Tuesday, October 12, 2010

3rd Qtr 2010 Review and Currency Wars


Written October 7th, 2010

The 2007 scenario we envisioned a few months ago continues to play out with large trading ranges in the equity market and a Euro that is gaining speed into the end of the year, a period seasonally strong for the common currency.

The recent hint by the Fed of a possible new round of Quantitative Easing set off a rally in commodities, gold and in most currencies versus the US Dollar. Equities and bonds have also benefited equally even though based on two diametrically opposed theories: the bond market perceives QE as a desperate response to unstoppable deflationary forces and the equity market perceives the additional injection of liquidity as the fuel for future growth and inflated P/E ratios. In a global economic system, Fed actions have international ramifications and a currency war seems to be starting among most economies: last month Japan intervened to sell Yen against the Dollar (even though their primary target would be the Renmimbi) and it announced its own QE program. Brazil and most other emerging markets are finding their currencies overheating and it will not take much before a global agreement is worked out or more protectionist policies will be adopted.

This state of affairs continues to make our strategies a valid solution for asset allocation: inflation protected securities and gold would seem to continue benefiting even though a temporary correction seems rather probable. As far as equities, if the bond market is right and the economic slowdown ends up being much more significant than anticipated, this asset class is indeed a bit overvalued; however, when compared to US Treasuries, equities don’t seem so scary.

Master Limited Partnerships have done extremely well this year handily beating broad market indexes; in absolute terms they seem expensive but in relative terms – measured by the spread of their distribution versus the yield on the 10 year UST – they still represent good value. MLP are now paying about 370 basis points over Treasuries, well above the 320 average spread and much above the 250 spread which has in the past indicated sector overvaluation.

Looking at the final stretch of this 2010, we cannot forget the upcoming November elections which may affect market direction. Overall, performance anxiety may stat to dictate market posture either way; in other words, I would expect buyers above and sellers below the recent range.

Corporate bonds which have performed very well since the 2008 lows are beginning to seem a bit pricey and a trimming of the exposure is in order.

--Davide Accomazzo, Managing Director

(This article was written on October 7, 2010)

Reversing the Model’s Line of Causation

The 1970s was a crucial turning point in the history of 20th century gold markets. The costs of the Vietnam War and increased domestic spending had the effect of accelerating inflation. Meanwhile, US gold stock declined to $10 billion versus outstanding foreign dollar holdings estimated at about $80 billion.[1] Prior to that, the London Gold Pool made up of seven European central banks and the US Federal Reserve, a group which cooperated in maintaining the Bretton Woods System, found itself increasingly unable to balance the outflow of gold reserves and defend the fixed gold price of US$35.[2]

On August 15, 1971, President Nixon, a self-proclaimed Republican “conservative,”[3] imposed a 90-day wage and price control program and other various expansionary fiscal policies in what became known as the “Nixon Shock”[4]. Most importantly, Nixon closed the gold window to prevent foreign governments that had been holding dollar-denominated financial assets from demanding gold in exchange for their dollars. By March 1973, all of the major world currencies were floating and in November 1975, the G-7 (i.e, Group of Seven) formed to hammer out the final details on a framework for a new monetary system. That agreement, which was finalized in January 1976, called for an end to the role of gold, the establishment of SDRs as the principal reserve asset, and legitimized the de facto system of fiat currencies and floating exchange rates.

The reason for retelling this story is because these events, along with a collapse in gold prices after peaking on January 21, 1980 at the high price of $850, led directly to formation of the gold leasing market during the mid-1980s. Gold loans evolved as a means for central banks to earn a return on their bullion inventories to cover the cost of warehousing bullion[5][6] by either leasing or swapping[7] gold in exchange for a lease rate. This rate is derived from the difference between the LIBOR and Gold Forward Offered (GOFO) rate.

A leasing transaction involves a central bank transferring ownership to a leasing institution (i.e., borrower), who could then sell the gold on the spot market and invest the proceeds. At a later date, the borrower would buy back the gold and return it to the central bank while paying the lease rate. Because gold could be leased at a relatively low rate from the central bank and then sold quickly on the spot market, participants in this market included gold producers who thereby gained cash to finance gold production at a comparatively low rate of interest, while simultaneously hedging against falling gold prices.[8]

The market for gold loans developed quickly after the October 1987 stock market crash left many mining companies with reduced access to capital. Prior to 1990, GOFO rates for gold normally were below 2 percent on an annualized basis and never exceeded 3 percent, providing an inexpensive source of finance for mining companies.[9] The Financial Times reported that some 30 central banks were estimated to have engaged in gold loans around this time.[10] Then in 1990 Drexel Burnham Lambert collapsed with large outstanding gold liabilities to many central banks, resulting in increased wariness and reduced supply of gold loans from central banks.[11] As a result, lease rates rose reflecting an increased tightness in the market after the loss of central bank suppliers, as well as a substantial risk premium over the implicit cost of providing such loans.

Nevertheless, the market for gold loans grew throughout the 1990s, and an informal global interbank system developed permitting dealers to borrow gold on a short-term basis in order to fulfill delivery requirements. When bullion subsequently dropped below $300 an ounce in late 1997, and drifted in that range through 2002 in what is now referred to as the “Brown Bottom,”[12] the gold carry trade came to dominate the derivatives markets. Gold’s steady appreciation since 2002, however, has rendered this trade obsolete. As a result, there has been a wholesale transformation in the gold market since the millennium began.

In a research paper published by the Swiss Finance Institute (SFI) titled, On the Lease Rate the Convenience Yield and Speculative Effects in the Gold Futures Market, the authors examine this aspect of the gold market in detail. They too note that, “…since late 2001, the profitability of the carry trade has diminished. Rising gold prices have increased risk and diminished the trade’s profitability as a result of increasing repayment costs. Consequently, the prevalence of the gold carry trade is predicated on two factors: the rate at which the central bank is willing to swap or lease gold, and whether or not the gold price is increasing.” Further, the authors Barone-Adesi, Geman and Theal (2009) observe that the COMEX “is witnessing historically low derived lease rates, decreasing hedging activity and steadily rising non-commercial open interest.”

The reason why is because the gold carry trade is risky on two dimensions. First, if the borrower invests in long-term bonds, rising interest rates could cause downward pressure on bond prices exposing the leasing institution to principal risk. Second, since the borrower is effectively short gold, if the loan is called by the central bank and gold has risen in value, they may have to purchase gold at a higher price in the spot market. Hence, there always exists the potential of driving up gold prices even higher due to short covering. This unwinding of the carry trade, as with other similar trades (e.g., yen carry trade), can result in volatile markets.

The question then is to what extent is speculation having a “tangible effect” on gold valuations, and “if so, by what mechanism does speculation influence prices?” The SFI paper points out other academics, such as Kocagil (1997), who defined “speculative intensity” as the “spread between the futures and expected spot price,” and concluded that “speculation increases spot price volatility and thus has a destabilizing effect on price.” Another researcher, Abken (1980), based his analysis on the intuition that the only return that gold yields is based on the anticipated appreciation of gold above “any marginal costs associated with the storage of gold.” Abken further argues that, “during times of uncertainty, excess demand for gold as a store of value [drives] up the spot price causing stored gold to be brought to market.”

The authors of the SFI paper, on the other hand, base part of their methodology on the work of Houthakker (1957), one of the first researchers to use trader commitment data to study speculation. To understand how speculative agents can affect the gold futures market, Barone-Adesi et al. (2009) examine the open interest data from the CFTC Commitment of Traders (CoT) report, thereby identifying commercial open interest with hedging activity, and conversely, non-commercial positions with speculative activity. The authors also study the relationship between gold leasing and the level of COMEX discretionary inventory.

Not surprisingly, Barone-Adesi et al. (2009) arrive at obvious conclusions: First, they note an ever-increasing percentage of non-commercial open interest reflects increased speculation in the gold market. Second, “the lease rate and the speculative pressure appear to work in opposition to one another; the former acts to decrease short-term bullion inventories via lease repayments, while the latter result suggests speculators dominate leasing activity in the long term… Finally, the presence of speculation in gold futures contracts can be associated with increased futures contract returns and that this effect increases with increased futures contract maturity.” What these observations suggest in their entirety is that “speculation plays a significant role in the COMEX gold futures market” as opposed to hedging activities.

Uh, okay… but isn’t this a foregone conclusion? Albeit, On the Lease Rate the Convenience Yield and Speculative Effects in the Gold Futures Market derives its determinations from some interesting theoretical ideas between the relationship of gold loans, bullion inventories, convenience yield and speculation; but in the final analysis the SFI paper raises the specter of Muth’s (1961) Rational Expectations and the Theory of Price Movements: “In order to explain fairly simply how expectations are formed, we advance the hypothesis that they are essentially the same as the predictions of the relevant economic theory.”

In other words, models unfortunately have the bad habit of assuming a predetermined conclusion around which expectations are formed, which in effect reverses the model’s line of causation. Our conclusion: research bias, the process where the scientists performing the research influence the results in order to portray a certain outcome, seems to be at work here—even though we happen to agree with such paper’s conclusions.

- Mack Frankfurter, Managing Director

On the Lease Rate and Convenience Yield of Gold Futures

[1] Spero, Joan Edelman, and Hart, Jeffrey A. (2010). The Politics of International Economic Relations. 7th ed. (originally published 1977). Boston, MA: Wadsworth Cengage Learning.

[2] Bordo, Michael D., and Barry J. Eichengreen (1993). A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. University of Chicago Press. pp. 461–494 “Chapter 9, Collapse of the Bretton Woods Fixed Rate Exchange System” by Peter M. Garber.

[3] Nixon tape conversation No. 607-11.

[4] “The Economy: Changing the World's Money” Time Magazine, Oct. 4, 1971 [First reference by Time of “Nixon Shock”]; http://www.time.com/time/magazine/article/0,9171,905418,00.html

[5] “Bullish on Bullion” by Peter Madigan, Risk Magazine, Feb. 1, 2008, Incisive Media Ltd.

[6] According to O’Callaghan, Gary (1991), two key disadvantages in holding gold as opposed to a financial instrument are storage costs and the fact that holding gold does not bear interest.

[7] A gold swap is essentially a transaction whereby gold is exchanged for currency.

[8] O’Callaghan, Gary (1991). The Structure and Operation of the World Gold Market. International Monetary Fund, IMF Working Paper WP/91/120, Master Files Room C-525, p 33.

[9] Ibid. pp 33-34.

[10] Gooding, Kenneth, “Gold Lending Rate at Record Level,” Financial Times (London), Dec. 4, 1990, p 34.

[11] “Fool’s Gold,” The Economist, Mar. 17, 1990, p 79.

[12] Term used to describe the period between 1999 and 2002, named from the decision of Gordon Brown, then the UK's Chancellor of the Exchequer to sell half of the UK's gold reserves in a series of auctions.

Barone-Adesi, Giovanni, Geman, Hélyette and Theal, John (2009). “On the Lease Rate, the Convenience Yield and Speculative Effects in the Gold Futures Market” (March 12, 2009). Swiss Finance Institute Research Paper No. 09-07.

Bordo, Michael D., and Barry J. Eichengreen (1993). A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform. University of Chicago Press. pp. 461–494 “Chapter 9, Collapse of the Bretton Woods Fixed Rate Exchange System” by Peter M. Garber.

O’Callaghan, Gary (1991). “The Structure and Operation of the World Gold Market” International Monetary Fund, IMF Working Paper WP/91/120, Master Files Room C-525

Spero, Joan Edelman, and Hart, Jeffrey A. (2010). The Politics of International Economic Relations. 7th ed. (originally published 1977). Boston, MA: Wadsworth Cengage Learning.

Wednesday, April 7, 2010

1st Qtr 2010 Review and Imploded Volatility


The first three months of 2010 have come and gone and not much changed from the momentum and liquidity driven market of 2009. Volatility continues to hit lower and lower levels while the S&P 500 seems unstoppable toward that 1200 level which, when broken to the downside in 2008, ushered in an almost terminal stroke to our financial system.

In the first quarter, the S&P 500 benchmark produced a net gain of 4.84% while the Volatility Index (VIX) collapsed almost 20%. Among other benchmarks we follow, gold in its ETF format (GLD) put on a positive 1.53% and our beloved MLP sector roared ahead by 6.22% (AMZ index).

The equity market did have a sizable yet incredibly short lived correction which started – in full accordance with seasonality – in the second half of January. This 9% correction stopped short of the traditional 10% pull-back mark and a bit short of the 200 day moving average and produced yet another V shaped rally which took the indexes to new relative highs.

This rally has made stocks not so attractive on a fundamental basis. Discounted cash flow models such as the Morningstar Fair Value model are now oscillating between overvalued and fair valued. Also, the general rise in Treasury yields is not helping valuations as fixed income becomes more attractive and valuation multiples like P/E ratios tend to shrink in a rising interest rates environment.

Most sentiment driven indicators are now in overbought mode; the percentage of stocks above the 50 day moving average and most Put and Call ratios for instance. On the other hand, one input which indicates smooth sailing ahead was highlighted by Bloomberg today: only 28% of operating profits are now spent in buybacks (2009 numbers) by companies in the S&P 500, and the last time we saw such a low levels in buybacks equities rallied for four years.

The “risk trade” is on for most asset classes, except the Treasuries. When one looks at the 10 month moving average cross-over indicator US equities, global equities, commodities and real estate are all above the average and therefore in long term buy mode. However, 10 year Treasuries are on sell mode.

On the fixed income side, we happen to agree with PIMCO, and we favor inflation protected securities in countries with large deficits and traditional sovereign debt in surplus countries. In light of this analysis, we repositioned many accounts and increased exposure to inflation protected securities (via TIP) and German sovereign debt (via closed-end fund RCS whose largest single position is a 2015 German Sovereign bond).

In the emerging markets space, we still like Brazil and we still think this is the better place to be in the long term out of the BRICs. Brazilian fixed income is also very attractive but we have no positions in it at the moment.

The US Dollar also increased since the beginning of the year by almost 4% (DX). One of the biggest relative losers was the EUR which shed about 6% thanks to, among other reasons, its inability to produce a crisis management protocol to deal with situations such as the Greek farce. We think the EUR is still a sell but are careful at this level since the short position is dramatically large. We did not trade the EUR particularly well this past quarter and while our thesis was correct, our execution tried to be “too cute” and our attempt to trade on a short term basis the long side inside our core short position unfortunately backfired. We are not so hot about the Yen either as we think that Japan will continue to keep rates low while the US may be more proactive in normalizing.

On the commodity side, as mentioned earlier, the 10 month moving average indicator triggered a new buy signal confirmed by break-outs in crude and copper. This may reflect that inflation is starting to creep into the equation. TIPs anyone?

--Davide Accomazzo, Managing Director
(This article was written on April 5, 2010)

Hamilton and Minsky's Instability Hypothesis

"Men often oppose a thing merely because they have had no agency in planning it, or because it may have been planned by those whom they dislike." ~Alexander Hamilton

Almost exactly two hundred years before Hyman Minsky published his paper The Financial Instability Hypothesis in 1992 (the relevance which will become apparent), a blind pool[1] known as the “six percent club” was engaged in the first market corner in the history of the United States. According to traditional accounts,[2] the Panic of 1792 was caused by the scheming and operations of William Duer, a well-connected businessman and speculator, who had recently resigned from his brief post as assistant secretary of the treasury of the newly formed country.

It all started when Treasury Secretary Alexander Hamilton put into action a plan to buy at par value the millions of dollars in promissory notes that the bankrupt Continental Congress and state governments had issued to soldiers, farmers, and other’s who had supported the Revolution. Duer, who combined government service with a passion for quick profits, leaked word to his fellow “grandees” that Hamilton intended to consolidate these debts with federal debt. Recognizing Hamilton’s plan as a way to make a killing, agents of Duer’s secret circle were soon galloping across the countryside buying up state paper at a few cents on the dollar.[3]

As a homily to the present-day bailout of the financial system wherein information asymmetry has become a recurrent headline about the markets,[4] Duer’s anecdote has some interesting parallels were it to end here. This brief episode, however, set in motion a series of events which ultimately led Hamilton to invent what in time would be termed Bagehot’s rules[5] for how a central bank should act in a crisis some [eight] decades before Walter Bagehot “rediscovered” them.[6]

In December 1790, Congress adopted Hamilton’s recommendations.[7] Old evidences of debt were already being exchanged for new federal debt in the form of 6% bonds, 6% deferred bonds and 3% bonds starting in October 1790.[8] These bonds were soon trading on America’s first “stock” exchange under a buttonwood tree at the foot of Wall Street. Hence, it was these very same events which presaged the origins of the New York Stock Exchange when twenty-four New York City stockbrokers and merchants signed the Buttonwood Agreement in 1792.

Around this time Hamilton had also called for Congress to incorporate a Bank of the United States capitalized with 25,000 shares of $400 par value each.[8] Noting that speculation was already brisk in federal 6% notes, Hamilton attempted to check a similar fever in the Bank’s stock by requiring $100 in specie[9] along with $300 in new United States debt securities. However, “Congress, already demonstrating an eagerness to please as many people as possible,” reduced the opening payment to $25 for a scrip”[10] which effectively served as a subscription right.

The initial offering took place on July 4, 1791 and was heavily oversubscribed. In five weeks the value of scrip soared reaching 264 bid-280 ask in New York and more than 300 in Philadelphia before tumbling. The so-called “U.S. sixes” rose from 90 at the time of the Bank’s offering to 112.50 on August 13th before falling to 100 by August 17th. In response, Hamilton convened a meeting of the Commissioners of the Sinking Fund which authorized open market purchases of U.S. debt. Working through various agents, Hamilton restored confidence by supporting the bond market.[8]

It turns out that the mini-panic of August 1791 served as “a trial run for the crisis-containment techniques Hamilton was to employ during the more serious price collapse in March-April 1792.”[8] In fact, Hamilton’s actions in 1791 illustrate the mixed blessings of crisis management in that his response may have encouraged the speculative bubble that followed. Almost two centuries later Alan Greenspan responded similarly to the stock market crash of 1987 as well as subsequent crisis during his tenure. As been argued, by coming to the aid of the market and creating the notion of a “Greenspan put,” the moral-hazard problem may have sowed the seeds of our current crisis.

This is where Minsky enters the picture. A little over a decade ago, the term “Minsky moment” was coined to describe the Russian debt crisis in 1998 which proceeded the fall of Long Term Capital Management. Minsky observed “that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control.” The Minsky moment occurs after a long period of prosperity in which debt is increasingly used to finance investments, in turn causing the value of assets to rise, which reflexively encourages speculation using borrowed money. At the point when investors’ cash flow no longer supports debt, a major selloff begins leading to a precipitous collapse in asset prices and market liquidity.

Theoretically, one could link the current financial crisis to a Minsky moment caused by the failure of two Bear Stearns hedge funds circa June 2007 resulting in the “reverse Minsky journey”.[11] The irony is hard not to miss in the following passage of Minsky’s paper:

Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities… For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts... Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts. [Bold added]
As Minsky points out, if authorities attempt to exorcise monetary constraint in “an economy with a sizeable body of speculative financial units… then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate.” Notwithstanding the obvious inference to the Madoff affair, the Oracle of Omaha, Warren Buffet, concisely summarized that, “Only when the tide goes out do you discover who's been swimming naked.”

The common factor distinguishing the difference between Minsky’s hedge, speculative, and Ponzi finance units is liquidity. Liquidity is conventionally defined as, “the ability of an asset to be converted into cash quickly and without any price discount”.[12] It has been said that the root of the current liquidity crisis is a lack of confidence—confidence basically disappeared and liquidity evaporated. But this behavioral observation is both simplistic and obscures turnkey concepts.

The exchange of money involves a valid and legal offer of payment for debts when tendered to a creditor. A debtor who is unable or unwilling to meet the legal obligations of a debt contract by not making a scheduled payment is said to have defaulted. In a very narrow sense, legal tender is a form of payment that, by law, functions in the settlement and discharge of debt. “There is, however, no Federal statute mandating [a person] must accept currency or coins as for payment for goods and/or services.”[13] A case study in non-payment is the recent default by debtor Tishman Speyer Properties on the Peter Cooper Village and Stuyvesant Town complex in Manhattan.

In 2006, Tishman Speyer headed a venture to acquire the 11,000 unit property for $5.4 billion—the most ever paid for a residential property in the U.S. Of that price tag, Tishman Speyer only invested $168 million; however, CalPERS, Church of England, Hartford Financial and even the Government of Singapore are in danger of having their investments wiped out. The venture’s acquisition was controversial to begin with as plans were to raise rents in the middle-class haven. The strategy backfired because of the economy and a court ruling which prevented conversion of rent-controlled units to market rates. As a result, the property depleted what was left in its reserve funds.[14] Tishman Speyer, having been closed out of the capital markets, essentially faced a liquidity crisis from a levered deal which could not be supported by the property’s revenues from rentals.

William Duer also faced a liquidity issue in March of 1792. After Hamilton intervened in 1791 by purchasing “U.S. sixes,” confidence was quickly restored. However, rather than learning his lesson, Duer and other members of his speculative “company” borrowed large amounts of money and rapidly drove up securities prices during the latter half of 1791. When Duer finally defaulted in 1792, it caused a contagion of defaults and panic selling. In response, Hamilton began “a series of lender-of-last resort operations that would last for several weeks as the panic went on”.[8]

- Mack Frankfurter, Managing Director

Bagehot, Walter (1873). “Lombard street: a description of the money market.” London: Henry S. King.

Fleming, Thomas (2009). “Wall Street’s First Collapse.” American Heritage Magazine, Volume 58, Issue 6.

Fraser, Steve (2005). “Every Man a Speculator History of Wall Street in American Life.” Harper Perennial.

Lahart, Justin (2007). “In Time of Tumult, Obscure Economist Gains Currency.” WSJ (August 18, 2007).

Madison, James. “The Federalist No. 44, Restrictions on the Authority of Several States.” (Jan. 25, 1788).

Markham, Jerry W. (2001). “A financial history of the United States.” Armonk, N.Y.: M.E. Sharpe.

McCulley, Paul (2007). “A Reverse Minsky Journey.” October 2007. http://tinyurl.com/2sbogw

Minsky, Hyman P. (1992). “The Financial Instability Hypothesis.” Working Paper No. 74, The Jerome Levy Economics Institute of Bard College, Prepared for Handbook of Radical Political Economy, edited by Phylip Arestis and Malcolm Sawyer, Edward Elgar: Adershot, 1993.

[1] A “blind pool” is an investment vehicle that raises capital from the public without telling investors how their funds will be utilized.

[2] According to Cowen, Sylla and Wright (2006), “Although specialists in financial history have known of the 1792 panic for decades, at least since Davis (1917) explored it in some detail, it did not make a strong impression on others.” Further, “The traditional account is not incorrect, but it is incomplete. Other events were unfolding at the time that are ignored or slighted in the traditional account.”

[3] Fleming, Thomas (2009). “Wall Street’s First Collapse,” American Heritage Magazine, Volume 58, Issue 6. See also: Fraser, Steve (2005). “Every Man a Speculator History of Wall Street in American Life,” HarperCollins.

[4] Information asymmetry encompasses “insider trading” (eg, indictment of Galleon Group founder Raj Rajaratnam); and “front-running” (eg, trading ahead of customer orders, trading ahead of research reports, etc.)

[5] “[T]o avert panic, central banks should lend early and freely, to solvent firms, against good collateral, and at ‘high rates.’” Bagehot, Walter (1873). “Lombard street: a description of the money market.” London: Henry S. King.

[6] Sylla, Richard; Wright, Robert E.; and Cowen, David J. (2006). “The U.S. Panic of 1792: Financial Crisis Management and the Lender of Last Resort.” Prepared for NBER DAE Summer Institute, July 2006.

[7] Knowledge that the new federal bonds could also be used at par to subscribe for three-fourths of the cost of a share in the Bank of the United States was officially made public in the Bank Report of December 13, 1790.

[8] Sylla, Richard; Wright, Robert E.; and Cowen, David J. (2006). “The U.S. Panic of 1792: Financial Crisis Management and the Lender of Last Resort.” Prepared for NBER DAE Summer Institute, July 2006.

[9] Latin phrase. It is used to indicate that distribution of an asset will be “in its actual form,” rather than cash.

[10] Fleming, Thomas (2009). “Wall Street’s First Collapse,” American Heritage Magazine, Volume 58, Issue 6.

[11] Term “reverse Minsky journey” is attributable to Paul McCulley of PIMCO, “A Reverse Minsky Journey,” October 2007. http://tinyurl.com/2sbogw

[12] “Glossary of Terms”, Federal Reserve Bank of St. Louis, September 2009

[13] U.S. Department of Treasury, http://tinyurl.com/36suqq

[14] Wei, Lingling and Spector, Mike. “Tishman Venture Gives Up Stuyvesant Project,” WSJ (January 25, 2010).

Monday, January 4, 2010

2009 Year End Thoughts and Policy Risks


In October 2008 things got bad, then in March 2009 it got worse, but now it is all better... or is it? The coordinated government and central bank intervention was on a magnitude not seen even during the 1930s (see table below). Yet despite the 66% rally since the March lows, “many of the bulls don’t appreciate just how much the government props still under the economy are masking its weakness,” says Pimco’s CEO, El-Erian. As for Cervino Capital, we admit playing 2009 over-defensively in light of such “unimaginable” stimulus, having maintained throughout the year primarily a delta-neutral position when in hindsight we should have been delta long. As a result, the market’s momentum and upside persistence resulted in our put-side hedges sapping returns, while our call-side premium writes causing us to continuously manage that risk.

Nevertheless, our Diversified Options Strategy is ending the year positive—the fourth in a row—in line with our absolute return objective. In fact, since inception in January 2006, our non-leveraged D1X program has returned 26.88% whereas the S&P 500 returned -10.66%. At the same time, we managed to generate this performance with a Sharpe Ratio of 1.15 versus -0.16 for the S&P 500, and a beta of 0.06 which is essentially non-correlated to the S&P 500. In light of an economic crisis not seen in generations and an unprecedented government and central bank response, given that we are mainly trading options on the S&P 500, this is seen as an accomplishment. The key to superior money management from our perspective remains strategy discipline and risk management.

To say the least 2009 was a strange year. Dubbed “the Great Recession,” the current economic period which follows the excesses of the past decade has resulted in a magma of monetary and fiscal interventionism, superficial stabilization of the financial system, historically large unemployment and more confusion on the future of our economy. Capitalism survived but only nominally as central bank intervention, albeit mostly unavoidable, corrupted the true price discovery process of most asset classes. The law of unintended consequences is already at work and those who actively engage in financial activities–-whether virtually by trading or on the ground by building businesses-–have already felt the winds of change. Markets do not move as they used to, and micro and macro economic dynamics do not interact as business schools have taught us for decades. Political divining is now more important than ever as an element of decision-making and so is subtle understanding of monetary policy. If the last 25 years was representative of aggressive entrepreneurship, the next 10-25 years will probably require superior coziness with government.

But what does all this mean for the future of investing? How should we position ourselves and where should our chips land? I believe that the fluidity of the situation requires flexibility, diversification of asset classes and strategies, and much work toward aligning your interests with governments. More specifically, I believe asset class timing must be part of the process and alpha driven strategies should be the core of every portfolio. Unless global GDP growth wildly exceeds the expected 4% rate, it is difficult to imagine significant multiple expansion from here. 2010 may bring about the kind of environment where investors should be prepared for constant cross-currents and no defined trends. Equities may still do fine as a result of liquidity pressures and by benefiting from potential pockets of resurging globalization, but I see such market action as collared. If in the nineties we learned to trade the “Greenspan put,” this new dawn may bring about the “Bernanke collar.”

The elephant in the room could be the US Dollar. The greenback has showed an inverse correlation with equities for much of this decade as part of the liquidity/leverage boom bust cycle. The degree of bearishness on the USD reached significant levels in the last quarter of the year and eventually resulted in a strong rebound. At this point a lot of USD bearishness has been corrected and the outlook for next year depends on many variables.

The bearish argument resides on the idea of massive FED money printing and large fiscal deficits. While I cannot argue against this idea, I would caution on the timing of it. As of now the FED has not actually printed much money and most of its intervention was either done thru electronic adjustments and stabilization types of credit facilities. Most of the liquidity injected is just sitting on banks balance sheets and it is very short term in nature. Should that liquidity be channeled into the real economy and multiplied by our fractional system then the inflation worry would materialize.

This scenario may be one to two years away and it is subject to many variables. In this case, the USD would suffer and equities could increase in nominal values. On the other hand, I think a more likely scenario in the intermediate term is a continuation of the deleveraging of private sector balance sheets; this would entail a stronger USD and possibly sagging equities. I feel a stronger USD is in the cards also because of its relative position versus the Euro. While we have significant issues to work thru in our effort to stabilize our economic cycle, I believe Euroland has higher sovereign risk (Spain, Greece, Italy, Baltic States) and more structural and political restrictions to maneuver.

What the USD may do in the next twelve months has repercussions on commodities as well. If the USD gets stronger, there would be less pressure on commodities (priced in USD globally) to re-adjust upward. However, if all global currencies accelerate the new trend of competitive devaluation, then commodities and gold especially will continue to benefit from investment flows. Political divining and close monetary policy scrutiny will be paramount in dealing with this unfolding issue.

On the other hand, stocks are not as expensive as they have been for most of the last 15 years and they should benefit, in case of sudden economic dislocation, by the generosity of global central banks which understand very well the role of confidence in perpetuating the system. Volatility is hovering around its 15 year moving average (as measured by the VIX) indicating neither panic nor complacency within an historical perspective.

Diversified high yield portfolios still seem to make sense in a world where yields are very compressed; MLPs and fixed income closed end funds still bring value to the table but timing and risk control are still forefront issues. The spread of MLPs as an asset class versus the 10 year Treasuries has now fallen below 400 basis points and spreads are at low levels indicating short-term caution. The key term is short-term. On that level most studies I have been looking at are flashing caution for equities in general: corporate insiders sales, smart/dumb money spreads, stock/bond ratios, options indicators. Mid January could present us with a tradable correction. A more pronounced two way trading than the V shaped momentum driven environment of 2009 would play well for alpha strategies like our options trading programs to outperform the benchmarks.

In conclusion, I would like to take a moment to thank all of our clients that believe in our strategies, risk management and unbiased analysis. At Cervino Capital Management LLC we strive every day (and almost every night considering our different shifts) to be the best money managers as we relentlessly push the boundaries of analysis in the never ending quest for alpha.

--Davide Accomazzo, Managing Director

It's the End of the World As We Know It

Marcellus: Something is rotten in the state of Denmark.
--William Shakespeare, Hamlet Act 1, scene 4

In the 1950s, Leon Festinger and two others infiltrated a UFO doomsday cult that was expecting the imminent end of the world on a certain date, and documented the increased proselytization they exhibited after the leader’s “end of the world” prophecy failed to come true. The prediction of the Earth's destruction, supposedly sent by aliens to the leader of the group, became a disconfirmed expectancy that caused dissonance between the cognitions, “the world is going to end” and “the world did not end”. Although some members abandoned the group when the prophecy failed, most of the members lessened their dissonance by accepting a new belief—that the planet was spared because of the faith of the group.

The economic crisis of the last two years provides a haunting corollary to Festinger’s study. In an interview on CSPAN on January 27, 2009, House Representative Paul Kanjorski defended the original emergency actions by the United States government to halt the financial crisis. Kanjorski stated that the move to raise the guarantee money funds up to $250,000 was an emergency measure to stave off a massive “electronic run” on money markets that removed $550 billion from the system in a matter of hours on the morning of September 18, 2008. He further asserted that, if not stopped, the run would not only have caused the American economy to crash immediately, within 24 hours it would have brought down the world economy as well.

As the “end of the world” did not come to pass, there are those who question Kanjorski’s account such as Felix Salmon of Condé Nast Portfolio; although financial writer Daniel Gross confirmed some elements of the story, but prefaced his remarks by saying “I don’t know if his numbers are 100 percent correct”. Such criticism raises the question of how we prejudice “fact” from “truthiness” in the so-called "soft science" of economics, which in turn leads to questions about the assumptions underlying economic models. Joseph Stiglitz, the Nobel Prize-winning economist and Columbia University professor, stated that economists are among those at fault for the financial crisis, which exposed “major flaws” in prevailing ideas. The now-flawed premises include the ideas that economic participants behave rationally and that financial markets are competitive and efficient. In a damning remark, Stiglitz claimed that “Globalization had opened up a global marketplace for fools.”

What the world economy now faces is cognitive dissonance on a global basis. The conundrum with respect to cognitive bias is that implicit in the concept is the standard of comparison. In other words, peel the onion and we’re left with the unsettling question as to which denomination do we use to value assets. Relativity, it seems, goes to the very heart of the inflation versus deflation debate. Are investors making rational decisions as a result of the currency in which they form their perspective of valuation? In a world in which the US dollar is no longer the world’s reserve currency, what substitutes as safehaven in a “flight to quality”?

The question of how banks manage their collateral deals with other financial players is usually not of interest to ordinary investors. Until recently, the widely held assumption that the credit standing of European countries and the US was secure resulted in banks not demanding collateral when sovereign entities are involved. Similarly, when banks made loans to western sovereign nations, they typically do not post big reserves since such debt is deemed “zero-risk weighted” in bank regulatory rules. However, as a result of seemingly remote events, or “tail risks” having come to fruition these past two years, debt default in a developed country is no longer unthinkable. In fact, once upon a time even the US repudiated its debt in 1933 by outlawing the private ownership of gold, and requiring creditors to be paid in “legal tender coin or currency”.

The Triffin dilemma is the fundamental problem of the US dollar's role as the world’s reserve currency leading to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, particularly in the US current account. According to Martin Wolf, chief economics commentator of the Financial Times, the host nation of a global reserve currency will inevitably run up a huge current account deficit that undermines the credibility of its currency and adversely impact the global economy. As it stands, the US currently has a national debt in excess of $12 trillion or almost $40,000 per citizen, with a debt to GDP ratio of more than 85 percent. “On the dollar, there is nothing to support this currency except the Chinese government and a few other governments that are prepared to buy it,” said Wolf at an event organized by the Singapore Institute of International Affairs.

More so, the perverse vendor-financing relationship between the Chinese renminbi and US dollar is highly destabilizing for the euro zone economy. The European Commission recently warned that public finances in half of the 16 euro-zone nations are at high risk of becoming unsustainable. Because there is little chance of European governments intervening in the foreign exchange markets to improve the competitiveness of the euro, American policy is effectively “shifting the recession from them(selves) to their trading partners,” according to Wolf. The decline of the US dollar underscores a phase of global power transition, with the balance of power moving from the US to Europe, China and India, Wolf argues, adding that the greenback’s loss of credibility as the dominant global reserve currency is part of this messy transition.

It is with this context in mind that one can begin to analyze the cognitive dissonance arising from the fundamental problem that the US cannot resolve this credit crisis by issuing more debt. Yet with the White House announcing that it had eliminated the maximum bailout cap for Fannie Mae and Freddie Mac on Christmas Eve, it seems that US policy-makers are finding yet another way to extend the process of quantitative easing. Such rule changes are the “tip of the spear” in a whole range of unprecedented policy actions which have hugely grown the monetary base in the hope that such action will “reflate” the economy. One likes to think that the US is a government-of-laws-not-men presiding over a level playing field, but in an effort to “save us from ourselves” it now seems that the US is constantly changing the rules anytime it wants. Unfortunately, such actions can only have the detrimental effect of undermining the moral standing of the US dollar long term. As the song says, “it’s the end of the world as we know, but I feel fine”.

- Mack Frankfurter, Managing Director