On Frail Wings of Vanity and Wax

The beginning of a new year brings with it the promise of a fresh start and resolutions for reform. This annual ritual has ironic relevance for the hedge fund and financial industry.  Clearly, the hedge fund industry would rather forget 2011 and happily begins a new performance and incentive compensation period.  According to Barclay's Hedge Index, the average 2011 hedge fund return was a pitiful (5.3%).

Meanwhile, many financial industry titans have renewed their pledge to continue to work as if they are gods in the face of rising investor and stakeholder contempt.  This capitalistic philosophy declares that material self enrichment is the truth and of prime importance.  Frequent industry and media references to financial titans as "Masters of the Universe" suggest that man is god to the financial pantheon ('of or for the gods'). This caricature was ridiculously manifest in October 2011 with Jon Corzine's Icarus-like belly flop at MF Global.  Who knew MF stood for 'Missing Funds?'  More than two months after its bankruptcy regulators and the bankruptcy trustee are still looking for the $1.2 billion in missing segregated client funds. No criminal prosecution has yet been initiated.  The financial sector ETF (XLF) dove (17.1%) in 2011 led by the MF Global meltdown from $8.36 per share at the start of 2011 to mere pennies at year end for its carcass.



 

The image above shows the epic failure of Icarus from Greek mythology. He is surrounded by lamenting sea-nymphs. His father, Daedalus the craftsman, made wings out of wax so that he and his son might escape from the island of Crete. But, overcome by pride, Icarus flies too close to the sun, the wax melts, and he plunges to his death. His sensible, god fearing father flies safely to Sicily. There Daedalus hangs up his wings and builds a temple as an offering to Apollo, the god of light, the sun, and truth.



Time will tell whether the failure of MF Global was due solely to the vainglory of its CEO or whether nefarious acts were involved.  Let's hope that no one places a fat thumb on the scales of justice.  Let justice be served.

 

Shine Some Light Please

A regular blog reader calls me a “gloom and doomer” because of my often cautious outlook on the economy and markets. This issue has less to do with viewing the glass as half empty rather than half full.  As an investment advisor my duty is to maintain an alert and watchful perspective like a sentinel in a watchtower.  In that light if from that vantage point the glass is filthy, it matters little how full it is.  This consistent, healthy skepticism arises from my upbringing.  My mother seemingly had advice for every difficult situation I found myself in as a young lad. Her admonition that “It’s better to be safe than sorry” corresponds with the Servant Financial’s investment management philosophy. 

Recent developments in the financial and hedge fund industries prompted these additional maternal words to live by – “The exalted will be humbled and the humbled will be exalted.”  The exalted (people of great wealth, power, prestige and celebrity) are being humbled in the hedge fund and financial industry due to mediocre performance and blatant ethical lapses.

Hedge funds are private pools of capital actively managed by investment advisers.  By regulation hedge funds are reserved for wealthy individuals and sophisticated institutions.  Most hedge funds are marketed as having proprietary investment strategies and deep investment expertise.  These competitive advantages purportedly allow the funds to achieve positive returns whether markets are rising or falling.  The volatile trading ranges of 2011 would arguably be an optimal performance environment for hedge funds.  Such has not been the case as the hedge fund industry has fallen short of their lofty sales and marketing assurances.  In fact, the average individual investor may be outperforming the hedge fund industry in 2011.    This revelation was discussed in a recent global market commentary from The Mad Hedge Fund Trader investment research report written by John Thomas.

Although I don’t have the hard data to back it, I bet the average individual investor is outperforming the average hedge fund in 2011. With such heavy weightings of bonds and cash, how could it be otherwise? While the current yields are miniscule, the capital gains have to be humongous this year, with yields plunging from 4% to 2%... (When bond yields drop bond prices increase generating unrealized capital gains.)

Thomas believes the average investor has benefitted from more conservative asset allocation decisions in the aftermath of the 2008 financial crisis.  Individual investors have shifted more of their assets into cash and fixed income securities from equities.  John Q Public has also done well by paying down debt and deleveraging rather than keeping funds in the market. 

Increased market efficiency is due in part to intense competition within the hedge fund industry as Thomas explains.

The problem is that hedge funds are no longer peripheral to the market. They are the market, and therein lies the headache. How are you supposed to outperform the market when it means beating yourself? As a result, hedge fund managers have replaced the individual as the new “dumb money, buying tops and selling bottoms, only to cover at a loss,” as we witnessed on Monday (November 28, 2011).

Hedge fund returns have been declining for a decade. Hedge fund industry returns have been pathetic in 2011 with Barclays Hedge Fund Index declining an estimated (4.8%) through the end of November.  This hardly justifies the 2% management fee and 20% share of investment profits paid by hedge fund investors.

The growth in hedge fund industry assets under management supports Thomas’s observation. Industry assets mushroomed from $118 billion in 1997 to $1.7 trillion at the end of the third quarter of 2011. 

Source: Marc Faber, Limited; GloomBoomDoom.com

Coincident with the enormous growth and influence of the hedge fund industry, the correlations (measurement of the relationship of interdependent variables) of global equity markets have almost doubled from about 50% in 1997 to more than 80% today.

Please allow me to introduce myself I'm a man of wealth and taste.
  Rolling Stones

Source: The Trends Journal, August 2011 www.trendsjournal.com

Like other walks of life where the economic payoffs and the egos are inflated the human weaknesses of greed and pride have led to cheating in the hedge fund industry.  Cheaters in the hedge fund industry do not use steroids or human growth hormones as was common in professional football, baseball, and the Tour de France.  Rather illegal trading on insider information was used to “juice” hedge fund performance. 

Reuters reports that since October 2009 there have been 50 people in the industry who have been convicted or pleaded guilty to insider trading charges.  Hedge fund billionaire Raj Rajaratnam is perhaps the most infamous hedge fund manager implicated in the probe. Rajaratnam was convicted in May of trading on illegal stock tips that produced fantastic results for his Galleon Group. He was sentenced to 11 years in prison.

The recent highly speculative collapse of MF Global, the largest Futures Commission Merchant in the U.S., is another example of ethical lapses in the financial industry.  Readers interested in a no holds barred discussion of MF Global’s collapse should read the following transcript at Financial Sense. In this interview host Jim Puplava is joined by Ann Barnhardt, who recently closed her commodity brokerage firm Barnhardt Capital Management after the MF Global collapse. Barnhardt believes that her client monies were no longer safe in the futures and options markets, and that the integrity of this market has been 'utterly destroyed' by the MF Global collapse. I had similar concerns and sold the sole ETF in client portfolios with any commodities futures or options exposure on November 27, 2011. Any future investments in commodities within Servant model portfolios will be limited to physical markets until appropriate regulatory and exchange actions have been taken to restore the integrity of the system. An example of a physical commodities market would be shares of the Central Fund of Canada (CEF) which holds physical gold and silver in a secure vault rather than paper futures contracts.

What does this all mean for the hedge fund and financial industry and you as investors?  Thomas expects that individual investors will flee markets dominated by hedge funds and migrate to those markets where hedge funds are not present, such as smaller, less liquid and more pedestrian markets.  Hedge fund managers will continue to slug it out in liquid equity and debt markets until their investors abandon the rich fee structure and take their capital with them. 

This dynamic is already in motion.  One of the most lucrative investment markets today is the purchase of hedge fund limited partnership interests in the secondary market.  Hedge fund secondary interests trade at discounts of up to 40% or more of managers' net asset or carrying value, return investor capital fairly quickly, and generate net returns of 30% plus.  This attractive opportunity set was identified in the course of providing investment advisory services to a Chicago family office.  Unfortunately by regulation this market is restricted to accredited investors – wealthy individuals and institutions. Nevertheless we will remain alert for other attractive investment opportunities that may arise from positions contrary to Wall Street and take advantage of dislocations in the hedge fund and financial industry.  Potential examples include investment funds that directly provide liquidity to stressed and distressed sellers or lend to small borrowers with limited access to traditional financing sources.

The 99% Declaration

Strategas Research recently published a report that showed that historically low growth periods (data analyzed for the years 1950 to 2010) have been associated with higher volatility in the S&P 500.  When nominal GDP growth is 4% or less as it is today,  the volatility of the S&P 500 averaged 45.5% as compared to roughly half that when GDP growth was 4% to 8% (23.8% volatility) or greater 8% (24.4% volatility).   As this study portends, market volatility continued into October, but this time to the upside with a gain of 11% after two straight losing months.  The markets reversed course on November 1, 2011, with the S&P 500 off (2.8%) on uncertainty over the end game for Greece and the Euro zone.  This manic depressive "Risk Off" to "Risk On" behavior of the stock market is not conducive to peace of mind, or social tranquility in Europe or our backyard in the U.S.  Serious global economic, geopolitical and monetary risks and imbalances prevail, fostering mass social issues and revolutionary populist movements like Occupy Wall Street and the Occupy movement.  These demonstrations have generally been peaceful to date, but at some point a fanatic on one side or the other will make a regrettable error in judgment.   

The Occupy Wall Street and broader Occupy movements are worth monitoring because of their potential to dramatically change the economic, political and monetary agenda in this country. The group's slogan “We are the 99%," is a protest of the trend since the 1970s for wealth and income to be concentrated in the top 1% of the United States population. According to the Congressional Budget Office, between 1979 and 2007 incomes of the top 1% of Americans have grown by an average of 275%, versus just 40% for the 60 percent of Americans who are in the middle of the income scale. The top 1% of the American population controls about 40% of the total wealth of the country and the top 10% controlled 73% of wealth. In 2010, of the 100 highest-paid chief executives in the U.S., 25 took home more pay than their company paid in federal corporate income taxes.

Dr. Marc Faber, renowned investment manager and strategist of the Gloom, Boom and Doom report,  discussed one potentially critical driver of the decline of the American working class in his November investment newsletter entitled "The Strongest Principle of Economic Development Lies in Human Choices." 

…it is important to understand the role multinationals played in the destruction of jobs in the Western industrialized countries. Small and private companies are largely local, serve customers in their immediate surroundings, are unable to take advantage of all kinds of tax avoidance schemes, and have some loyalty to their own communities. They create jobs when they wish to expand. Multinational conglomerates, on the other hand have the tendency to migrate their production facilities to the lowest cost location in order to maximize profits. Therefore, large multinational companies tend to destroy jobs in Western Europe and the US and fuel employment growth in emerging economies in order to reduce their costs, which partly explains as to why in the wake of high unemployment and hardly any economic growth at home their profits are at record highs.

 By fueling employment growth in emerging economies (notably in China), they also boost economic growth rates in the emerging world and the profits they derive from the emerging economies (foreign earnings now account for about 45% of total US corporate profits).

 It should come as no surprise then that the Occupy protests are largely focused on issues that contribute to the growing economic disparity in the U.S.  Some may view this group as being unstructured, leaderless and largely comprised of people seeking their 15 seconds of fame on television or You Tube. One of the group's goals is to be as inclusive as possible and achieve consensus whenever practical.  The Occupiers typically form working groups to govern themselves with committees to oversee cleanup, security, food, media and other issues.  Early indications are that the movement is technologically savvy and has excelled at organizing themselves, maintaining media relevance, and generating national debate on issues of economic inequality, high unemployment and the hardships of millions of Americans, and the influence of corporate and special interest groups on government. 

The Occupy protests have been described as a "democratic awakening."  However, the movement is having difficulty distilling its message to a few core demands.  The group has drafted The 99% Declaration which outlines their social and political agenda.  The declaration claims to be founded on the immutable democratic principles set out by Thomas Jefferson, "Educate and inform the whole mass of the people.  They are the only sure reliance for the preservation of our liberty."  The following is a summary of The 99% Declaration beginning with its introductory paragraphs.

WHEREAS THE FIRST AMENDMENT TO THE UNITED STATES CONSTITUTION PROVIDES THAT:

Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances.

BE IT RESOLVED THAT:

WE, THE NINETY-NINE PERCENT OF THE PEOPLE of the UNITED STATES OF AMERICA, in order to form a more perfect Union, by, for and of the PEOPLE, shall elect and convene a NATIONAL GENERAL ASSEMBLY beginning on July 4, 2012 in the City Of Philadelphia.

The Occupy movement declaration seeks to do an end around the established government processes by forming a non-partisan National General Assembly to be held on July 4, 2012 in Philadelphia.  The people will elect two delegates, one male and one female, from each of the existing 435 Congressional Districts.  The National General Assembly will then petition the government for redress of grievances - the Senate, House of Representatives, the Supreme Court and the President.  The following is a draft list of the grievances prepared by an Occupy working group.  The declaration will no doubt change and evolve around consensus issues.  Grievances that relate more directly to the Occupy movement's fundamental issue of economic disparity and political influence have been highlighted.  My commentary on grievances is in parentheses.

1. Elimination of the Corporate State - immediate ban on all private contributions to all politicians for federal office and switch to public financing of political campaigns.
2. Abrogation and Rejection of the Citizen United Case - decision equated the payment of money to politicians with the exercise of the freedom of speech.
3. Elimination of All Private Benefits and "Perks" to Politicians - politicians and public employees may only collect their salary and generous healthcare and pensions.
4. Term Limits - House of Representatives - four 2 year terms; Senate - two 6 year terms.
5. A Fair Tax Code - complete reformation of the U.S. Tax Code to require ALL citizens and corporations to pay a fair share of a progressive, graduated income tax.
6. Healthcare for All - Medicare for all or adoption of a single-payer healthcare system.
7. Protection of the Planet - new comprehensive regulations to expand EPA powers.
8. Debt Reduction - reduce national debt to a sustainable percentage of GDP by 2020.
9. Jobs for All Americans - passage of a comprehensive job and job-training act like the American Jobs Act.
10. Student Loan Forgiveness - reduction of interest rates and deferral of interest and principal payments during periods of unemployment.  Principal forgiven over time by phasing in a graduated corporate tax surcharge.  (Also recommends amendment of the Tax Code to provide tax deduction for employers that pay off employee student loans which would contravene Grievance no. 5)
11. Immigration Reform - immediate passage of the Dream Act and comprehensive immigration and border security reform.
12. Ending of Perpetual War for Profit - recall all military personnel at all non-essential bases and focus on 21st century national defense threats.
13. Reforming Public Education - eliminate tenure and pay teachers a competitive salary.
14. End Outsourcing - offer tax incentives to businesses to remain in U.S. and hire our citizens rather than outsource jobs (Another conflict with Grievance no. 5).
15. End Currency Manipulation - implement legislation to encourage China and other trading partners to end currency manipulation.
16. Banking and Securities Reform - immediate reenactment of Glass-Steagall Act.  (This is an absolute no brainer.  Why hasn't our government already done so?)
17. Foreclosure Moratorium - have the privately owned Federal Reserve discontinue its favorable interest rate on loans to banks and instead have it buy all underwater or foreclosed mortgages. (This is the bail out the mortgagees rather than the banks provision.)
18. Ending the Fed - transfer functions to United States Treasury Department.  (This would make the monetary games too transparent.  With the Fed gone, who bails folks out of their underwater mortgages?)
19. Abolish the Electoral College, Comprehensive Campaign Finance and Election Reform - switch to a popular vote for presidential elections.
20. Ending the War in Afghanistan - immediate withdrawal of combat troops.  (This trumps Grievance no. 12 in case Afghanistan war is deemed essential.)
21. Repeal of the Defense of Marriage Act - all human beings have the right to love and marry another human being regardless of gender or sexual orientation.

Many Americans may feel that several of these draft grievances have little merit because they go beyond the scope of redress for economic disparity and the removal corporate and special interest money from politics.  The credibility of the movement is diluted by the inclusion of indiscriminate grievances.  That said this fledgling movement's plan to give the masses a more direct voice in a government for the people and take direct aim on the money interests that often debase our democratic system is something few Americans would denounce. 

The Occupy movement began less than two months ago in New York City on September 17, 2011 with Occupy Wall Street.  As of November 4 the movement seems to be going viral with the Meetup page Occupy Together listing Occupy communities in 2,353 towns and cities worldwide.  We will continue to monitor the Occupy movement because it has the potential to cause disruptive social, political and economic changes and impact markets.

Titanic Proportions of Bernanke Policy

 A lot has been written lately about the unprecedented nature of Fed monetary policy on markets.   Many economic experts are debating the pros and cons of these policies.  We wonder aloud whether the titanic proportions of  Fed policies are modestly helpful for the economy in the short term but are providing a false sense of security against dangers lurking below the surface.

Let's begin with a review of the economic impacts of Chairman Ben Bernanke’s quantitative easing or "money printing" policies. Wikipedia defines quantitative easing (QE) as "an unconventional monetary policy used by some central banks to stimulate their economy when conventional monetary policy has become ineffective. The central bank buys government bonds and other financial assets, with new money that the bank creates electronically, in order to increase money supply and the excess reserves of the banking system."  Quantitative easing also inflates prices of financial and other assets as the excess liquidity created by the Fed needs to find a home.  This phenomenon lowers the expected future return/yield of financial and other assets.  Take for example short term U.S. treasuries where the Fed has targeted their QE purchases.  The distribution yield on iShares 1-3 year Treasury ETF (SHY) is 0.96%.  This compares to the Consumer Price Index (CPI) for March 2011 of 2.7% and Core CPI (excluding food and energy) of 1.2%.  This loss in purchasing power is the "injustice inflicted on savers" referenced by Dallas Fed Governor Richard Fisher last month.  Note that the injustice is far more tolerable if miraculously you do not require food or energy for your daily existence!

The initial $1.7 trillion of quantitative easing, or QE1, was designed to buy mortgage backed securities to bring liquidity back to that market place. QE2 initiated last fall enabled the purchase of a further $600 billion in U.S treasury securities to prevent a double dip recession. On top of this the Treasury advanced $700 billion through the Troubled Asset Relief Program (TARP) to recapitalize the major banks. All three of these programs were viewed as wildly successful in the eyes of its architects but in reality are "not worth the paper the trillions of digital dollars were not printed on" to quote Gerald Celente of Trends Journal.  The housing market is still in shambles, a technical double dip recession has been avoided in lieu of confiscatory monetary policy, and zombie banks hide their loan losses through weak accounting practices condoned by bank regulators.

Meanwhile, the Federal Reserve balance sheet has grown from a pre-crash $800 billion to $2.8 trillion.  Normally this would be highly inflationary, but it has not been this time because all of the extra money is being held as excess reserves at the zombie banks.  Inflation is also being exported to our trading partners in China, the Middle East and other suppliers in the rest of the developing world that peg their currencies to the dollar.  These trading partners don't let their currencies appreciate against the dollar by printing money themselves which brings on inflation in their own economies.  According to Hussman Funds, the U.S. monetary base will soon reach a new historical high relative to GDP of about 17 cents for each dollar of GDP at the end of QE2.  This compares to the previous high of 15 cents which occurred at the peak of the 2008 financial crisis as everyone rushed to the safety of cash and waited for the deflationary impacts to lower prices for goods and services and assets of all types.

The challenge for the Fed going forward is for it to skillfully unwind its balance sheet at the same rate that the banks begin paring back excess reserves through more lending. If the Fed adjusts its balance sheet too slowly, it risks inflation. If the Fed moves too quickly, it risks falling back into recession.  The Fed has recently signaled that at the end of QE2 it is likely to maintain a neutral stance by only reinvesting principal and interest payments received on its mortgage and treasury investments into new securities purchases.  In other words, the Fed will maintain the monetary base near its current size. If the zombie banks don't increase lending with Fed money creation on hold, the logical outcome is for the economy and markets to stagnate.

Although these quantitative easing policies have been highly effective at causing asset price inflation and the appearance of a sound economy, recent global stock and commodity sell-offs suggest investors have started to discount the reality of a weakening U.S. and global economy.  For example, decline in the CRB commodity index of over 6% in the first week of May represented the fifth deepest weekly plunge in the last forty years, rivaling the declines posted during the 2008 market meltdown (when the monetary base last peaked) and exceeding the deflationary plunges posted in 1975 and 1980.

This could be the beginning of a market corrective phase given the high correlation (something like 0.88) of the advances in all asset classes, particularly equities and commodities, with Fed increases in the monetary base.  Investor worries seemingly began when the initial report of first quarter 2011 GDP came in at 1.8% down considerably from fourth quarter 2010 GDP of 3.1% and well below economists' consensus.  This was followed by weekly jobless claims taking a turn for the worse and a poor showing for a leading indicator for the all important U.S. service sector when the non-manufacturing Institute for Supply Management (ISM) index dropped 4.5 percentage points to 53.7%.  In addition to the completion of QE2, the end of many of Obama's stimulus programs are just around the corner.  Factor in the deflationary impact of $4 to $5 gasoline (non-core CPI item) on discretionary spending and that suggests significant headwinds for the U.S economy by the beginning of 2012. Meanwhile global central banks have been moving aggressively to tighten monetary policy to counter inflationary pressures. The first week of May alone saw the Reserve Bank of India, State Bank of Vietnam, the Philippine and Malaysia central banks raise their short-term interest rates.

By definition we know that 1) conventional monetary policy has become ineffective and 2) quantitative easing is intended to stimulate the economy.  With the economy seemingly sputtering, some investors have begun to conclude that despite Chairman Bernanke's self congratulatory demeanor, his unconventional monetary policy has largely been ineffective in stimulating the economy.  The quandary for the Fed and market participants is what can the real economy do on its own?  This creates uncertainty and market volatility. With Fed monetary policy already at extremes and an election cycle underway the greatest national risk is that Chairman Bernanke and his crony Fed governors believe more unconventional monetary policy is necessary and continue pushing modern economic policy to new limits. 

One financial analyst likened the riskiness of current Fed monetary policy to Chairman Bernanke doing a high wire act in high winds with no safety net.  Unfortunately there are more stakeholders involved in Ben's high wire act, and it is far more appropriate to think of Bernanke as the captain of the cruise ship America charging through uncharted, dangerous, and bone-chilling waters with all of us aboard.

"I cannot imagine any condition which would cause a ship to founder. I cannot conceive of any vital disaster happening to this vessel. Modern ship building has gone beyond that."
-Captain Smith, Commander of Titanic

 

 

All is not well, but rest assured that policymakers are busily rearranging the deck chairs.  With each additional policy action, Captain Bernanke will leverage the media (60 Minutes, Washington Post and press conferences) to assuage passengers that the ship is sound, the path is clear and unassailable, and his infallible hand is firmly at the helm.

Our recommendation is that you steer your portfolios to safer waters and make your long term investment journey more enjoyable.

Bon voyage.