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June 21, 2007

"Goldilocks" 65 Basis Pts Higher
by Econotech

"Goldilocks" 65 Basis Pts Higher; Public Equity Mkts Lopsided Info Disadvantage; Emerging Mkts 2 Std Dev Above Trend; Laggard Large Cap/Tech Rise

June 21 -- (Econotech FHPN)

"Last month, Enhanced Leverage reported that its value fell 6.75% in April after the [hedge] fund's bets on the mortgage market went wrong. Two weeks later, it put the loss at 18%, spooking already-nervous investors and creditors and sending many of them running for the exits. The huge revision at least in part reflected conversations Bear Stearns hedge-fund managers had with bond dealers, three of which told them in late April that some of the funds' assets were worth less than the values stated on the funds' books ... "No one in the subprime business wants to ask the question of whether they need to re-mark all the assets. That would open the floodgates," said Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm in Chicago. "Everyone is trying to stop the problem, but they should face up to it. The assets may all be mispriced."" "Two Big Funds At Bear Stearns Face Shutdown," WSJ, June 20, front page

"The giant market for securities backed by US subprime mortgages was thrown into turmoil on Wednesday as lenders struggled to sell more than $1bn of assets seized from two Bear Stearns hedge funds that suffered heavy losses on subprime bets. The complex securities being auctioned are rarely traded and early attempts to sell the collateral met with mixed results. The prospect of the "fire sale" knocked down prices for similar mortgage-backed assets and sent a key derivative index for the market to record lows. The rout highlights the risks investors take when they buy illiquid and hard-to-value securities. Fire sales in times of stress can trigger dramatic changes in pricing in such markets, perhaps leading other holders of assets to mark their values down and triggering demands for additional collateral from lenders." FT, June 21, front-page

""It's a blood bath," said Mark Kiesel, [EVP of Pimco], the manager of $668 billion in bond funds. "We're talking about a two- to three-year downturn that will take a whole host of characters with it, from job creation to consumer confidence. Eventually it will take the stock market and corporate profit." ... "When all these people see their mortgage payment and it's up 40 or 50 percent, they're going to say, 'We can't stay in this house,"' Pimco's Kiesel said. "And there are millions of people in this situation." ... The recent increase in mortgage rates is the biggest spike since 2004. The change means buyers can afford 8 percent less house than they could five weeks ago, Kiesel said. "Prices are going lower," he said." Bloomberg, June 20

Can Public Fund Managers Accurately Assess Private Fund Risks?

The first two quotes above are from WSJ and FT front-page articles on problems at two Bear Stearns' private hedge funds, High Grade Structured Credit Strategies Enhanced Leverage Fund and High Grade Structured Credit Strategies Fund.

The problems at these two private hedge funds is indicative of some of the financial impact of the ongoing fiasco in the subprime mortgage market, which I won't go into in this article, as it has been extensively covered everywhere else.

My focus here is on how this hedge funds' story also highlights the difficulty that public market equity investors in this 2002-07 cycle will continue to have in accurately gauging key risks in several critical areas dominated by private funds, leveraged debt and structured finance deals and derivatives.

(Btw, sorry for my article's long title, I wanted to convey all the ground covered in it. This article intersperses more pragmatic investing-oriented sections, often with charts, with ones on more "big picture" issues, as does my web site in general, so if a particular section doesn't interest you, please skip further down, thanks.)

Given that these two private hedge funds' managers themselves did not accurately know the prices (let alone values) of these structured finance assets (and Bear Stearns is considered to be one of the most knowledgeable i-banks in the mortgage markets), as indicated in the two quotes above, honestly highlighted by Tavakoli, a well-regarded expert, then what fair, honest chance does any outsider public equity investor, no matter how diligent and well-informed, have of knowing about the risks of what may happen to these two structured finance funds, and what may be their likely impact on global financial markets?

Probably virtually zero chance of accurately knowing, and that's exactly my point. And that point is not limited to whether these two particular funds may or may not work out, and what impact that may or may not have, as important as that might become.

I want to emphasize the more general point that most public equity market investors, including mutual and pension fund professionals, have no real idea what may happen not only in the case of these two particular Bear Stearns' funds, but also much more broadly no real way of accurately assessing the riskiness of potential, yet still unknown, situations in the leveraged debt, structured finance and derivatives markets, now and into the future.

And now making this public equity market information disadvantage considerably worse, the risks of playing that lopsided information game have been significantly increasing with rising 10-year rates the past few months, which is making it more difficult to even price some of the more esoteric private securities, as mentioned in the quotes above, let alone assess their real future economic value.

To re-iterate the analogy about unseen sub-surface cracks in the ice of bullish investor psychology in my June 7 article link, public equity market investors and fund managers simply have no way of being intimately familiar with the working details and hence actual risks of various critical markets, most of which are dominated by private players, especially leveraged debt and structured finance deals and derivatives, in the 2002-07 cycle. (Another key sector in this cycle, emerging markets, is also very difficult for U.S.-based equity investors to adequately assess.)

It's not that well-informed public equity market managers are not very aware of these opaque private markets and issues, many have diligently, professionally stayed on top of them, in general outline.

And these issues are well covered in the mainstream media, as indicated by the front-page quotes leading off this article, and on many informative web sites, including those I've provided links to on my web site (right below the long list of my own articles in the "Links" section on my web site link).

Nevertheless, whatever public knowledge is available is almost always from an outsider perspective into mostly private, and often deliberately opaque, markets. (Global financial regulators are often in a similar informational disadvantage situation, and along with multinational economic organizations, have been saying so for years now.)

Unfortunately for public market equity investors, these more opaque private markets are where the main financial action is in the 2002-7 global boom, one key way in which this cycle is significantly different than the tech bubble of the late 1990s. Back in that earlier bubble, when private hedge fund LTCM ran into huge trouble in Sep-Oct 1998, briefly freezing up global financial markets, the Fed stepped in with interest rate cuts and organized a bail-out, then the main action quickly shifted back to the enormous speculation in the public equity markets in 1999, with Nasdaq up over 80% in a huge torrent of legal but nevertheless essentially negligently, if not even fraudulently, mispriced IPO's.

In that bubble, which of course ultimately worked out extremely poorly for most public equity market investors in the deep bear market of 2000-02, public equity fund managers knew all the critical working details of the IPO deals they were involved in, even though they tended to get caught up in the hype and lunacy, for obvious self-gain and/or self-delusion, but were at a huge information disadvantage to the private venture capitalists and i-banks feeding the IPO's into the public markets, an inherent information disadvantage that private equity firms once again intend to take advantage of in this cycle when they sell back their LBO's into the public markets, more on this in a section below.

So, to sum up, a not insignificant risk for public market equity investors right now that I continue to believe is underappreciated is that most of them, including professional mangers of mutual and pension funds, less so in private hedge funds that are involved in many private equity and structured finance deals, are assuming a level of safety for which their daily working knowledge simply is not adequate to assume, and thus are probably overly complacent.

As I've said, public equity market investors are not unaware of the risks in their lack of working knowledge of these leveraged debt and structured finance deals, but because they do not know the deal details, most, including public market mutual and pension fund managers, seem to assume that these deals must be okay, simply because nothing has happened so far, until proven otherwise, in which case it might be too late.

For a structured finance professional's assessment of the Bear Stearns' hedge fund situation, see this June 20 video interview of Andrew Brenner on Bloomberg link.

U.S. Equity Market Valuation Now 20% Less Attractive than Three Months Ago

By my back-of-the-envelope calculation, just plugging a few numbers into the ultra-simple "Fed" valuation model, the S&P 500 is about 20% less attractive today than it was just three months ago in early March (as of June 20, the 10-year bond yield was about 12% lower back in early March, and the S&P 500 price, hence p/e, was about 10% lower back then, assuming consensus 2007 estimates haven't moved up too significantly since then, though first quarter earnings were signficantly better than previously drastically reduced expectations).

Yet so far, global financial markets don't seem to care very much. If one wanted to explain or rationalize this, then perhaps you could say markets may just be about 20% less undervalued now than they were then, though based on cyclically high earnings and profit margins, and still historically low long-term interest rates, with it still being too early to tell if that critical secular disinflationary downtrend line since the 1980s has been decisively broken. (The recent move up in long-term rates was due mainly to an increase in the extremely low term premium, since estimtates of both long-term real growth and long-term inflation have barely moved.)

Along with the still consensus belief that the combination of strong global economic growth and high liquidity continues to create a best possible "Goldilocks" investment environment, especially for record-setting m&a and lbo deals and emerging markets, the prevailing investor belief is in Goldilocks, perhaps a little heavier with 10-year bond yields 65 basis point higher, regardless of less attractive valuation levels than three months ago.

To be sure, there is no shortage of hand-wringing over this Goldilocks view. One can constantly read of all the various concerns of mainstream investors, economists, regulators, journalists, etc. consistently in Bloomberg and FT articles, let alone the more dire ones of the Net denizens.

Needless to say, one of the key sectors on everyone's radar screen remains housing, which has just had yet another leg down of bad news, mainstream views of this recent news are discussed in these two video interviews on Bloomberg on June 18, link and link.

Here is a chart of XHB, the homebuilder etf, courtesy of prophet.net (left click once to enlarge).

XHB tracks the changing sentiment regarding the outlook for the U.S. housing market. The small upturn in sentiment in the second-half of 2006 topped out in Feb with renewed concerns about sub-prime lending woes. XHB is now at its previous April 2007 low, breaking that and going toward the lows of last summer 2006 would be a poor indicator not only for this critical sector, but obviously also for the overall U.S. economy.

But so far none of these highly articulated concerns have dented global markets very much, other than throwing small periodic scares that the global hyper-speculators still quickly shrug off.

Despite far lower equity valuations, this is now getting to feel just a little similar to 1999-early 2000, perhaps not accidentally, though once again, the main excesses this time around are in the global credit, not equity, markets, valuations in the latter are far below the earlier bubble, while credit spreads remain at historically low levels, even after the recent rise in long-term rates.

I recall reading around five years ago about a study, by Ned Davis research I believe, that said that since 1950, the S&P 500 has averaged a 50% increase from its low in the second-year of the 4-year political cycle to its high in the third year.

At that time, Nasdaq had gone up up over 80% in 1999, it later went up 50% in 2003. So far this time around, as if on schedule, the S&P 500 is up 25% from its closing low of 1224 in June 2006.

Unfortunate Evolution of Global Financial Markets: Transfer of Risk to the Public for Private Gain

"Blackstone IPO seven times subscribed amid overseas demand," FT, June 21, lead headline

Today's FT lead headline on the Blackstone IPO runs opposite one that says, "Subprime sector hit by $1 bn assets sale," so while the latter sector remains in the outhouse, the private equity sector is clearly enjoying penthouse status.

Perhaps one of the key features in many aspects of the current global economic and financial landscape is the transfer of risks to the public for private gain. One sees that in the corporate sector, with "at will" employment contracts, outsourcing, pension and healthcare looting, etc., and may soon see it politically with respect to Social Security, Medicare, Medicaid, etc.

One can view much of what is going in the financial markets in a similar way of public risk transfer for private gain, most especially with rampant, record-setting private equity deals. As I say, they call it "private" equity for a very good reason.

Of course there is absolutely nothing wrong with private capital, per se. In fact, one can make a very plausible argument that private capital may be inherently far less manic and irrational than public markets (can you picture Jim Cramer at Blackstone?)

That is perhaps because, with private capital, crucial confidential corporate business information can be readily shared between the financial sector and corporate officers, which simply can't be efficiently done in U.S. public markets, and is now completely illegal with the so-called level playing field. (This more efficient transfer of confidential corporate information also characterizes Asian and European bank-based financial systems and their more industrial customer base, systems which have had other drawbacks--alas, there is no perfect system.)

But there are at least two glaring issues with the current private equity boom/bubble.

First, and more relevant here, currently private equity has increasingly become essentially a legalized con game (hence my term ROLLL, return on leverage legal looting), in which the inevitable sucker to be played almost always is fully expected and projected to be the public investor and public corporations, which have incredibly far less inside information and financial incentives than the private equity side when the expected transfer of assets, at wildly overly inflated prices, is made back to the public.

(I'm ignoring the inherent information disadvantage, enormous incentives, and obvious legal conflicts of interest in any LBO with senior corporate management participation, in which management essentially forsakes its legal fiduciary responsibility, in order to trade against public equity and bond holders. Private equity apologists attempt to cover up these various inherently unfair con games by claiming that pension funds are increasingly beneficiaries of the con. That's like saying private equity robs Peter, the public, to pay Paul, themselves, then gives a little back to Peter. Same, btw, with private equity philanthropic giving.)

A second glaring problem with the current version of private equity, as I've said several times before, especially in my long Dec 19 article on "World Needs Better "Face of American Capitalism" than Private Equity" link, is that it focuses mainly on sheer financial leverage and hence excessive short-term corporate cost cutting, at the expense of longer-term investments in innovation.

That cost-cutting focus may have made some sense in the 1980s LBOs, but at this point it is the exact opposite of what is necessary for corporate incentives, since corporate America have been cutting to the bone under various guises and banners--total quality management, restructuring, reinventing, lean production, outsourcing, offshoring, six sigma, i.e. repackaged tqm, etc.--for well over twenty years now. Not that there's anything wrong with these efforts, per se, especially in terms of improving quality of products and services, and hopefully customer focus, though that they tend to more internally oriented.

To put the private equity legalized con game in human nature terms, the basic thing wrong with current private equity excesses ironically may not be that much different than the very same thing that inevitably undermined what private equity would claim to be its polar opposite, socialism and all other utopian schemes, namely rampant human greed and excessive power that is unchecked by any publicly accountable strong enough countervailing power. Btw, the same has probably been true in the political arena. Neither seem to have much hope of changing at the current time, but that a whole other story (for those interested, see my 17,000 word Oct 27 article, "Global Strategic Bargins: Positive Reality Therapy for America's Critical "States of Denial," link).

Global Emerging Markets Currently 2 Standard Deviations Above 4-Year Trend

As I've said in my most recent articles (e.g. on May 31 link), to me most key charts still look very over-extended, even though they haven't wanted to go down, as of yet. This view obviously presents a dilemma, the specific nature of which and how to address it (try to hedge risks perhaps trying to time entry and exit points to keep hedging costs reasonable, ignore rising risks, lighten up, lower beta, etc) depends on one's own particular investment positions and outlook, financial situation, risk aversion, etc. (hence I don't give investment advice on my web site link).

Anyway, I'll discuss once again EEM, the MSCI emerging market etf, since emerging markets have clearly been the market leader in the 2002-07 cycle. With EEM outperforming the S&P 500 and Nasdaq 100 by 4 to 1 over the past four years, it's difficult for me to see how this cycle can end without this chart eventually rolling over. This is a four-year weekly chart of EEM, as of June 20 close, courtesy of prophet.net, except without my usual log scale (as I will explain shortly), left click to enlarge.

The key message on the chart is that EEM still seems to be very over-extended, using simple linear regression analysis. The center green parallel line is a linear regression line generated statistically.

(I use regressions because, if you get the endpoints right, which is the key to accurately depicting a trend using this approach, then simple regression trendlines are fairly "objective" (ignoring the issue of which regression technique to choose) and thus helps to minimize the all too human condition to see and draw trendlines that one wants to see, per my comments on investors bull/bear "cognitive dissonance," in "A Tale of Two Cognitions, Bull and Bear" on June 7 link).

The parallel red lines on this chart are 2 standard deviations away from the center trend line, the parallel green ones 1 sd, and the blue ones 1.5 sd. (These parallel lines excessively curve on a log scale chart due to EEM's very large percent price change, 240%, over the past four years.)

Two sd's indicates that 95% of the observations fall between the red lines (assuming a bell-shaped normal probability distribution).

EEM is now at the red line, 2 sd's above trend. I chose that color to indicate a clear warning, i.e. that if this trendline is correct, and that is the key if, then there would seem to be a rather low probability of strong gains from this level, prior to, at minimum, a sideways consolidation, or maybe worse a sharp pullback, as occurred in May-June 2006, or perhaps then becoming the beginning of something worse over time.

Is such a pullback statistically pre-ordained? Of course not.

E.g., we could easily imagine or draw other plausible steeper trendlines, such as one connecting the previous major high in April 2004 and April 2006, which would make EEM seem less overbought (I haven't done so to avoid overly cluttering this chart for presentation purposes). Or if EEM were to continue strongly up, it would have the effect, over time, of simply steepening the slope of the regression channels, making the up move look more reasonable, in retrospect.

Nevertheless, to me, at this moment, this regression line is the best fit look I have, coming off the March-April 2003 (Iraq invasion) lows, and so the odds seeme to be stacked against a strong up EEM move from here. The same picture emerges using different timeframes, and also using other leading indexes, etfs, etc., though U.S. major indexes are generally less overextended, as I discuss regarding QQQQ, the Nasdaq 100, below. The U.S. market hasn't wanted to go down in seasonally weak May-June, and it's soon to enter seasonally better July and August.

Going back to the 4-year cycle numbers I mentioned earlier, could global equity markets go much higher? Perhaps could global markets be in an era not only of serial multiple asset bubbles, which many observers now readily concede, but bubbles of such magnitude that the 1998-2000 equity market bubble was not a once in a lifetime experience, but rather just one of a series of seemingly once-in-a-lifetime bubbles (as already was the case with the follow-on global real estate "re-rating" bubble)? E.g., could the emerging markets boom just continue right off the charts, so to speak?

Of course, China's white-hot equity markets are on everyone's radar screen nowadays, so here is a chart of the Shanghai composite, courtesy of stockcharts.com (lift click to enlarge). Obviously this index is once again at an important point, namely whether, after its recent sharp pullback to once again its 50-day moving average, it can take out its previous high, as it quickly did after the smaller pullbacks in Feb and April of this year.

Btw, to shift gears, there are several good independent analysts who have done excellent work for a long time, often combining fundamental and technical data from a huge number of data series into their numerous models, among them the above-mentioned Ned Davis, Steve Leuthold, John Hussman, Jim Stack, etc. E.g., here's a June 18 Bloomberg interview link with Leuthold that is representative of the views of those who do so much hard work, in his case he's recently reduced his equity asset allocation.

Update on Nascent Shift into U.S. Large Cap and Tech Stocks

For both momentum investors and die-hard U.S. large cap and tech stock ones, the latter haven't had too much to cheer about in the 2002-07 cycle, there is some ongoing rotation into these stocks, as I noted in my May 31 "Brief Update on U.S. Materials, Retail, Large Cap/Tech ETF Trends link. Another indicator of the same nascent speculative sentiment shift is that the long-term alphas, risk-adjusted excess return, of the semiconductor index and etf (SOX, SMH) are just now turning back to positive.

QQQQ, the Nasdaq 100 etf, is only 1 sd above its lackluster 4-year trendline, as shown in the 4-year weekly chart below, courtesy of prophet.net (left click to enlarge), encouraging the current buy-the-laggard mentality for tech sector stocks. Also note in the bottom panel that QQQQ alpha has just turned positive.

Cyclical GARP-type tech bulls have lately started bidding up such stocks as Micron (MU), a commodity play hence usually a good indicator of increasing tech sector speculative sentiment (some also like it as a longer term play on video bandwidth secular growth), while growth bulls continue to love such much more highly valued tech stocks as AAPL, GOOG, RIMM, AMZN, and smaller ones like RVBD (an emerging leader in WAN optimization).

Here is a 60-day, 60-minute chart, as of the June 20 close, of QQQQ, the Nasdaq 100 etf, courtesy of prophet.net, left click once to enlarge. Due to the length of this article, I'll keep my description of this chart briefer than usual.

QQQQ has been in modest uptrend the past two months, consolidating the sharper gains off its March lows. After breaking down to the bottom red line, it had its almost requisite short-covering bounce last week, but so far only back to the center green trendline, which is also near the purple trendline connecting recent tops, both now around 48, before turning down June 20 afternoon, again about on schedule. For the uptrend to continue, 48 eventually needs to be taken out.

If and When to Hedge?

As I've tried to imply earlier in this article and in recent previous ones, while I have consistently presented "the long-term uptrend is your friend" view on my web site since the middle of the sharp global sell-off May-June 2006 (starting with my June 2, 2006 article link), now might be one of those times to consider incurring the costs of hedging your bets, in some way to some extent, depending on your preferences. Again, in terms of timing a hedge strategy, July, like most first months of each quarter, tend to seasonally strong, after the negative news comes out in the previous month.

Why consider hedging at all at this time? Perhaps one reason is the one I lead off with in my June 7 article link and this one, i.e. one of the key differences in this 2002-07 cycle is the opacity, often deliberate, of critical markets to public market equity investors, including professionals, and that rising long-term rates have now made these information gaps considerably more risky to continue to ignore.

To finish up, here are a few quotes, in alphabetical order, without my editorial comment from this week's mid-year Barron's roundtable update (I may add a few more quotes from this roundtable later today):

Mario Gabelli: "We are no longer at the dawn of the fourth major takeover boom since the 1950s. But we are certainly not at the sunset. We are probably just starting the mid-afternoon. When does the stress-testing come? In 2009 or '10. Deals with covenant-lite provisions can cover two years of economic challenges. At the end someone will overpay, there will be an episode of insider trading, or something. A lot of garbage will surface. My major concern about deals is no different than my major concern about the stock market: There is so much leverage, and the use of derivatives has built in so much leverage below the surface."

Bill Gross: "Corporate bonds for the most part, and high-yields, and certainly subprime debt are moving into a vulnerable period, unless the economy really snaps back to its good old healthy self. We don't see that happening."

Art Samberg: "The S&P 500 is up about 7%, or 15% on an annualized basis. That's too much, so I'm sure we'll get hit over the head soon. Adjustable-rate mortgages really started resetting in May and the resets peak around January, so housing-market troubles could impact the stock market in the second half. There will be another consumer scare between here and the end of the year. We'll get some kind of a correction. But the big drivers are corporate profitability and all the money sloshing around. Not much has changed since January."

Felix Zulauf: "We had a mild and short correction in late spring, and likely will get a sharper one in the third quarter. But this is not going to be the end of the bull market. It will shake out a lot of investors, and then the market will go up again. Eventually, the difference between a 7% earnings yield and a 5% bond yield will be arbitraged away through all sorts of merger and acquisition activity, corporate buybacks, private-equity deals and such."

And from Greenspan from the previous week on Bloomberg, again without editorial comment:

"Referring to historically low premiums on emerging-market debt, Greenspan said "it ain't going to continue that way. And indeed, all the spreads you are looking at, including your spreads relative to the 10-year, are going to start to open up and the 10-year is going to be moving as well." "So I'd suggest someone out there is not going to be as happy as we are today," Greenspan said" Bloomberg, June 12

Econotech

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