that the consumer has stalled.

Tally all these effects up and you are looking at the prospects of 0% growth as early as Q4.

Tags: Asian Trade, Capex, Corporate Profits, Correlation, Dalio, David Rosenberg, Downside, Dramatic Slowdown, Export Orders, Export Trade, Export Volumes, GDP, GDP Growth, Gluskin Sheff, Growth Outlook, Inventory Investment, Ism, Korean Exports, Real Gdp, Recession, S David
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Is Buy-and-Hold Dead?

Wednesday, August 8th, 2012

by Richard Bernstein, Richard Bernstein Advisors

Is buy-and-hold dead?

If one searches in Google for “Does buy-and-hold work?”, more than 191 million results will appear. If one searches for “Is buy-and-hold dead?”, more than 81 million results will appear. However, if one searches for “Successful buy-and-hold strategies”, only about 9 million results will appear. It’s pretty clear that the investing world believes that buy-and-hold strategies are basically dead and gone.

Is the consensus correct, and are buy-and-hold strategies truly dead? The answer, if you ask us, is a definitive no. Buy-and-hold is very much alive and well.

Navigate the Noise

In Navigate the Noise – Investing in the New Age of Media and Hype (Wiley: 2001), I pointed out that investment returns can be significantly hurt by strategies based on short-term, noise-driven strategies. The data clearly and consistently showed that extending one’s investment time horizon was a simple method for improving investment returns. Eleven years later, those conclusions remain very much intact.

There are sound economic reasons why extending one’s time horizon can benefit investment returns. Changes within the economy tend to be very gradual, and significant adjustments rarely happen within a short period of time. Certainly, there is plenty of daily news, but how much of that news is actually important and worth acting on? The data suggest very little of that information is meaningful and valuable. Most of it is simply noise.

Chart 1 shows the probability of losing money in the S&P 500 based on varying time horizons. As one extends one’s investment time horizon, and increasingly focuses on the fundamentals of the slow-moving economy, the probability of losing money decreases. In fact, short-term trading is like flipping a coin; it is virtually a 50/50 proposition.

Using longer investment time horizons to improve investment returns seems to work for a broad range of financial assets, but does not seem to work particularly well for real assets such as gold and commodities. (See the charts at the end of this report).

Buy-and-hold isn’t dead, but one has to buy-and-hold the correct assets

Buy-and-hold strategies typically do perform well, but their success is predicated on buying and holding the correct assets. Having exposures to the correct market segments is called beta management, and investors tend to be very poor beta managers.

“Stocks for the long run” was the theme of the late 1990s and early-2000s, and investors were encouraged to buy-and-hold S&P 500 index funds. That seemed to make sense to them at the time because the US stock market had just finished one of its most successful performance decades in history. As a result, investors preferred US stocks. Unfortunately, US stocks subsequently underperformed.

Chart 2 shows why investors wanted to accentuate US stocks in their portfolios at the beginning of the 2000s. Chart 3 shows what actually happened in the subsequent ten years, and why investors perceive that there was a “lost decade in stocks” and that “buy-and-hold is dead”.

However, if one had bought and held emerging market stocks in 2000 rather than US stocks, one would be very happy today. If one had bought and held BRICs, one would be very happy today. Buy-and-hold has continued to be a viable investment strategy, so long as investors bought and held the correct stocks!

Ironically, many investors today seem to be following the same formula they followed last decade, and are again buying and holding the prior decade’s winners. In our opinion, these investors are positioning their portfolios for another “lost decade in equities”.

A “lost decade” in emerging markets?

This decade has so far been another decade of change. Chart 4 shows the performance of equity segments since December 31. 2009. Note that the prior decade’s winners are so far not fairing very well. Might there be a “lost decade” in the emerging markets?

Buy-and-hold isn’t dead

Buy-and-hold seems alive and well. The Sirens’ song of daily economic and financial noise lures investors away from investing with longer time horizons. In addition, investors need to be careful not to chase past performance, and carefully manage the beta-exposures of their portfolios.

Our strategies continue to be highly disciplined to limit the detrimental portfolio effects of short-term noise, we continue to maintain longer-term investment time horizons, and we continue to combine that discipline and time horizon to try to get more effective beta exposures within our portfolios.

INDEX DESCRIPTIONS:

The following descriptions, while believed to be accurate, are in some cases abbreviated versions of more detailed or comprehensive definitions available from the sponsors or originators of the respective indices. Anyone interested in such further details is free to consult each such sponsor’s or originator’s website.

The past performance of an index is not a guarantee of future results.

Tags: BRICs
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