Wealth International, Limited (trustprofessionals.com) : Where There's W.I.L., There's A Way

W.I.L. Finance Digest :: January 2009, Part 1

This Week’s Entries :


The Street Nostradamuses are out in force, notes Alan Abelson. He especially admires their refusal to be cowed by their abject failure in 2008 to see calamity unfolding right before their eyes.

The worst thing about the dawn of a new year, besides the aching hangover induced by celebration of its arrival, is the avalanche of forecasts that accompanies it. Clairvoyance runs rampant, and in these days of unremitting assault by hydra-headed media, there is no escaping it.

The dire straits in which both the economy and the stock market find themselves has sparked vast interest and more than a little apprehension as to what the year ahead has in store and imbued predictions with a fervor and urgency rivaled only by speculation as to who will win the Super Bowl and will the Yankees’ payroll exceed the combined GDP of Luxembourg and Monaco.

We must interject here and make plain our unstinting esteem for the energy, confidence and perspicuity of the brave Street Nostradamuses fearlessly tossing out prognostications by the bushel. We especially admire their refusal to be cowed by their abject failure in the year that has now skulked into history to see calamity unfolding right before their eyes.

A quick review of a clutch of prophesies a year ago only reinforces the wisdom of the sage who advised that when forecasting the stock market, give a number but not a date, or a date, but not a number. We are inclined to go that sage one better and give neither number nor date. Just put us down as bearish still. And we cling to that view in the full knowledge that the final couple of sessions of 2008 and the opening day of 2009 demonstrated beyond cavil that stocks have not completely forgotten how to go up.

Moreover, despite our less than exuberant view of the market’s prospects, we have spotted something possibly quite positive for equities that does not seem to have received the notice it deserves. And we chanced upon it while gingerly inspecting the gory remains of commodities futures.

On that score, the Commodity Research Bureau’s index was down 36% last year and an awesome 52% from its July peak. Of the 19 commodities that make up the index, 15 suffered serious price losses last year, ranging from 59% in gasoline to 11% in corn. The lucky quartet that bucked this sorry trend to post gains included cocoa, sugar, gold and, most interestingly, hogs.

As any of the voodoo investment clan will tell you, the market gods favor using metaphors to communicate with us earthlings (it stops the devil from front-running). So it seems to us a reasonable inference, since hogs, traditionally one of the stock market’s key constituencies and absolutely essential for any decent bull move, are flourishing, that the market gods just could be signaling there is hope for equities. (If you find this revelation persuasive and act on it, please don’t go hog-wild; no hard feelings if you think it is hogwash.)

Change, we realize, is supposed to define 2009, and we stand ready to honor that theme in our view of the markets and the economy, but only when the facts on the ground warrant the switch. Where is it written, incidentally, that change is necessarily for the better? In any case, as the French, who feast on paradox after having their fill of pâté de foie gras, so eloquently noted long ago, the more things change, the more they stay the same.

We will happily abandon our nagging negativism on the stock market when everyone stops saying it is time to buy because everyone is bearish. As was nicely enunciated last week by an options maven in this space, the professed ubiquitous bearishness does not square with unmistakable evidence of widespread stealth bullishness. We will pay more heed to the optimism of the most luminous pundits, including those few who properly urged caution in advance of the debacle, when they stop offering projections five and seven years out in urging one and all to invest now.

Besides an incurable bias in favor of caution, our skepticism reflects our fear that we have not felt anywhere near the full brunt of the financial and economic collapse. The evils that took a generation to nurture are not likely to be expunged in a few months or even a year. Nor are we convinced that massive government handouts and exertions, no matter how well-intentioned, can put Humpty-Dumpty together again.

There is a cute quip making the rounds of trading desks and other dubious haunts, passed along to us by Art Smith, an old Street hand whose specialty is oil and gas (and who, incidentally, sold his service, John S. Herold, at the peak of the petro boom for $48 million in cash).

Such are these times, according to said quip, that when a bank sends a notice claiming it has been unable to cash one of your checks because of insufficient funds, you never know whether it is you or the bank that is out of dough.

Our troubles will not be over until that joke’s neat punch line has lost its punch.

That the economy remains locked in a terrible tailspin was written all over Friday’s (January 4) melancholy dispatch from the Institute for Supply Management – or ISM, as it is known in popular parlance. More specifically, its December index of manufacturing activity sank to 32.4, the lowest level since June 1980, when the bottom fell out of the economy, with a shove from Jimmy Carter’s imposition of credit controls. (Ronald Reagan never did thank Jimmy for that.)

The survey found that new orders plunged to their sorriest showing since the ISM started collecting data back in 1948, when the supply managers were laboring under the less elevated title of purchasing agents. Just about every category, including production, employment, deliveries, prices, backlogs and exports as well as orders were weaker, many sharply so. Inventories were an unwelcome exception to that mournful trend.

To give you a measure of how bad things are going for the folks who actually make things, an index reading above 50 indicates expansion; anything less than 50, contraction. The December number (forgive the repetition; it is strictly for effect) was a meager 32.4.

Not, to be sure, every facet of the economy is on the skids. Pawnbrokers are going gangbusters, we are happy to report, even as the more stuffy kind of lenders are having a heck of a job trying desperately to keep their heads above water, and not always succeeding. Second basemen with stone hands and hollow bats are still drawing millions for sitting on the bench.

And we suspect cobblers and podiatrists will enjoy bonanzas now that the bomb-throwers in the Middle East are beginning to switch to tossing shoes at their targets (as witness the Iranian mobs – taking a leaf from that Iraqi journalist who let fly at Mr. Bush – attacking Jordan’s embassy with sneakers, slippers and all manner of assorted and sordid footwear), a fad that is bound to catch on.

But these, alas, are mere microscopic crosscurrents that are destined to be swallowed up in the mighty recessionary wave sweeping over virtually every part of this poor planet. One of the prime conceptual casualties of the global slump is decoupling, the notion that Asia and South America, for example, would be immune to the severe downturn here and in other developed countries, which we always thought absurd. And so it is proving to be.

The simple truth remains that there is no place to hide and very few asset havens in which to ride out the storm.

Lest you shrug off our concerns about the economy and the stock market as just another of our patented rants, we are enlisting the views of Jay and David Levy, proprietors of the Levy Forecasts, whose predictions of the decline and fall of the economy have been right as rain. Father and son, they have been at this game a lot of years, and while not infallible (a quality restricted to popes and financial journalists), they have a truly extraordinary record of being right.

In a nutshell, they think most people, from consumers to CEOs and investors to, yes, economists, are way too optimistic. Even many of those who have come to recognize how the credit crunch has hurt the economy, the Levys say, fail to grasp that the “damage to the economy will rapidly accelerate the financial crisis.”

One of their trademarks is an emphasis on corporate profits, which they see suffering some powerful strains. Among the serious negative economic pressures, they cite the inexorable rise in personal savings, which is likely to cause a reduction of hundreds of billions in corporate profits this year and more next. They gauge that nonresidential investment will shrink by at least $350 billion over the next two years, while residential investment, weak as it has been, is slated to drop another $50 to $75 billion, with no real recovery in housing likely until 2011.

They further expect a swing from the $57 billion in 3rd-quarter nonfarm inventories to a “severe negative number” that will knock another $200 billion off profits. Not least, the flow of dividends, which, of course, is a principal source of profits, they envision drying up by at least $100 billion.

In light of this gloomy outlook for profits, the Levys reckon that even if another $850 billion of stimulus is passed by Congress and spent quickly – $200 billion, perhaps, this year, $350 billion in 2010 and $300 billion in 2011 – “the recession will likely run well into 2010” and require another big infusion next year before the economy can begin to show signs of improvement.

All this grim forecasting of vanishing profits frankly gives us the willies, since we cannot get over the idea that profits and stock prices are inextricably bound together.


Laszlo Birinyi is cautiously optimistic. How to avoid getting caught in bear-market traps.

Laszlo Birinyi, 65, has spent more than 30 years studying the stock market, analyzing everything from daily closing prices to advance-decline lines. He and his colleagues at Birinyi Associates, which he founded in 1989, try to get an edge by turning the data into investment ideas.

For Birinyi, whose Westport, Connecticut, firm also manages about $250 million in assets, 2008 was a tough year in terms of performance, as it was for most money managers. The firm’s managed accounts were down last year, though typically ahead of the S&P 500’s 40% loss by five to eight percentage points, he says. However, Birinyi is approaching the new year with cautious optimism, having published a note last month titled “S&P 750: The Bottom.”

Barron’s: You are a longtime observer of the market going back to the mid-1970s. What is your assessment of what happened in 2008?

Birinyi: It was a unique market in that, first of all, it was not a market crisis, it was a markets crisis. Unlike Long Term Capital Management in 1998, when the issue was debt, or in 1994, when the issue was Mexico, this permeated across all markets, and it was global. So it was not just the U.S. or Europe or Russia. This was all markets, all over. There were no areas where you could take shelter, whether it was commodities, money markets, municipals or segments of the stock market.

Was it the worst market you have seen?

Absolutely, because in 1974, which is the market most similar to this one today, you had a much smaller universe.

The market was considerably smaller, and Wall Street was, for the most part, private firms. And while in terms of impact on individuals, 1974 might have been just as bad, there were just a lot fewer individuals involved in trading and making markets, because 1974 basically was about stocks and bonds and nothing else.

Your Website says the firm’s approach, in part, is “to understand the psychology and history of the market and most importantly the actions of investors.” Could you elaborate?

One thing about market behavior that has really not been discussed widely is the impact of a lot of structural changes that have taken place over the last 15 or 20 years.

In 1987, the market’s decline was somewhat arrested by the action of the New York Stock Exchange specialists; the market makers had a fiduciary responsibility to try to even out the volatility. But with all of the electronic trading today, no one necessarily has that responsibility.

When you remove something like the short-selling uptick rule and basically squeeze commissions to the point where no one has the incentive to make markets, there is a more dramatic increase in volatility because there is no one else on the other side of a trade, and no one has to be on the other side. In 1987, there were market makers whose responsibility was to at least try to slow the decline, if they could not stop it.

You have argued that the institutional knowledge of market makers has been diminished owing to structural market changes – i.e., the advent of electronic trading.

That is right. For me, one of the things that has had a negative impact, especially among mutual-fund investment advisers, is they have gone to almost automated trading where people try to slice an order into many, many pieces – and they have gotten away from having a trader accumulate and distribute the order while at the same time gathering market intelligence and providing market input. It reminds me of something my old business school professor Peter Drucker once wrote: That one reason the Germans lost World War I was not enough generals got killed. His point was that people were so far removed from the action that they really did not know what was going on. Nowadays, we do not have many traders with the market intelligence and an understanding of what is transpiring on a day-to-day basis.

You spend a lot of time looking at various market indicators. How have those indicators changed in terms of what you think is important?

There have been huge changes. For example, when I came into the business, we still looked at the odd-lot indicator, if only as an indication of what the individual investor was doing. No one has mentioned the odd-lot indicator in the last 10 years.

Likewise, once upon a time we looked at mutual-fund cash positions. No one looks at mutual-fund cash anymore because funds are so large that to take an 8% or 10% position in cash is not making a market bet. Instead, it is making a business bet, because funds are so big that if they are wrong, they cannot invest that cash in a matter of days like they could, say, 25 years ago.

What are you paying attention to these days?

An indicator that we developed is the number of stocks that are down 50% from their highs. At the market bottom recently, 322 of the S&P 500 stocks were down 50% from a year ago. That is an extremely oversold condition. The previous record, which was set in July of 2002, was 130 stocks. To us, that is a very useful measure of whether the market is oversold or overbought.

We have also found tremendous value in creating an index that studies group movements, especially group rotation, and historical relationships between those groups and fundamentals such as the market and interest rates.

What are some pillars of conventional investing wisdom you think are flawed?

There always has been this contention that the market has some sort of a rotational process where at the beginning of a bull market, you have financials and small-capitalization stocks leading the way. But we found that is not necessarily the case, and so it is enabling us not to get caught in some of the traps of what do you do at the end of a bear market and what do you do if interest rates are going up. That is because we have found that conventional wisdom is often not correct.

Another one is this idea of capitulation, which suggests that at the end of a bear market, heavy cash positions are taken and you have a great deal of selling – but that is not borne out. We love to point to a New York Times article in the summer of 1982 which talked about this in great detail. The article suggests that a capitulation was likely to happen that fall. What was interesting, though, was that the market had actually bottomed the week before. So everyone was looking forward to a capitulation when in fact the market had already gone higher.

You put out a piece in 1996 asserting that technical analysis had failed. What is your stance on that today?

A lot people think I am really anti-technical analysis but I am really anti-technical analysts.

Analysis of the stock market really should be somewhat comparable to a physical where you spend as much time diagnosing as you do prescribing. I find that too many technicians prescribe and really do not try to understand what they are looking at.

I also find that a lot of technical indicators are not predictive. For example, an advance-decline line tells you that a lot of stocks are going down but it does not necessarily tell you about what is going to happen.

You published a note last month titled “S&P 750: The Bottom.” What led to that conclusion?

A few things caught our eye. One was that we started to have some very bad days in November but the market still recovered. On December 5, the unemployment news was really terrible and yet the market recovered that day, with the S&P closing up 3.7%. To us, those are signs of a positive market where people are starting to look beyond the bad news.

We also like it that stocks such as ExxonMobil and Chevron are starting to do very well, even though oil prices have dropped. That suggests to me that people were trying to get into the market via the back door, because you could put a lot of money to work in an Exxon or Chevron.

What else caught your eye in calling a market bottom?

We did an analysis that came out of our cycle study, and it showed that the greatest amount of decline in a bear market is always at the very end of the bear market. As we saw it, if indeed the market did bottom in November, as we suggested, a total of 70% of the decline occurred in the last quartile of the bear market. We also noticed that financial stocks were starting to show some stability, as well as large-cap stocks.

The conventional wisdom is that small-caps are a good place to be when the economy starts to turn around.

There are many things that are logical and work in the laboratory but in the real world they are different. This requires a lot of data and analysis. Not everyone has the time and resources to go ahead and do these things, especially an individual investor. We find that a lot of things that we read or that people say are really very dubious.

In your note about the market having bottomed you were concerned about growth stocks. Why is that?

There is a lot of money in growth mutual funds and aggressive growth mutual funds. But today in the category of growth, you would be hard-pressed to find many stocks doing well.

You once had the Nifty 50 or some group of stocks considered to be in the growth category and where a lot of people were active. But today it is very hard to find names that are so categorized. In the past, they have been the focus of attention and been able to pull the rest of the market ahead. But nowadays, a stock like an IBM is just another stock, and it does not have the glamour or the halo effect these stocks were given in the past.

While you say the market has bottomed, you do not necessarily see it going up very much for now, noting, “We expect volatility, fits and starts and the continuation of an environment where every data point is interpreted as a new trend.”

There is so much daily information available that to make a 12-month prediction is very difficult. The trends are much more condensed and compressed than they were.

At the beginning of 2008, we expected that over the next three to six months – and perhaps longer – that the market would be somewhat trendless. That is pretty much what we are looking for now going into 2009. We already know that this market is going to continue to be volatile, to be driven by that day’s news, and one in which trends are going to be difficult to discern. But at the end of the day, we do not think the market is going down from here.

Where do you see investment opportunities today?

One thing investors, especially even institutional investors, should think about is not so much strategy but tactics. This market is somewhat similar to the 4th quarter of a football game where you are behind by only four points. You are not going to complete a 60-yard pass. So you have got to go for six 10-yarders or whatever. What we focus on is taking small bites.

Where are you nibbling?

We are willing to settle for 10% to 15% gains in a 4- or 5-day period, rather than buy and hold, because one quarter today can ultimately destroy a stock. For example, eBay (EBAY) was a growth stock until in the 4th quarter of 2004, when it missed its number, and since then it has gone off the charts. You cannot just have a wonderful long-term perspective. We are willing to set up for 10% or 15% gains, especially in a short time period, because we have seen the markets reverse so often and so swiftly.

How about a few quick stock picks?

We have a little bit of a different perspective on General Electric (GE). Given that it pays an 8% dividend, it has limited downside, though it is probably not going to make us a whole of money in the next three to six months. But if we do not make money on GE in the next 12 or 18 months, then we have got some real problems.

What else do you like about GE?

They have global reach and a number of different business units. And they have said the dividend is going to be solid, so it will be a huge credibility issue if that changes.

And we still like Amazon.com (AMZN). It is a controversial name and the stock has had a difficult time, but we are encouraged by the success of its product known as the Kindle, an electronic book.

Another name we like is Hess (HES), an oil company. It is a solid company, and it has a very nice trading pattern between 42 or 43 and 50. We buy it low and try to sell it high.

Thanks, Laszlo, and Happy New Year.


After the worst stock-market year in generations, optimism that 2009 has to be better.

The common Wall Street admonition never to believe that “it’s different this time” sounds wise and clearheaded and always elicits hums of approval from the other guys at the club as they moisten their cigars.

For sure, no one should justify an investment position strictly by claiming that current circumstances have been liberated from precedent. Yet the fact is, in its particulars, every cycle differs, and the trick is to determine what the differences are and which among them matters.

The level of apparent “differentness” of the past market year demands attention and analysis more than any period in memory. Carpenter Analytix furnishes this anomalous scorecard for 2008: Despite the historic 12-month decline, there were as many up days as down, 126 each. The up days averaged a 1.57% gain and the down sessions a loss of 1.92% – which proprietor Robin Carpenter calls “immense magnitudes.”

And what a difference the worst stock-market year in generations can make for even the long-term record. The S&P 500’s 37% loss of 2008 served to knock 3/4 of a percentage point off the annualized index total return since 1927, to 9.7% from 10.4%, according to Aronson+Partners. The 10-year trailing returns for large-cap stocks now appear to be at their worst level since 1827, says Morgan Keegan, and trailing returns of world equities versus bonds are at their weakest since the late 1970s, says BCA Research.

The combination of the nerve-searing daily volatility and the lousy risk adjusted record for stocks that now dominate investors’ memory is discrediting equities in the public mind as a wealth-building asset class.

This is helpful, and implies the direction of mean reversion for asset classes will favor stocks again before long, though who knows from what ultimate level? The five years following the 10 worst calendar years for stocks were always up in total – sometimes not much, sometimes a lot, an average of about 10% annualized – yet three times the year immediately afterward was down more than 20%.

The folks at BCA, in discussing the 2009 outlook, plumb the potential “differentness” of this environment under the rubric of “A Changed Regime,” from debt-enabled excess growth to thrift-driven economic drags. They offer that even if the lows are in for stocks, perhaps “the market will churn for an extended period, as occasional decent rallies will not be sustained.” This is more than reasonable, while also approximating the consensus view. The BCA analysts add: “The poor long-run performance of equities has drawn remarkably little attention. However, that could change with books touting equities for the long run being removed the shelves, replaced by books describing the scandals and disastrous investment climate of the 2000s.”

The escape from having to predict what the Dow will do is to lean on the idea that even if the indexes continue to struggle – even if this latest spurt above Dow 9000 is a head fake – no one should expect the universal devastation that 2008 brought. Last year virtually nothing worked, and beginning in September the liquidation took down high-quality shares along with the dubious. According to Morningstar figures, any diversified equity mutual fund that lost a mere 27% in 2008 ranked in the top 5%. Even with the benchmark suffering as it did, more than 60% of all funds did worse than the S&P 500. And there was only a single diversified stock fund that labored to a positive return, the $53 million Forester Value fund, which is free to go to cash and hedge with futures and options. It gained 0.39% – and is now fully invested in stocks.

After such an oppressive period, any cash-leaning investor who is not trying to figure out what amid the wreckage might be worth owning is effectively betting the bears will continue undefeated in fighting the Fed, that the best analysis is mere extrapolation of the trend, that the law of unintended consequences will reign unchallenged.

Those with a taste for recovery projects might join David Leibowitz of Horizon Asset Management in buying what he calls The Underwhelmers – the 5 worst-performing Dow stocks of the prior year. A twist on the Dogs of the Dow idea, which involves the highest-yielding members, this approach would have easily out-earned the Dow itself over the decades. It will hurt to bid for this year’s class, which features Alcoa (AA), American International Group (AIG), Bank of America (BAC), Citigroup (C) and General Motors (GM). But what worth doing is effortless? As Leibowitz writes, “It is difficult to find a voice of optimism regarding any of these names at the present moment. In and of itself that might spell opportunity.”

Dennis Gartman of the Gartman Letter has been spotlighting a collection of old-line blue chips whose dividend yields approach or exceed their depressed price/earnings ratios. Among them are Dow Chemical (DOW), General Electric (GE), US Steel (X), ConocoPhilips (COP) and Norfolk Southern (NSC). There is no mathematical significance to the comparison, but it is sure another stark way of saying it is not necessary to delve into the obscure reaches of the market to locate things that look cheap.


How do we replicate the trip the U.S. economy took from the mire of 1970-71 to the (apparently) comparatively healthy situation that prevailed in 1995? Consistently reliable and interesting Martin Hutchinson looks at the major factors behind the earlier revival and concludes we are, unfortunately, unlikely to see a repeat.

With an unpopular war, a deep recession, an irresistibly growing public sector, excessively rapid money supply growth that may spark off inflation, a dangerously large payments deficit and a workforce excruciatingly vulnerable to international competition, the United States is today in a similar position to that of 1970-71. The current objective must surely be to produce an explosively expanding new technology, declining inflation with complete market confidence in the Federal Reserve, a budget approaching balance, a moderate payments deficit and a workforce of immense international competitiveness and spiraling remuneration – in other words, roughly the position of 1995.

So how do we reproduce a quarter-century of history in a few years?

Going the other way, from 1995 to a reproduction of 1970, was quite easy and took only 14 years. The explosively expanding new technology became an infinite source of investor losses through the magic of the IPO market in the late 1990s, plus a small number of established new companies such as Amazon.com, E-Bay and Google. Inflation was suppressed by the forces of globalization, which reduced costs by empowering low-cost emerging market competitors. However, once those competitors entered fully into the world economy and their own costs began to rise, inflation returned. And once again, the United States is mired in an unpopular war.

Market confidence in the Fed remained absolute for a decade, outlasting the retirement of Fed Chairman Alan Greenspan in 2006. But under his successor, Ben Bernanke, it has begun to waver. The budget was balanced only briefly, and the public sector is once again bloating uncontrollably. The U.S. balance of payments deficit has quadrupled, not producing a currency crisis since we are no longer on the Bretton Woods fixed parity system, but an endlessly declining dollar. The U.S. workforce is no longer particularly competitive against emerging-markets labor, and its remuneration even at the top is spiraling downwards rather than upwards.

2009 is not 1970. There are a number of important differences, but it would take a brave man to claim that the U.S. economy was definitively better positioned today than in 1970. Its position is clearly vastly inferior to that of 1995. It is thus instructive to look at how the United States moved from its 1970 situation to its 1995 situation, and see which factors could be replicated today.

First, and perhaps most important, was a reduction beginning around 1973 in the uncertainty of business’s regulatory environment. The late 1960s and early 1970s were a period of extraordinary government activism, much of which forced costly new mandates onto business, particularly in the areas of human resources and environmental controls. Notable examples of the latter were the Clean Air Act of 1970, the Environmental Policy Act of 1970 and the Corporate Average Fuel Economy legislation of 1975. In addition, the antitrust environment of the time was highly arbitrary, with major antitrust cases being instituted against General Motors in 1959, General Electric in 1960, IBM in 1969 and AT&T in 1974. Railroad, trucking and airline businesses were highly regulated, with government bodies setting prices.

The recessions of 1970, 1974 and 1980-82, with their accompanying bankruptcies, brought a realization that business could not continue to be loaded with ever-increasing costs and regulations. Starting with the deregulation of airlines, from the late 1970s to the 1990s, businesses could be increasingly confident that they would not be subject to further major government depredation.

Second, also beginning around 1970, there was a steady increase in the economic returns for education, entrepreneurial activity and hard work. Part of this came from the reductions in top income tax rates in 1981 and 1986, but there was also a substantial widening in income differentials between the highly skilled and the unskilled. At the bottom of the scale, rapid immigration following the 1965 Immigration Act reduced the power of unionized labor, which declined from almost 30% to around 10% of the private sector workforce. Immigration also placed substantial downward pressure on real incomes for the unskilled. Thus the real income of adult male workers with only a high school qualification declined by a quarter between 1970 and 1995, while female workers barely broke even. Even overall, real male median personal incomes in 1995 were 6% below those of 1970, although real female personal incomes rose 50% during the period. GDP per capita increased by 2/3, a huge proportion of which went to capitalists and the most highly skilled, while the wage pressure on low-skilled labor increased U.S. competitiveness.

A third change that has been underrated was the increasing ease of raising venture capital. The first modern venture capital company, American Research and Development, was founded in 1946 and had its first big success with Digital Equipment in 1957. But in 1970, the industry was still in its infancy. By 1995, venture capital was readily available for almost any new idea in the tech sector – indeed, the next five years were to produce a venture capital glut. The 1978 reduction in the capital gains tax assisted the development of this industry, but did not cause it.

Finally, the great achievement of the 1970-95 period was the conquest of inflation, achieved by a decade of tighter money than had ever been thought either desirable or politically possible. The elimination of inflation focused capital on those enterprises that were truly profitable, eliminating illusionary inflation-produced gains. It also reduced nominal interest rates, increasing the ability to restructure corporations that had grown flaccid.

A few of these forces are still present. The tax system is probably not going back to 1970, either in top marginal income tax or in capital gains tax rates. The ending of the Vietnam War, which reunited society and released resources for civilian uses, will probably be matched by a winding down of the wars in Iraq and Afghanistan.

However, most other factors that produced improvement between 1970 and 1995 have reversed. Since the collapse of the dot-com bubble, the venture capital business has gone into a deep funk. During the 2003-07 boom, the money pools that would previously have supplied venture capital were diverted into private equity funds and hedge funds, neither of which have economic value-added commensurate with their current enormous size. Further, “alternative investments” as an asset class have been deeply tainted by the excessive fees charged by managers and by such excrescences as the Madoff scandal. Hence raising capital for new ventures is likely to be more difficult in the next decade than it has been since at least the downturn of 1973-74.

Fiscal and monetary policies are also likely to be much less helpful than in the 1980s. Real interest rates remain substantially negative, which will cause a resurgence of inflation and a diversion of resources from productive investments into asset- and commodity-based investments that add little economic value. The public sector is growing at an appalling rate, and its deficits are exploding. Those deficits will divert increasing percentages of a capital pool that is likely to be much smaller than in recent years. Recent political developments suggest fiscal expansionism is likely to last for several years, although there must be some hope of reversing monetary profligacy by replacing Bernanke at the Fed. Nevertheless, substantial progress towards the 1995 fiscal and monetary nirvana seems unlikely before 2015 or so at the earliest.

A third and very disquieting development has been the sharp increase in regulatory uncertainty. Existing systems of regulation have been discredited by the financial collapse, while government has shown in the last few months that it is capable of behaving entirely arbitrarily, spending $150 billion to rescue the house of cards at AIG and guaranteeing $300 billion to rescue badly run and repeated-flirter-with disaster Citigroup while allowing Lehman Brothers, without a stain on its reputation, to crash into bankruptcy. With a new administration and a heavy Democrat congressional majority, the urge to regulate will be almost uncontrollable, and both healthcare reform and global warming regulations are likely to impose huge new costs on the U.S. economy.

There are also additional negative factors today that were not present in either 1970 or 1995. With the explosion in global communications capability, U.S. workers now face competition from emerging markets workers who are generally younger, often better educated and have, through competing internationally, acquired capabilities equal to their own. As I have written, global living standards are likely to equalize to a large extent over the next few decades, and the well-paid U.S. workforce will be major victims of this. The leveling tendency will not be limited to the lower-skilled – though mass immigration, if permitted, will make their lives especially miserable – but will extend up to the Ph.D. level in many fields. After all, an Indian IT worker with an advanced degree and five years experience is likely to be fully as capable and productive as his U.S. counterpart. The miserable, niggardly advances of the last four decades in most Americans’ living standards may come to seem like a lost Nirvana to the unfortunate workers forced into the full rigors of global competition.

Finally, the decline in transparency in the investment area and business generally appears to have caused a rise in corruption. For example, the U.S. score on Transparency International’s Corruption Perceptions Index has declined from 7.8 to 7.3 between 1995 and 2008. In the political field, this datum is confirmed by the doubling in the number of Washington lobbyists since 2000 and the 10-fold increase in spending “earmarks” since 1995. The Madoff scandal, as well as demonstrating criminality’s enormous costs to society, also symbolizes the poisoning of established social networks by modern finance – Madoff"s old college friends were more likely to be swindled by him, not less likely as would traditionally have been expected. Increased corruption represents a deadweight cost to the economy, both through the wealth siphoned off directly and through the increased legal and policing costs necessary to surmount it.

The chance of a transition from 1970 to 1995 thus appears small, whether over a short period or even over the 25 years it took the first time around (though we must bear in mind that even five years may make a huge change in the most entrenched of political and economic realities.) On the other hand, 1970 was by no means the worst period in U.S. history. A similar analysis would fortunately show that we are also unlikely to regress from our current 1970 to a renewed 1932.

Instead, we appear to be heading towards a new destination, at present obscure. That destination need not represent a deterioration from our current position. However, ensuring that it does not will require us to secure the low innovation taxes and tight money of the 1980-2000 period, while minimizing any added burdens of regulatory uncertainty, runaway public spending and new social and environmental programs. If those policy requirements are not met, the rigors of competing in a fully globalized economy will impose a grievous cost on U.S. living standards.


Unless you go to the root of the problem, the boom-and-bust cycle will not go away. It will only seek new forms.

In this short essay, Barron’s “Economic Beat” column writer Gene Epstein explains that both efficient market believers and those who believe the current crisis reflects a failure in regulation have their are wrong.

Graduate students spot a $100 bill on the sidewalk, and their economics professor decides to teach them a lesson in efficient-market theory – duly informing them: “If there really were a $100 bill lying there, someone would have picked it up already.”

A well-worn joke, but unfortunately relevant. For example, commenting on the financial crisis in a recent article (“Where Do We Go From Here?”) economics professor Robert Skidelsky dismisses the notion that the crisis was caused by the fact that “U.S. money was kept too cheap for too long ...,” calling it “a shaky defense, to say the least: if the market is so easily fooled, it cannot be very efficient.”

No, the market is not very “efficient.” More accurately, it is a process in which imperfect humans with imperfect knowledge of the future plan the allocation of resources to meet the needs and wants of often fickle consumers.

Meanwhile, “market failure” happens all the time. We know in hindsight, at least, that entrepreneurs are constantly leaving $100 bills on that sidewalk. The only saving grace is that, when it comes to solving what Austrian economist F. A. Hayek called this “fundamental problem” of the economy (in his classic essay “The Use of Knowledge in Society”), the system of profit-and-loss ensures that market institutions will fail us least of all.

Now say a non-market institution like the Federal Reserve expands credit by keeping the interest rate below where the market would. Should entrepreneurs really be smarter than the Fed and not borrow at that rate? As author Gene Callahan points out (in Economics for Real People, p. 219), even sober-minded risk-takers cannot know the market rate of interest, since the central bank obliterates this crucial information.

Then bring in other real-world assumptions: A charismatic Fed chairman who actively encourages excessive risk-taking in the housing market; a Congress and White House that promote the goal of a detached home for all, irrespective of party. In the real world of imperfect people, might a critical mass of risk-takers get the irrationally exuberant impression that there are no losses possible in housing, only gains?

Naysayer Skidelsky, a learned man, cites Austrian economist Hayek but strangely ignores Hayek’s writings that refute his position. Less learned but certainly well-intentioned, Slate Group editor-in-chief Jacob Weisberg argues that pro-free market types need to learn that the financial crisis arose from a failure of regulation (in an essay called “End of Libertarianism").

Weisberg needs to learn that in the system of casino capitalism created by the Fed, the risk-addicted get on top by elbowing aside the more sober risk-takers, as their leveraged schemes bring outsized profits. Think of the momentum players pushing aside the fundamental analysts during the Fed-induced internet bubble. Even with greater regulation, many of the worst will get on top anyway, by gaming the system, staying ahead of regulators – and in the process inevitably deter the risk-taking entrepreneurs who enhance wealth.

Unless you go to the root of the problem, the boom-and-bust cycle will not go away. It will only seek new forms.

To paraphrase a well-worn aphorism that is no joke: Those who cannot understand the errors of the past are condemned to repeat them.


The bubble in Treasuries looks ready to pop, sending prices on government debt sharply lower. But just about every other corner of the bond market beckons – and could provide competitive returns with stocks, even if the equity markets have a strong 2009.

The biggest investment bubble today may involve one of the safest asset classes: U.S. Treasuries. Yields have plunged to some of the lowest levels since the 1940s as investors, fearful of a sustained global economic downturn and potential deflation, have rushed to purchase government-issued debt.

The market also has been supported by comments from the Federal Reserve that it, too, may buy long-term Treasuries. As a result, the benchmark 10-year Treasury note yields just 2.40%, down from 3.85% as recently as mid-November. The 30-year T-bond stands at 2.82%, and 3-month Treasury bills were sold last week for a yield of just 0.05%. Many investors argue it is dangerous to buy Treasuries with such low yields. While a holder can expect to get repaid in full at maturity, the price of longer-term Treasuries could fall sharply in the interim if yields rise. The 30-year T-bond, for instance, would drop 25% in price if its yield rose to 4.35%, where it stood as recently as November 13. The bear market may have begun Wednesday (December 31), when prices of 30-year Treasuries fell 3%. They lost another 3% Friday. “Get out of Treasuries. They are very, very expensive,” Mohamed El-Erian, chief investment officer of Pacific Investment Management Co., warned recently. Pimco runs the country’s largest bond fund, Pimco Total Return. Treasuries offer little or no margin of safety if the economy unexpectedly strengthens in 2009, or the dollar weakens significantly, or inflation shows signs of reaccelerating. Yields on 30-year Treasuries easily could top 4% by year end.

The chief risk to the Treasury market stems from the potentially inflationary impact of both the Federal Reserve’s super-accommodative monetary policy, which has dropped short rates close to zero, and the enormous looming fiscal stimulus from the federal government. It also may take higher yields to attract investors – particularly foreigners – as the Treasury seeks to fund an estimated deficit of $1 trillion or more in the coming year.

One sign of trouble for Treasuries is the resilient price of gold, which has risen $150 an ounce since late October, to $880 an ounce, despite weakness in most commodity prices. Investors rightly see gold as an appealing alternative to low-yielding Treasuries and virtually nonexistent yields on short-term debt as the government cranks up its printing presses. Gold was up $45 an ounce last year, while oil was down 50%. Another worrisome indicator: The dollar has weakened recently, losing 10% of its value against the euro in the past month.

It is difficult for individuals to sell Treasuries short, but two exchange-traded funds, the Ultrashort Lehman 20+Year Treasury Proshares (TBT) and the smaller Ultrashort Lehman 7-10 Year Treasury Proshares (PST), offer a bearish bet on the Treasury market. Both these securities are designed to move at twice the inverse of the daily price movement in Treasury notes and bonds. Since the summer, the 20+Year Proshares has fallen almost 50% as Treasury prices have surged. If Treasury yields return to June levels, the ETF could double in price. Another alternative for T-bond bears is to sell short the iShares Barclays 20+Year Treasury Bond Fund (TLT), an ETF that gives exposure to the long-term government-bond market.

While Treasuries look rich, other parts of the bond market beckon, including municipals, corporate bonds, convertible securities, some mortgage securities and preferred stock. The average junk bond now yields 20%, compared with 9% at the start of 2008.

AAA-rated munis with 30-year maturities are yielding about 5.25%, almost double the yield on 30-year Treasuries. The yield differential between the two markets is unprecedented. Until this year, munis almost always yielded less than Treasuries because of their tax benefits.

Long-term corporate bonds with investment-grade ratings of BBB now yield an average of 8%, nearly 5.5 percentage points more than Treasuries of comparable maturity. They rarely have yielded more than four points above government debt. Preferred stock of financial companies such as Bank of America and Morgan Stanley yields 9% or more, and many preferreds carry tax advantages because their dividends, like those on common shares, are subject to a 15% federal tax rather than rates on ordinary income.

“The only part of the bond market that you need to be bearish on is Treasuries,” says Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. “The other sectors are attractively priced.”

A bearish stance toward Treasuries and a bullish one toward the rest of the bond market represents the consensus view. Most equity and bond analysts surveyed last month by Barron’s projected the Treasury 10-year note would carry a yield of 3% or higher by the end of 2009 (“Out With the Old,” Dec. 22). At the same time, it is hard to find bears on corporate bonds. It is nice to be contrary. Sometimes, however, the consensus view is right.

Lately corporate and municipal bonds have rallied, with Merrill Lynch’s junk-bond index gaining more than 6% in December, the strongest monthly increase since 1991. Most yield disparities between corporate and municipal bonds and Treasuries still are off the charts relative to historical ranges. Perhaps more important, absolute yields on corporate and municipal debt look attractive relative to inflation, and even stocks.

It is tough to estimate the current price/earnings ratio on the Standard & Poor’s 500 stock index because the profit outlook is so uncertain amid a recession. Assume $60 in S&P earnings for 2009 and the index, now about 925, trades for 15 times forward profits, not cheap by historical standards. Equity bulls are betting the $60 estimate proves conservative, and that corporate earnings grow sharply in 2010. The S&P likely earned about $72 in 2008, before massive write-offs.

The smart money is crowding into the corporate-bond market, including investment-grade debt, junk bonds and so-called leveraged loans, which are bank loans to debt-laden companies such as Neiman Marcus, Georgia-Pacific and First Data. Leveraged loans, which are senior to junk bonds, now trade for an average of about 70 cents on the dollar and carry yield to maturities of 10% to 15%. Many equity-oriented hedge funds and mutual funds have added to their corporate-bond holdings because of enticing yields. [See chart.]

“The argument is that the credit markets have to straighten themselves out before stocks rebound,” says Marty Fridson, who heads Fridson Investment Advisors in New York. “Investors will rotate into the credit markets and then into stocks when they look more promising.”

Some investors argue the credit markets are discounting a grimmer economic and financial outlook than the stock market, and thus more opportunity lies in bonds.

There clearly is risk in corporate bonds. Junk-bond default rates, which ran at just 3.4% in the past 12 months, are certain to spike in 2009. Moody’s Investors Service expects the U.S. junk-default rate to top 10% in the next year.

Yet, with a 20% average yield, junk bonds could provide nice returns, even in that scenario. “You are buying the market at a pretty steep discount,” Fridson says. “You are getting compensated for a severe escalation in defaults.”

The average junk issue trades for less than 60 cents on the dollar, and some bonds, like those issued by the bankrupt Tribune, have sunk to just pennies on the dollar. Defaults might have to run at a cumulative 50% rate in the next five years and recovery rates average just 30 cents on the dollar – versus a historical average of about 40 cents – for investors to get sub-par returns. The junk market declined about 27% in 2008, by far the worst showing in the past 20 years. If history is any guide, 2009 should be better because down years like 1990 often have been followed by big gains. It would not take a lot for junk to return 20% in 2009, given the elevated yields throughout the market.

There are plenty of ways to play the junk sector, including ETFs like the iShares iBoxx $ High-Yield (HYG), open-end funds like Fidelity Capital and Income (FAGIX) and many closed-end funds, including some that trade at double-digit discounts to their net asset value. A complete list of closed-end funds starts on page M45. The Loomis Sayles Bond fund (LSBRX), which owns a mix of U.S. and foreign government bonds, investment-grade corporates and junk debt, fell 22% last year. The fund, co-managed by bond veteran Dan Fuss, now has a current yield of around 11%.

Convertible securities, which were bashed in 2008 in part from forced selling by leveraged hedge funds, offer a nice combination of yield and equity kickers. Issuers include Citigroup (C), Chesapeake Energy (CHK), Vornado Realty Trust (VNO) and Transocean (RIG). Ford Motor’s 4.25% convertible bond due in 2036, trading for about 27 cents on the dollar for a 27% yield to an optional redemption date in 2016, is a good alternative to the common stock (F), which yields nothing.

Vanguard, Fidelity and Putnam all have open-end convertible mutual funds, and there are many closed-end funds, including some trading at discounts to their net asset values.

The backdrop for municipal bonds is troubled because state and local governments are getting squeezed by lower tax revenue and sizable outlays for basic services and other needs. Investors are getting compensation via 5% to 6% yields on top-grade long-term securities and high single-digit to low-double-digit yields on Baa-rated bonds from a range of issuers, including hospitals and state-issued tobacco-revenue debt. Risk-averse investors should stick with state general-obligation bonds or essential-service revenue bonds, which rarely default.

The giant Vanguard Intermediate Tax-Exempt fund (VWITX) was unchanged in 2008, while many long-term funds were down 5% to 10%. There are numerous closed-end muni funds trading at double-digit percentage discounts to their NAVs. Closed-end funds carry more risk because of financial leverage. Their yields generally top 6%.

Low-grade munis were bashed in 2008, and no big fund was harder hit than the Oppenheimer Rochester National Municipals (ORNAX), which specializes in riskier securities. It fell almost 50% on the year, two to three times more than other large funds focused on high-yielding munis. It now carries a tempting current yield of 13%.

While the mortgage market was the root of much of Wall Street’s troubles in 2008, the country’s largest mortgage fund, the Vanguard GNMA (VFIIX), turned in a good year, rising about 7%, by sticking with government-guaranteed Ginnie Maes and avoiding riskier investments.

The problem with Ginnie Maes now is that yields have fallen to about 4%, which will make it tough for investors to generate decent returns barring further rate declines. The better opportunities probably lie in riskier mortgage securities that lack a government backing, including battered issues secured by subprime loans and so-called Alt-A loans, which are a notch above subprime. This area is a minefield, and difficult to play directly. It is probably best to stick with a mutual fund like the TCW Total Return Fund (TGMNX), a mortgage fund run by long-time specialists Jeff Gundlach and Phil Barach. About half its assets are in securities that lack Ginnie Mae, Freddie Mac or Fannie Mae backing. It was up about 1% last year.

For those seeking the safety of Treasuries, the best bet probably is TIPS, or Treasury Inflation Protected Securities. They provide much better yields than ordinary Treasuries unless inflation disappears.

The 10-year TIPS yield 2.23%, versus 2.40% for the regular 10-year Treasury. The so-called breakeven annual inflation rate that would result in similar yields on the two securities is just 0.17% annually (2.40% minus 2.23%), versus a typical spread of more than two percentage points.

TIPS offer a nominal yield, plus principal indexed to inflation. If inflation is 3% annually in the next 10 years, in line with the historical average, TIPS will return 5.25% (the 2.25% nominal yield plus 3% for the inflation component). There are several ways to invest in TIPS, including through open-end mutual funds such as the Vanguard Inflation-Protected Securities fund (VIPSX), and an ETF, the iShares Barclays US Treasury Inflation Protected Securities Fund (TIP).

Despite the risks in government bonds, there is a case for the sector. David Rosenberg, the Merrill Lynch economist who correctly called the housing bubble and resulting economic downturn, wrote in a recent client note titled “The Frugal Future” that the current recession resembles the vicious downturns prior to World War II more than the mild downturns since. The credit crisis and what Rosenberg calls “imploding” household net worth in the U.S. are apt to make it linger through 2009, when the economy could contract 3% in real terms, and perhaps into 2010.

Rosenberg thinks the yield on the 10-year Treasury note might bottom at 1.5%. “Sustained negative wealth effects from the slide in housing and equity prices will reinforce the uptrend in the personal saving rate, creating a highly deflationary environment as job losses mount and push the unemployment rate up toward 8.5% in the coming year,” he wrote.

It may take such a grim scenario to support Treasuries, given their lofty prices and super-low yields. More likely, the combination of U.S. fiscal and monetary stimulus lifts the U.S. out of recession by the second half of next year and the global economy expands in 2009, albeit at a slower pace than in 2008. Morgan Stanley economists see global growth of 0.9% in 2009, boosted by 3% growth in the developing world. If the more bullish economic and financial scenarios come to pass, interest rates – and Treasury yields – likely will rise.

In any event, the Treasury would do well to take advantage of today’s rock-bottom yields and significantly increase the issuance of 30-year bonds. One reason the 30-year yields so little is scarcity value.

Of the $874 billion of Treasury notes and bonds issued in 2008, just $35 billion was 30-year debt, according to analysts at Wrightson ICAP in New York. Given its huge borrowing needs, the government arguably ought to issue at least $100 billion of 30-year debt this year and perhaps as much as $200 billion. Treasury bills cost the government next to nothing now, and for better or worse, near-zero rates almost certainly will not last.


For fund manager Jerry Jordan, finding the right investment theme is better than picking the right stock. His hot spots: energy and health care.

Many fund managers describe themselves as “bottom-up” stockpickers, meaning they look for undervalued securities with growth potential, regardless of what the economy or market is doing. Jerry Jordan, who runs the Jordan Opportunity Fund (ticker: JORDX), is not part of that crowd. Although he admits to occasionally buying a stock solely on its own merits, he prefers “top-down” investing. He takes a bird’s-eye view of the economy, looks for three to five investment themes, and then picks stocks that he believes stand to benefit from the large trends he sees.

“Top-down is a better approach for us,” says Jordan, who also doubles as president of Hellman Jordan Management, a Boston-based asset manager founded by his father in 1978. Hellman Jordan oversees some $300 million, mainly for wealthy individuals, in separate accounts, limited partnerships and the Opportunity fund. “We believe that finding the right concept is better than picking the right stock, since group dynamics are often 50% of a stock’s eventual gain,” he adds. “So owning the best stock in a mediocre group is a tough way to win. Conversely, a mediocre stock in a great industry can still be a big outperformer. As a small money manager, we try to focus our investment ideas and process around what we are capable of, and where we can add value.”

Jordan’s portfolio normally includes no more than 25 to 40 names, which means that even the smallest positions can have a big impact on performance. About 35% of the fund’s assets go into the top 10 holdings, which currently include oilfield-service specialist Schlumberger (SLB), Internet services provider Google (GOOG), drilling contractor Diamond Offshore (DO), power-systems supplier ABB (ABB), coal producer Peabody Energy (BTU) and entertainment behemoth Walt Disney (DIS).

Focusing on trends like rising – or now, falling – oil and commodities prices or the boom in global infrastructure has paid off for Jordan since he took over management of the Hellman Jordan limited partnership in 1996 and opened it to the public in January 2005.

In the three years through Dec. 31, the fund outpaced its large-growth peers, ranking in the top 3% of Morningstar’s large-cap growth category. The fund returned 9.5% in 2006, its first full year, slightly underperforming its benchmark, the S&P 500. But it generated a 25.8% return in 2007, which was about 20 percentage points better than the S&P’s advance. Over three years, the fund has an annualized loss of 4.84%, versus an 8.36% decline for its benchmark.

Like most of its peers, the fund had a miserable 2008. It slid 37.4%, compared with the broad market’s decline of 37%.

Despite these woes, fund researcher Morningstar gives Jordan Opportunity its highest ranking – five stars. And TRS Reports, a quantitative research service that tracks the performance of open- and closed-end fund managers, this year ranked Jerry Jordan, a Harvard business school graduate, third among 7,000 money managers.

David Snowball, in his monthly Fundalarm Annex, an online column about new and overlooked funds says that, while Jordan Opportunity “has not established itself as a ‘gotta have’ investment, it does merit serious attention from investors ... anticipating a cyclical swing from value to growth.”

With only $72 million in assets, Jordan Opportunity can be nimble in a volatile market. Jerry Jordan trades a lot, routinely turning over his portfolio twice a year while seeking what he calls big ideas and timely sector themes. “Actively managed turnover is an important part of our process in managing the inherently volatile nature of a concentrated portfolio,” the 42-year-old portfolio chief says. “Recent analysis has shown that two-thirds of our turnover is managing around the swings of the individual holdings in our portfolio, selling when they have been overbought or buying back when they have been oversold.”

Bets on energy and commodities paid off handsomely in 2007 and 2008’s first half, as oil rose 50% from January to June 2008 before peaking at $147 a barrel in July. That, plus strong demand for minerals and metals ran up the quotes of holdings like Peabody, Schlumberger, Transocean (RIG), U.S. Steel (X) and Nucor (NUE), generating a 12% return in the second quarter.

But the correspondingly precipitous drop in the prices of oil (now in the 40s), coal and other commodities in the second half sent the fund plummeting by 23% in the third quarter (and further in the fourth) forcing Jordan to trim – or, in some cases, dump – holdings. He reduced his stakes in Peabody, Nucor, and construction-engineering firms Foster Wheeler (FWLT) and Jacobs Engineering (JEC), while selling his total positions in U.S. Steel and oil-equipment provider Weatherford (WFT).

Jordan also unloaded, at a hefty profit, all of his Apple (AAPL) shares and about half his position in Google. “Both had been terrific performers in 2007, but I became worried about the valuations of both stocks. I was especially concerned that Apple was receiving too much credit for what is essentially a glorified hardware company,” he explains. He recently bought back in the mid-90s about half the Apple he had sold around 200 “because the price-earnings multiple has improved markedly and the company’s execution of the iPhone has outperformed my expectations.”

He is also become fond of some energy and materials companies, on the belief that measures taken by the Fed and other central banks will start reviving the global economy, perhaps by 2009’s second half.

In fact, he suspects that the next 10 years “should be the best opportunity to make money that we have seen in a decade.” In part, that is because “we expect the global supply/demand balance of many commodities, especially oil, to tighten further as the economies of China and other developing countries begin to reaccelerate.”

“As the global economy reaccelerates, demand for coal is going to reaccelerate again, particularly in Asia,” benefitting Peabody, which owns a big Australian mine that ships coal to Asia. At a recent 23, the stock was far below its high of 88. And, Jordan asserts, it “can easily touch the 40s or 50s, looking out 12 to 18 months.”

Schlumberger’s profits, on the other hand, are likely to be off by up to 50% in 2009 because of less drilling in Russia, where it is the biggest oilfield-service player. But the energy market – and the company – should recover in 2010, he predicts. The stock, recently near 42, could hit 80 or 90 in the next 12 to 18 months, he says.

At its recent price of 58, another energy play – Diamond Offshore – is attractive, too, in his view, trading at about six times trailing earnings. Jordan believes that the driller will earn less than the consensus forecast of $11.28 next year, versus $9.73 in 2008. But with no debt and a $7-a-share special dividend, “it’s easily a 90-dollar stock.”

Jordan also likes the health-care industry. He recently repurchased Biogen Idec (BIIB), which has developed a drug called Tysabri for relapsing forms of multiple sclerosis. “We believe Tysabri will be a big hit for Biogen,” he says. He also likes Gilead Sciences (GILD), a biopharmaceutical company that makes treatments for life-threatening infectious diseases. The stock is trading around 50; Jordan contends that its “intrinsic value” is in the 60s.

He also favors Genzyme (GENZ) because of its “strong franchise in drugs for hard-to-solve medical needs,” and Abbott Laboratories (ABT), which he says has a solid new-product pipeline, plus “a dominant share in a number of key drug treatments and medical products.”

When he is not working, the Boston native enjoys playing his acoustic guitar and studying martial arts. He has a black belt in tae kwan do. “My kids were doing it, so I decided to join with them,” says Jordan, who has two elementary-school-age children. Makes sense. Skills in self-defense could be valuable for any money manager if the market does not recover this year.


Many hedge funds will not survive 2009. But there could be some good investment opportunities for those still standing later this year.

Can the masters of the universe save themselves?

Hedge fund managers, the stars of the investing world for most of this decade, were brought to their knees in the turmoil of 2008. The average fund fell far short of its goal of “absolute returns,” posting an 18% loss through November. Old standby strategies, such as buying some stocks and selling others short, suddenly stopped working. Customers bolted in record numbers. Then, at year’s end, the industry got a black eye for putting money in Bernard Madoff’s black box.

“The hedge fund is being questioned, and it’s in danger,” says Timothy Brog of Locksmith Capital Management, an activist New York hedge fund.

Indeed, the industry is moving into survival mode for 2009 – and many funds will not make it. The number of hedge funds, which surged in recent years to an estimated 10,000, could eventually fall to about half that, as small, marginal players are sold or go out of business.

The survivors will no longer be able to rely on leverage to goose returns, thanks to the credit crisis. They will have to prove that they seriously investigate potential investments. And they will have to make their own operations considerably more transparent. All the while, regulators are sure to be watching over the industry with new vigor.

Unquestionably, hedge funds will have a tougher time winning the outsized returns – and profits for themselves – for which they became famous in recent years. But that hardly spells the end of the industry.

“We contend that the hedge-fund story is bruised but still alive,” Christopher Miller, chief executive of Allenbridge Hedgeinfo in London, recently wrote. “Certainly many clients have been so badly hit that they never intend to invest with (insert name of just about any manager) again, and it will take a while before they trust the asset class at all.”

Hedge funds did beat the broad market last year – for what that is worth.

To their credit, hedge funds did beat the broad market last year; the Standard & Poor’s 500 fell by some 38%. But that is not an accomplishment the industry can easily ballyhoo. After all, hedge funds long have promoted themselves as vehicles for making money in any kind of market, thereby preserving capital. By simply measuring themselves against the market, hedge funds start to look like mutual funds, and mutual funds charge much lower fees.

For long/short funds, those industry staples that not only buy stocks but also bet on declines, the big problem last year was on the long side. The huge majority of stocks went down. In the 2000-2002 bear market, by contrast, there was much greater dispersion among stocks. Hedge funds as a group almost broke even back then, while the broad market was off 22%.

Long/short was by no means the only hedge-fund strategy to fail last year. Convertible arbitrage, which entails buying convertible securities and short-selling the related stocks, racked up losses of nearly 50%, according to Dow Jones indexes. And investing in distressed securities produced average losses of 37%.

Investors could scarcely get out fast enough. As of October 31, the industry’s net redemptions for the year totaled a startling $43.5 billion, versus a net inflow of $194.4 billion in 2007. It was by far the largest withdrawal since Hedge Fund Research began tracking the field in 1990.

In all, 2008 was “the worst year in terms of performance and capital flows that we have seen,” says Kenneth Heinz, president of HFR. “It clearly extends into 2009. The question is how far into ‘09 it extends.”

Michael Singer, co-president of alternative asset manager Ivy Asset Management, says that those redeeming their hedge-fund holdings are largely high-net-worth investors, endowments and foundations. He adds, “High-net-worth investors were spooked and want to own Treasuries and to wait it out, probably for a year.”

The entire hedge-fund industry’s assets will have shrunk from roughly $2 trillion to around $1.25 trillion by the time the shakeout is over.

Singer estimates that the entire hedge-fund industry’s assets will have shrunk from roughly $2 trillion to around $1.25 trillion by the time the shakeout is over, with big funds generally faring the best.

For one thing, heft helps giants like Caxton and Farallon ride out stretches of poor performance. Big funds are better positioned to pay for extensive due diligence on investments – a task investors will increasingly value in the wake of the Madoff scandal.

“There is a whole host of processes and responsibilities that people have fallen down on,” says Brog of Locksmith Capital.

“Institutions are looking for safety and security,” adds Nadia Papagiannis, hedge fund analyst at Morningstar. “Institutional investors are still the driver of hedge-fund flows, and they are going to be looking at the resources devoted to due diligence.” The still-unfolding Madoff scandal could also affect funds of funds, which charge their clients an extra layer of fees to vet the suitability of potential hedge-fund investments. There are not a lot of funds of funds connected to the alleged fraud, but having names like Tremont Capital Management, a prominent fund of funds in Rye, New York, associated with the story is enough to give investors pause.


When the market goes down where does all the money go, besides “money heaven”? Satyajit Das, risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives, explains where it all went. Hint: Most of it did not exist in the first place.

In recent years, money was cheap and other assets were expensive. But as each of the global economy’s credit creation engines breaks down and systemic leverage declines, money becomes scarce and expensive, triggering adjustments that are reversing the run-up in asset prices.

In this current financial crisis, the quantum of available capital, the munificent resources of central banks and sovereign wealth funds, and the globalization of capital flows may be some of the accepted “facts” that are revealed to be grand illusions. As Mark Twain once advised: “Don’t part with you illusions. When they are gone, you may still exist, but you have ceased to live.”

Reserve Illusions

In recent years, there has been speculation about the amount of capital or liquidity available for investment globally. The substantial reserves of central banks and their acolytes, sovereign wealth funds, were frequently cited in support of the case for a large pool of “unleveraged” liquidity – that is, “real” money. In reality, the available pool of money may be more modest than assumed.

For example, China has close to $2 trillion in foreign exchange reserves. The reserves arise from dollars received from exports and foreign investment into China that are exchanged into Renminbi. The central bank generates Renminbi by printing money or borrowing through issuing bonds in the domestic market. On China’s “balance sheet,” the reserves are essentially leveraged using domestic “liabilities.”

In order to avoid increases in the value of the Renminbi that would affect the competitive position of its exporters, China undertakes “currency sterilization” – operations where it issues bonds to mop up the excess liquidity. China incurs costs – effectively a subsidy to its exporters – of around $60 billion per annum (the difference between the rate it pays on its Renminbi debt and the investment income on its reserves).

The dollars acquired are invested in foreign currency assets, around 60% in dollar-denominated U.S. Treasury bonds, government-sponsored enterprise (GSE) paper such as Freddie and Fannie Mae debt, and other high quality securities. China is exposed to price changes in these investments and currency risk because of the mismatch between foreign currency assets funded with local currency debt.

Deterioration in the U.S. economy and the need to issue additional debt to support the financial sector may place increasing pressure on the U.S. sovereign rating and the dollar. U.S. government support for financial institutions is already approaching 6% of GDP, compared to less than 4% for the savings and loan crisis.

Deterioration in the credit quality of the United States results in losses on investment through falls in the market value of the debt and a weaker dollar. The credit default swap (CDS) market for sovereign debt is increasingly pricing-in increased funding costs for the United States. The fee for hedging against losses on $10 million of Treasurys was about 0.58 per annum for 10 years (equivalent to $58,000 annually) in December 2008. This is an increase from 0.01% ($1,000) in 2007 and 0.40% ($40,000) in October 2008.

It is also not easy to tap this liquidity pool. Given the size of the portfolios, it is difficult for large investors such as China to rapidly mobilize a large portion of these funds by liquidating their investments and converting them into the home currency without substantial losses. This means that this money may not, in reality, be available, at least at short notice. If the dollar assets lose value or cannot be accessed, then China must still service its liabilities. It can print money but will suffer the economic consequences including inflation and higher funding costs.

The position of emerging-market sovereign investors with large portfolios of dollar assets is similar to that of a bank or leveraged hedge fund with poor quality assets. China’s Premier Wen Jiabao recently expressed concern: “If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital ...” In December 2008, Wang Qishan, a Chinese vice premier, noted: “We hope the U.S. side will take the necessary measures to stabilize the economy and financial markets as well as guarantee the safety of China’s assets and investments in the U.S.”

There are other factors affecting the availability of the reserves at central banks and sovereign wealth funds. In recent years, sovereign wealth funds have also suffered losses on some of their investments, most notably in U.S. and European financial institutions.

Some central banks have been forced to utilize reserves to support the domestic economy and banking system. For example, South Korea has used a portion of its reserves to provide dollars to banks unable to refinance short-term dollar borrowings in international money markets.

Russia has similarly used a significant portion of its reserves to support financial institutions and also its domestic markets. Russia’s reserves, which rank third after China's and Japan’s reserves in size, have fallen $122.7 billion, or 21%, since August 2008. The reserves, including oil funds that exclusively act as a safety cushion for the budget, stood at $475.4 billion on November 2008.

Capital Illusions

The substantial buildup of foreign reserves in central banks of emerging markets and developing countries, as identified by David Roche (see David Roche and Bob McKee, 2007, New Monetarism, Independent Strategy Publications), is really a liquidity creation scheme that relies on the dollar’s favored position in trade and as a reserve currency.

Many global currencies are pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This creates an outflow of dollars (via the trade deficit that is driven by excess U.S. demand for imports based on an overvalued dollar). Foreign central bankers are forced to purchase U.S. debt with dollars to mitigate upward pressure on their domestic currency.

Facilitating this process are the large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements and the historically unimpeachable credit quality of the U.S. sovereign assets. The recycled dollars flow back to the United States to finance the spending.

This merry-go-round is a significant source of liquidity creation in financial markets. It also kept U.S. interest rates and cost of capital low, encouraging further borrowing to finance consumption and imports to keep the cycle going. This process increased the velocity of money and exaggerated the level of global liquidity.

The large buildup in reserves in oil exporters from higher oil prices and higher demand from strong world growth was also recycled into U.S. dollar debt. The entire process was reminiscent of the “petrodollar” recycling of the 1970s.

The central banks holding reserves were lending the funds used to purchase goods from the country. In effect, the exporter never got paid – at least until the loan to the buyer (the finance vendor) was paid off. As the debt crisis intensifies and global growth diminishes with increased defaults, it is increasingly likely that this debt will not be paid back in it entirety.

This liquidity circulation process supported, in part, the growth in global trade. This too may have been an illusion as the underlying process is a gigantic vendor financing scheme.

Trade Illusions

An accepted article of economic faith is that failure of economic cooperation and resurgent nationalism in the form of trade protectionism (for example, the Smoot-Hawley Tariff Act) contributed to the global financial crisis of the 1930s.

The stock market crash of 1929 and the subsequent banking crisis caused a collapse in financing and global demand, resulting in a sharp decrease in the U.S. trade surplus. Smoot-Hawley was passed in 1930 to deal with the problem of overcapacity in the U.S. economy through higher tariffs designed to increase domestic firms’ market share. The higher U.S. tariffs led to retaliation from trading partners affecting global trade.

The slowdown in central bank reserve recirculation affects global trade by decreasing the availability of financing for purchasers to buy goods and services. This is apparent in the sharp slowdown in consumer consumption in the United States, United Kingdom and other economies. It should be noted that it was the availability of cheap financing that fueled consumption by helping drive up asset prices which, in turn, allowed excessive borrowing against the inflated value of the assets.

Weakness in the global banking system (in particular, loan losses, the lack of capital and concerns about counter-party risk between large financial institutions) contributes to restricted availability of trade letters of credit, guarantees and trade finance generally. This exacerbates the problem. The restrictions, in turn, further impact the level of trade flows and capital recirculation, resulting in a further decrease in trade activity that in turn further slows down international credit creation.

It is not easy to fix the problem. Redirection of capital held in central banks and sovereign wealth funds to domestic economies affects the global capital flows needed to finance the debtor countries, such as the United States, and recapitalize the banking system. Maintenance of the cross border capital flows to finance the debtor countries budget and trade deficits slows down growth in emerging countries and also perpetuates the imbalances.

Trade has become subordinate to and the handmaiden of capital flows. As capital flows slow down, global trade follows. Indirectly, the contraction of cross border capital flows and credit acts as a barrier to trade. In each case, deleveraging is the end result.

This opens the way to “capital protectionism.” Foreign investors may change their focus and reduce their willingness to finance the United States. Wen Jiabao, the Chinese prime minister, indicated that China’s “greatest contribution to the world” would be to keep its own economy running smoothly. This may signal a shift whereby China uses its savings to invest in the domestic economy rather than to finance U.S. needs.

China and other emerging countries with large reserves were motivated to build surpluses in response to the Asian crisis of 1997-98. Reserves were seen as protection against the destabilizing volatility of short-term capital flows. The strategy has proved to be flawed.

It promoted a global economy based on “vendor financing” by the exporting nations. The strategy also exposed the emerging countries to the currency and credit risk of the investments made with the reserves. Significant shifts in economic strategy are likely. Zhou Xiaochuan, governor of the Chinese central bank, commented: “Over-consumption and a high reliance on credit is the cause of the U.S. financial crisis. As the largest and most important economy in the world, the U.S. should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.”

More ominously, Chinese President Hu Jintao recently noted: “From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies.”

There is also the risk of “traditional” trade protectionism. The end of the current liquidity cycle, like the one in the 1930s, may cause a sharp fall in exports. Exporting countries, seeking to maintain domestic growth, may try to boost exports by devaluation of the currency or subsidies. Import tariffs are less effective unless there is a large domestic market. Recently, the Chinese central bank did not rule out China depreciating its currency.

The change in these credit engines also distorts currency values and the patterns of global trade and capital flows. The current strength in the dollar, particularly against the euro, reflects repatriation of capital by investors and the shortage of dollars from the slowdown in the dollar liquidity recirculation process. It is also driven by the reliance on short-term dollar financing of some banks and countries and the need for refinancing. This is evident in the persistence of high interbank dollar rates and dollar strength.

The strength of the dollar is unhelpful in facilitating the required adjustment in the current account and also financing of the U.S. budget deficit.

The slowdown in the credit and liquidity processes outlined may have long-term effects on global trade flows. The volume of world traded, according to the World Bank, may contract by 2.1% in 2009. This contrasts with growth of 9.8% 2006 and an estimated 6.2% in 2008. The expected drop for 2009 is more severe than the last major contraction in trade volume of 1.9 % in 1975.

End of “Candy Floss” Money

Gillian Tett of the Financial Times coined the phrase “candy floss money” (see “Should Atlas still shrug?” January 15, 2007 Financial Times). New financial technology spun available “real” money into an exaggerated bubble that, like its fairground equivalent, collapses ultimately.

The global liquidity process was multifaceted. There was traditional domestic credit creation system built on the fractional reserve system that underpins banking. The leverage in the system was pushed to extreme levels. Losses and renewed regulation are forcing this system of credit creation to shut down.

The foreign exchange reserve system was another part of the global credit process. Dollar liquidity recirculation has also slowed as a result of reduced trade flows (driven by declines in U.S. consumption and imports), losses on dollar investments, domestic claims on reserves and the inability to readily mobilize large amount of reserves.

Another credit process – the export of yen savings via the yen carry trade and acquisition of foreign assets by Japanese investors – has also slowed.

The focus of the November 2008 G-20 meeting was firmly on financial sector reform. Stabilization of global capital flows in the short term and addressing global imbalances over the medium to long term barely merited a mention. It may well come to be seen in coming weeks and months as a major missed opportunity to address these issues.

Markets placed great faith in the volume of money available to support asset prices and assist in alleviating shortages of liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage as well as the structure of global capital flows. As the financial system deleverages, it is becoming clear, unsurprisingly, that available capital is more limited than previously estimated.

As Sigmund Freud once observed: “Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.”

There is an apocryphal story about a disgraced rock star who ended up in bankruptcy court. When asked what happened to his fortune of several million dollars, he responded: “Some went in drugs and alcohol, I gambled some of it away, some went on women and the rest I probably wasted!” Financial markets have “wasted” a staggering amount of money that ironically probably did not “exist” in the first place.


Tailoring Commodities Funds for Islamic Investors

Commodity funds are now among the investment products available in versions tailored specifically for the Islamic market.

Despite prices that have been halved in recent months, commodity-focused companies and hedge funds are introducing special products that comply with Islamic law, or Sharia, and thus allow observant Muslim investors to buy commodity exchange-traded funds, or shares in companies that deal in goods like wheat and gold.

In Islamic finance, investors are not allowed to invest in companies that produce alcohol or pork, for example – and short-selling and interest-bearing instruments are prohibited. Companies must also carry low debt and not have too much cash. Commodities fit nicely into the Sharia sector because they are physical goods that can be bought and sold for a profit, and many commodities companies have little debt. And while prices are falling now, demand is expected to increase in the Middle East and elsewhere for the likes of copper and oil – once economic growth resumes. ...

The Islamic finance sector has grown at a rate of about 15% a year, and assets managed by Islamic lenders are estimated to hit $1 trillion by 2010, as demand from the world’s 1.3 billion Muslims grows, management consulting firm McKinsey & Co. says.

“There is an affinity with commodity investment to begin with in the region. It should notch up a few decibels,” says John Hathaway, portfolio manager at Tocqueville Asset Management, which will run a Sharia fund as part of its larger portfolio investing in Sharia-compliant gold and precious-metals stocks.

“We are already 94% Sharia-compliant without trying – literally seamlessly,” said Russell Lucas, a founding partner at Lucas Capital Management, which will focus on oil and natural-gas stocks.