April Fool's Day

April 1, 2009

They say it’s always darkest before the dawn. But then again, it’s pretty dark at 1:00 AM, too, and you still have a ways to go before the sun comes up. 

Let's  consider a few basic financial factoids currently circulating: (1) stock markets typically recover before the economy does; (2) recessions rarely last more than a couple of years; and (3) compared to recent history, stocks are now cheap. 

Combine all of these factors, and what do you get? Some pretty bold and beautiful advances in the market, despite a lack of visible improvement in the economy. Factor in massive stock shorting by momentum investors and hedge funds – risky stakes this deep into a bear market that will have to be covered if the market takes off – and you have a recipe for a month like March – one of the best on record. Of course, “best month evers” often follow “worst month evers”. Even with March’s 8.5% jump in the S&P 500, the market is still down 11.5% in 2009.

At this point, we're as guilty as the other bottom-fishers, although we'd argue that we had far more cash, bonds, and shorts at the top then most (at least, compared to the average 2008 performance of most mutual fund and advisory firms.) 

In fact, our latest trade made at the end of February was a mere five (largely bad) trading days from what some believe is the elusive "bottom" – around Dow 6,500 and 666 (gulp) on the S&P 500. Of course, last fall, Dow 7,500 was supposed to be the bottom…

So far, the market has rebounded approximately 20% since the low in  early March. Some more beaten-down areas, notably the Russian ETF and Financials ETF we added in the last trade, are up even more than the market. Better still, we got out of our commodities short just in time to witness a commodities comeback (which we expect to be short-lived).

We don't assume that the market will continue to rise without dropping again or that the economy is mounting a recovery, but we are confident these prices will work out in the longer term regardless. Besides, we have a master plan if things grow appreciably worse: buy more and wait patiently. For now, we're comfortably continuing to zig whilst other fund investors zag. 

There were monster outflows from stock funds right before the latest bottom, and there appear to have slowed now that things are "improving." Specifically investors took out around $60 billion from stock funds in the three weeks through March 11th (just in time to miss the big move back up).  But as contrarians, we prefer to do our investing when the market appears to be eroding, when other investors panic. Which means we're likely done with major trades for the time-being. Although you never know. The waves are crashing in awfully fast these days.

Brother, can you spare a billion?

The latest iteration of government aid to the not-so-needy-but-important-nevertheless sparked the most recent rise in down-in-the-dumps banks and other financials. We're talking 20% hikes in one day for some in this area, notably the government’s new investment partners, highfalutin Wall Street money managers, many of whom didn't do such a great job avoiding investments in troubled debt in the first place.

Specifically, the government laid out details on how it plans to use previously set-aside rescue funds to buy troubled "assets" (and we use this term loosely…) from banks in order to free them up to make more, hopefully slightly less crappy, loans. The  trouble is, a hundred billion dollars in troubled asset relief ain't what it used to be. After all, this is no longer merely a subprime problem. The figures being batted around are mere chump change when you consider that the financial sector probably has $1-2 trillion in losses on recently-lent money.

The solution, of course, is a little hair of the dog that bit you - namely, leverage that puppy up. But due to an apparent disdain for any actual government profit on these bailouts, the government has instead opted to protect money managers from downside so they'll have a decent shot at hitting the sorts of bonuses they received in the years prior to the crash.

It breaks down like this. First, the government will partner up with XYZ Hedge Fund or money manager. Now let’s say there's a billion dollar loan portfolio at ABC Bank currently worth about $800 million (we hope…it may turn out to be worth $200 million). Each party – the government and the Hedge Fund - will pony up about $50 million to buy the depressed loans from ABC Bank (because that was the problem…since the bank instructed the mortgage lending department to "Always Be Closing," regardless of who signed on the dotted line or what overpriced shoebox they happened to be buying). 

But that’s only $100 million. Where is the next $700 million coming from? Why, from investors, of course. Wondering who would lend money to purchase risky mortgage securities at a low enough interest rate to actually make some money? That’s where the government steps in and backs up any borrowing with FDIC insurance. This is sort of what the government is now doing with many troubled banks and GE – telling debt buyers they'll cover the losses. The government may even make the loans needed to buy the $800 million dollar portfolio. 

So let’s say the value of the portfolio falls from $800 million to $500 million. The hedge fund will only lose the original $50 million. They won’t owe the loan back. They can "walk away," similar to someone who bought a condo with hardly any money down only to watch it later plummet in price. Unlike said condo flipper, however, the hedge fund’s credit won’t get dinged, and the lenders won’t come after them, since the FDIC will make good on the losses.

So what if the $800 million grows to $950 million? Said hedge fund will split the $150 million dollar profits with Uncle Sam: $75 million in upside and $50 million in downside for the Hedge Fund, $75 million in upside and $750 million in downside for the government. 

On Wall Street, that’s what we call Asymmetrical Risk. Particularly for the government.

So why bring Wall Street in on the action at all? Why doesn’t the government just buy the troubled assets themselves, as it originally intended (only with more borrowed FDIC-backed funds?) Supposedly, we need someone to price these securities so the government doesn’t get ripped off (admittedly, a likely scenario, and one that's almost required if the banks are going to get enough money to get back to even.) 

But then, we have fund managers price stocks and bonds for us in our model portfolios. That’s what we pay them often less than 1% to do – and that’s a small individual account. Why not just pay Wall Street a small management fee to manage the portfolio for the government, similar to a pension fund? Who knows. Perhaps the government just doesn’t want to appear to be nationalizing this much of the financial services industry or taking on this much risk. Having some Wall Street paws in the mix makes it look more "free market" with shared upside and downside. We get the distinct sensation the government is more concerned with how things appear than how they'll actually work out. Of course, in light of the recent near-mob mentality surrounding the announcement of the AIG bonuses, perhaps they have a point. 

Why the government doesn’t just lend people money to go buy homes, with no fear of losses beyond a small down payment, as a way to support the actual declining assets – homes - that caused the mess in the first place, is still unknown. Even if banks could resume lending, it's unclear if consumers want to resume borrowing now that they've suddenly been made painfully aware of the concept of real estate downside. Apparently, the producers responsible for various HGTV programs haven’t yet received the memo about housing prices.

Anyway, this is the sort of insanity we’re now dealing with month to month in the markets. We can’t complain, though, because some of our new buys are benefiting from these plans. For now, at least.