Monday, December 29, 2008

What Happens if America Returns to a Historical Savings Rate?

A lot of the focus of the punditry is when we'll recover - personally I think it's a bit of a moot point. What I'm thinking through is not when, but what the recovery will be in America. I posted many of my thoughts in [The US Economic "Recovery"] but essentially a lot of cross currents are forming which should make for a very interesting 5, 10, and indeed 20 years ahead.

Much of the current recovery thesis is based on (a) government spending replacing private enterprise and (b) coaxing Americans back to their old habits. But I'd like to ask what are "old habits?" - most of us in our 20s, 30s and 40s know one reality; our context of history is very different than one who has a longer precedent to view. So let's take a few steps back and I will give you some insight on why I think we're not going to be going back to the binge we've just left for a long time. And why I appear to be so negative on any near term "recovery" - relative to reaching anywhere near the potential of the economy. No we won't be at a -5% GDP figure quarter after quarter for years on end... but what will the "recovered" America look like?

There are many global structural changes happening slowly but surely [Do the Bottom 80% of Americans Stand a Chance?] which I believe will bring the standard of living (and wages) into more of an equilibrium across developed and developing countries. For humankind that is a net positive since many on the globe live in stark poverty - much of it based on nothing more than what mother they are born to, and in what country. But for those at the top of the totem pole, it will mean a harsh readjustment downward for many within the society. I believe this is not a prediction; that in fact it has started in the lower rungs of society and it's been working up the food chain to the middle class. I won't go into my long term predictions for the country but I believe we will be "forced" into a more European model as jobs security is in a constant state of threat as capital floods to the lower cost countries - safety nets, healthcare, higher taxes; it has to happen here eventually because many more pieces of our society will be subject to the forces of globalization (both good and bad) and demand protection to protect our living standard. This is a lot bigger than a "recession" - the recession is a symptom of the national disease.

Median wages have not increased (adjusted for inflation) this decade; and the stratification of wealth has become more concentrated in the top % than any time since the 1920s. Political dogma has thus far allowed this to happen as the citizenry has been busy pointing fingers at each other, rather than looking at why these things are really happening. While the reasons could be debated, the facts are the facts. I believe the past decade many in the country have been compensating for their lack of wage growth with leverage (borrowing). The house ATM was just the apex of a credit bubble that has been building for a long time and obviously peaked in the middle of this decade.

I'd like to present the graph below which shows the historical saving rate of Americans since the 1960s. (click to enlarge)

As you can see, Americans used to save. They used to act quite near our European and Asian friends

People keep asking when Americans will go back to their old ways, as if saving 0% or 2% is our old ways. Not really - that's our most recent ways. But let's peel back the onion.

In the 1960s, Americans typically saved in the 7.5% to 10% range. A bit below where Germany has been the past 15 years.
In the 1970s, Americans typically saved in the 8.0% to 12% range. A bit below where France has been the past 15 years.

Then something changed in the mid 1980s - call it culture, call it entitlement, call it lack of financial literacy - call it what you may. The reasons are immaterial for our purposes - we just care about the raw numbers. After being over 8% for just about all of the 1960s and 1970s, the savings rate has never hit that level since 1987.

Between 1987 and 1993, Americans typically saved in the 6% to 8% range.
Between 1994 and 2000, Americans typically saved in the 4% to 6% range.

Uncle Alan Greenspan's "easy money" policies (year 2k baby!), 9/11 easy money policies, 0% financing for cars, furniture, deregulation of financial institutions, crazy mortgage - all that marked 2001 onward. The above mentioned stagnation of median wages (inflation adjusted) for many in the bottom 2/3rds of the country also was a trademark of this decade. Jobs that were not outsourced could be "threatened" with such, wresting power away from workers - and inflation began to soar in health, tuition, all the normal culprits.

Our saving rate plummeted to 0-2% for much of the decade, famously dropping to a negative rate at the peak of the housing boom in 2006. Literally we spent more than we had as a nation of individuals.

Didn't globalization and wage pressures affect Europe just as much? Why did their savings rate not plummet just the same to compensate? In my opinion, part is culture (Germany/France versus UK) and part of it is workers protections. In the "socialistic countries" (the ones not recently named U.S.A.R) worker protections and unionism are high. It is very hard to fire, so companies are reluctant many times to hire. But once your "in" you're gold - sort of like public school systems and the teacher unions. So wage pressure is lower - contrast that to the more open UK which has modeled itself after the US (while retaining safety social nets/healthcare for all that the US lacks) - its saving rate has also plummeted and corporations tend to run more free with the ability to hire/fire much more readily than those countries on the mainland. That's part of the "flexibility" the dogma tells us is necessary to "react to globalization". Now the interesting case study that supports my theory is Japan - they used to be very high savers with solid worker protections. But now they also have embarked on U.S. style worker rights where humans are commodities. I won't pretend to be a Japan expert but the more I have been reading the past half year the more I see they have adopted a lot of principles that make their corporations "flexible" over the past decade - i.e. huge influx of temporary workers, birth of a generation of working poor - i.e. similar to our service industry, huge growth in the income gap, pulling back benefits, et al. As we saw in [Oct 28: Pooring of Japan Too?]
  • The 29-year-old laborer is one of a burgeoning class in Japan -- the working poor. The number of Japanese earning less than $19,610 a year surged 40 percent from 2002 to 2006, the latest data available, the government says. They now number more than 10 million.
  • "It is unprecedented to see such a widening income gap in Japan," said Yoshio Sasajima, economist at Meiji Gakuin University in Tokyo. "Our society is definitely becoming a class society."
  • In the 2000s, that was followed by a round of free market reforms that widened the disparity between haves and have-nots. (sounds vaguely familiar)
  • A key to the growth of the working poor has been the explosion in temporary employment agencies, which allow corporations to take on labor without having to pay benefits -- and then unload workers at will. (sounds vaguely familiar) "Instead of hiring costly, full-time employees, companies are bringing in cheaper, part-time workers as part of their cost-cutting efforts," said Yasuyuki Iida, an economist at Komazawa University in Tokyo.
So as these "reforms" have taken hold in Japan (strengthen corporation, weaken worker) the saving rate has plummeted from 12% to 6%, and now from 6% to 2%. People try to maintain "old lifestyle" with "new compensation" which is less than old compensation (inflation adjusted) - hence savings deplete. Those are my theories, and of course they can be argued. Eventually I think as more U.S. workers become disenfranchised and lack of stability engulfs the working class as they compete with wage earners in developing countries, a major backlash will happen in this country and indeed others that have adopted the "dog eat dog" capitalism structure. Perhaps it's fruitless for workers, and most corporations will move plants to locales were labor is cheapest - I don't know. But it will prove to be a very interesting era ahead.

As Uncle Ben Bernanke sits here and destroys American savers (just imagine the 65+ crowd trying to live on these CD interest rates) the master plan is to return Americans to spenders so we can kick the can down the road. But what if Americans do what is best for themselves (save) and not for the "service based economy" (spend like drunken sailors)? What happens if we don't return to 0 to 2% saving rates but seeing the increasing lack of job stability and stock market shenanigans (where many of our retirement savings are) - not to mention a country that should have anywhere from 1 in 4 to 1 in 3 people "underwater" on their homes by this time next year - turn back to our REAL "old habits"?

A 10% savings rate? Could it be possible? What would that translate to in real dollars?

We have about a $13 Trillion economy, with about $10 Trillion in private spending. (one could quibble the exact number but it's within a degree of that and $10 T makes for a nice round number). A 10% savings rate very easily translates $1 Trillion in savings. A 8% savings rate translates to $800 Billion. Even a 5% savings rate translates to $500 Billion. All these number exceed the next stimulus plan on an annual basis - which means all the government would do is borrow from our grandchildren, layer more debt on them (that we need to eventually pay) to offset money from our "old economy model" (of the past 6-8 years) as Americans, in self preservation, move to the real "old economy model" (of the past 40 years).

I don't know if this is the outcome - I am a saver by nature so I don't understand how many people live the way they do. I don't know how their "sentiment" will change or if they will repeat old mistakes in the near term. I'd like to think they would be scared straight after seeing what is happening now and a saving rate re-emerges nearer to historical norms. That would be a very healthy long term situation - but a horrible one for an economy which has been transformed to rely on spending over our heads. I do know a great many Americans are retiring (or trying to) with little to no savings - and what many had was in their homes. Which are falling in value for the first time nationally since the Great Depression. I wonder how these people will "spend" at previous rates when they will struggle just to subsist. I continue to believe that even at 0% interest rates many people, with depleted savings, simply won't want more debt at any cost; they will be too busy trying to rebuild balance sheets depleted by a decade of global forces/bad behavior. Which leads to my gloomy view of any economic recovery that rekindles images of the middle part of the decade. I don't think a Japanese style decade+ hangover is out of the question.

If I am correct, consumer discretionary items will continue to suffer far deeper and longer than the pundits and hedge fund thesis algorithms currently posit. I do not believe these pundits and PhD programmers at hedge funds understand the median wage in America is about $30K (meaning half make less). Many declaring impending recoveries probably make this wage in a month. It is 2 Americas, and the punditry does not live on Main Street. Unfortunately the non punditry portion of 2 Americas need to drive this economy. If I am correct, my bearishness for retailers (non grocery, non essential) will last much longer than those who run up said stocks on "early cycle" thesis - as they will do repeatedly in 2009 (as they have done prematurely multiple times in 2008) We are overbuilt in America - in almost everything; "right sizing" will be a long, painful process and those who dream this all gets solved in "6 months" due to easy money need to look back at our history. Remember, our country has SIX times more retail space, per capita than any other nation. If we take $800 Billion to $1 Trillion of spending (8 to 10% savings rate returns) out of the economy and into personal savings on a permanent basis - what do you think happens to a lot of that space? Will we approve 2 year, $800 Billion stimulus plans every 24 months to offset this? (kick the can forever?)

The case against me? Within 6-12 months, companies suddenly decide 6-8% wage increases are the new 3%. Or the US consumer will be back to their overspending ways and the small rebound in savings rate (2%ish) will retrace back to 0% or negative. The irony is that is not a positive outcome - it's just kicking the can of an eventually down the road. Which is what we specialize at; and our government is encouraging it.
  • The good news for retailers reeling from the holiday sales season is that 2008 is almost over. The bad news: The fallout in 2009 could be worse. This year's retailing slide -- when stores were forced to cut prices to convince wary consumers to spend -- promises to have a lasting impact on the way the retail industry operates. Many retailers are rethinking how they do business, as others prepared for a large number of bankruptcies and store closures.
  • Other retailers are saying they will trim inventory and reduce the number of suppliers. That, in turn, will cause a ripple effect, prompting a number of weaker manufacturers, small brands and underfunded fashion labels to fail. New retail formats and concepts stores are likely to be curtailed in the coming year.
  • "We will have a lot fewer stores by the middle of 2009," says Nancy Koehn, professor of business administration at Harvard Business School. "It's happening very, very quickly because of the financial crisis and the recession." Analysts estimate that from about 10% to 26% of all retailers are in financial distress and in danger of filing for Chapter 11.
Unfortunately we don't have great outcomes either way - it's either take the pain now and re-adjust back to the "old" consumption patterns, or kill savers who acted responsibly while force feeding debtors to take on more... so that we can have the next consumer crash down the road 3-6 years - instead of now.

Until then - we'll stay in denial talking about how things will go back to "normal" in "6 months" as the federal government saves us.

Indian Banks Perking my Interest from a Technical Viewpoint

We haven't owned the Indian banks in a long while but both ICICI (IBN) and HDFC (HBN) are looking a lot better technically of late. If you read my piece this weekend [New York Times - How India Avoided the Crisis] on how India did some out of this world stuff like "regulate" you will see why I don't believe in the "U.S. shall lead them" thesis of recovery. A handful of countries in this world have destroyed their financial systems, and are facing a deep recession. The other countries are just facing a deep recession. Which do you believe is easier to recover from? In the U.S. it appears to be group think to believe its the former... which makes little rational sense. Its a narcissistic view in my opinion. But that's belief in the power of the "government" to solve all ills.

In the Asian banks we don't have these ludicrous capital destruction situations since they are still old school and don't have political dogma that says regulation is the bane of all evil. Now, I am not saying they will have an easy road either since the globe is interconnected, and weakness in the biggest spender on the planet (us) is affecting everyone but it's all about relative degrees of bad situations. India is also interesting to me because it's less reliant on exports than China or Brazil. So it could be the sleeper market of 2009 - at least of the former BRIC countries.

One issue with India is the almost complete lack of individual companies for Americans to buy, so over the years I've usually gone with the 2 banks when I want to go long India. (there was a closed end fund that I also used for years but some new ETNs have since arrived on the scene)

With HDB, you see a thus far successful retrace to the 50 day moving average ($65) and now a bounce today. There are two key levels here, $75 which is a "double top" (early Nov/mid Dec) - a move north of that would be very bullish and of course clearing the 200 day moving average ($79s) would be extremely constructive. So an aggressive buyer could buy on pullbacks to mid $60s with parachute ready to deploy if $63 or so breaks. A conservative investor would wait to see either $75 cleared or even better the 200 day moving average cleared.

The picture is a lot easier on IBN since the stock has been much weaker over time and is much farther below the 200 day moving average. We have the identical "multiple" top situation at $20. A close above it, and it should be off to the races. Support is around $18 and stop loss $17 or lower would be my play here.

Fundamentally I prefer HDFC to ICICI in terms of business model, but this is not a market of fundamentals.

The general country ETFs for India are not quite so constructive - the strength seems concentrated in the financials
. At some point in 2009 I'll also be looking to re-enter the ETFs for Signapore, Hong Kong and the like. But the charts have yet to indicate its time.

No positions, but stalking

Doug Kass' 20 Suprises for 2009

As promised, presented at are Doug Kass' 20 Surprises for 2009; Doug is a hedge fund manager who I have been following for a long time and who excels in non Kool Aid analysis. Probably because his main hedge fund has had a short bias all these years, hence you tend to be more cynical when you need to fight drunk bulls every day. As Doug says, Wall Street is dominated by group think and herd behavior. While standing in front of the herd is dangerous, one can find some profitable opportunities from thinking outside the box.

These are his predictions from last year [Jan 2: Doug Kass 20 Predictions for 2008]

These were mine from last year
[Dec 31, 2007: 13 Outlier 2008 Predictions] and a self assessment I did in October [Reviewing Our 13 Outlier 2008 Predictions]

Here are mine that I posted two weeks ago [Dec 16: 13 Outlier 2009 Predictions]

Unlike 2008 when Doug and I had a myriad of similar predictions this year we have a lot less in common - both of us touched on the change coming in sports and he talked about municipal budgets and a TARP fund; I said the Federal Reserve backstops all municipal debt - same ends to the means. We both are bearish on the hedge fund industry in the near term, and point to media having a very gosh awful year ahead. But other than that we are swimming in different pools for 2009 :)


In late December over the past six years, I have taken a page from former Morgan Stanley strategist Byron Wien (now the chief investment strategist at Pequot Capital Management) and prepared a list of possible surprises for the coming year.

These are not intended to be predictions but rather events that have a reasonable chance of occurring despite the general perception that the odds are very long. I call these "possible improbable" events.

The real purpose of this endeavor is to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs. After all, the quality of Wall Street research has deteriorated (in some measure because of brokerage industry consolidation) and remains, more than ever, maintenance-oriented, conventional and "groupthink," even despite the mandated reforms over the past several years. Mainstream and consensus expectations are just that, and in most cases they are deeply imbedded into today's stock prices. If I succeed in at least making you think about outlier events, then the exercise has been worthwhile.

Without further ado, here is my list of 20 surprises for 2009. In doing so, we start the new year with the surprising story that ended the old year, the alleged Madoff Ponzi scheme.

    1. The Russian mafia and Russian oligarchs are found to be large investors with Madoff. During the next few weeks, a well-known CNBC investigative reporter documents that the Russian oligarchs, certain members of the Russian mafia and several Colombian drug cartel families have invested and laundered more than $2 billion in Madoff's strategy through offshore master feeders and through several fund of funds. There are several unsuccessful attempts made on Madoff and/or his family's lives. With the large Russian investments in Madoff having gone sour and in light of the subsequent acts of violence against his family, U.S./Russian relations, which already were at a low point, are threatened. Madoff's lawyers disclose that he has cancer, and his trial is delayed indefinitely as he undergoes chemotherapy.

    2. Housing stabilizes sooner than expected. President Obama, under the aegis of Larry Summers, initiates a massive and unprecedented Marshall Plan to turn the housing market around. His plan includes several unconventional measures: Among other items is a $25,000 tax credit on all home purchases as well as a large tax credit and other subsidies to the financial intermediaries that provide the mortgage loans and commitments. This, combined with a lowering in mortgage rates (and a boom in refinancing), the bankruptcy/financial restructuring of three public homebuilders (which serves to lessen new home supply) and a flip-flop in the benefits of ownership vs. the merits of renting, trigger a second-quarter 2009 improvement in national housing activity, but the rebound is uneven. While the middle market rebounds, the high-end coastal housing markets remain moribund, as they impacted adversely by the Wall Street layoffs and the carnage in the hedge fund industry.

    3. The nation's commercial real estate markets experience only a shallow pricing downturn in the first half of 2009. President Obama's broad-ranging housing legislation incorporates tax credits and other unconventional remedies directed toward nonresidential lending and borrowing. Banks become more active in office lending (as they do in residential real estate lending), and the commercial mortgage-backed securities market never experiences anything like the weakness exhibited in the 2007 to 2008 market. Office REIT shares, similar to housing-related equities, rebound dramatically, with several doubling in the new year's first six months.

    4. The U.S. economy stabilizes sooner than expected. After a decidedly weak January-to-February period (and a negative first-quarter 2009 GDP reading, which is similar to fourth-quarter 2008's black hole), the massive and creative stimulus instituted by the newly elected President begins to work. Banks begin to lend more aggressively, and lower interest rates coupled with aggressive policy serve to contribute to an unexpected refinancing boom. By March, personal consumption expenditures begin to rebound slowly from an abysmal holiday and post-holiday season as energy prices remain subdued, and a shallow recovery occurs far sooner than many expect. Second-quarter corporate profits growth comfortably beats the downbeat and consensus forecasts as inflation remains tame, commodity prices are subdued, productivity rebounds and labor costs are well under control.

    5. The U.S. stock market rises by close to 20% in the year's first half. Housing-related stocks (title insurance, home remodeling, mortgage servicers and REITs) exhibit outsized and market-leading gains during the January-to-June interval. Heavily shorted retail and financial stocks also advance smartly. The year's first-half market rise of about 20% is surprisingly orderly throughout the six-month period, as volatility moves back down to pre-2008 levels, but rising domestic interest rates, still weak European economies and a halt to China's economic growth limit the stock market's progress in the back half of the year.

    6. A second quarter "growth scare" bursts the bubble in the government bond market. The yield on the 10-year U.S. Treasury note moves steadily higher from 2.10% at year-end to over 3.50% by early fall, putting a ceiling on the first-half recovery in the U.S. stock market, which is range-bound for the remainder of the year, settling up by approximately 20% for the 12-month period ending Dec. 31, 2009. Foreign central banks, faced with worsening domestic economies, begin to shy away from U.S. Treasury auctions and continue to diversify their reserve assets. By year-end, the U.S. dollar represents less than 60% of worldwide reserve assets, down from 2008's year-end at 62% and down from 70% only five years ago. China's 2008 economic growth proves to be greatly exaggerated as unemployment surprisingly rises in early 2009 and the rate of growth in China's real GDP moves towards zero by the second quarter. Unlike more developed countries, the absence of a social safety net turns China's fiscal economic policy inward and aggressively so. Importantly, China not only is no longer a natural buyer of U.S. Treasuries but it is forced to dip into it's piggy bank of foreign reserves, adding significant upside pressure to U.S. note and bond yields.

    7. Commodities markets remain subdued. Despite an improving domestic economy, a further erosion in the Western European and Chinese economies weighs on the world's commodities markets. Gold never reaches $1,000 an ounce and trades at $500 an ounce at some point during the year. (Gold-related shares are among 2009's worst stock market performers.) The price of crude oil briefly rallies early in the year after a step up in the violence in the Middle East but trades in a broad $25 to $65 range for all of 2009 as President Obama successfully introduces aggressive and meaningful legislation aimed at reducing our reliance on imported oil. The price of gasoline briefly breaches $1.00 a gallon sometime in the year. The U.S. dollar outperforms most of the world's currencies as the U.S. regains its place as an economic and political powerhouse.

    8. Capital spending disappoints further. Despite an improving economy, large-scale capital spending projects continue to be delayed in favor of maintenance spending. Technology shares continue to lag badly, and Advanced Micro Devices (AMD Quote - Cramer on AMD - Stock Picks) files bankruptcy.

    9. The hedge fund and fund of funds industries do not recover in 2009. The Madoff fraud, poor hedge fund performance and renewed controversy regarding private equity marks (particularly among a number of high-profile colleges like Harvard and Yale) prove to be a short-term death knell to the alternative investments industry. As well, the gating of redemption requests disaffects high net worth, pension plan, endowment and University investors to both traditional hedge funds and to private equity (which suffers from a series of questionable and subjective marking of private equity deal pricings at several leading funds). Three of the 10 largest hedge funds close their doors as numerous hedge funds reduce their fee structures in order to retain investors. Faced with an increasingly uncertain investor base, several big hedge funds merge with like-sized competitors in a quickening hedge fund industry consolidation. By year-end, the number of hedge funds is down by well over 50%.

    10. Mutual fund redemptions from 2008 reverse into inflows in 2009. The mutual fund industry does not suffer the same fate as the hedge fund industry. In fact, a renaissance of interest in mutual funds (especially of a passive/indexed kind) develops. Fidelity is the largest employer of the graduating classes (May 2009) at the Wharton and Harvard Business Schools; it goes public in late 2009 in the year's largest IPO. Shares of T. Rowe Price (TROW Quote - Cramer on TROW - Stock Picks) and AllianceBernstein (AB Quote - Cramer on AB - Stock Picks) enjoy sharp price gains in the new year. Bill Miller retires from active fund management at Legg Mason (LM Quote - Cramer on LM - Stock Picks).

    11. State and municipal imbalances and deficits mushroom. The municipal bond market seizes up in the face of poor fiscal management, revenue shortfalls and rising budgets at state and local levels. Municipal bond yields spike higher. A new Municipal TARP totaling $2 trillion is introduced in the year's second half.

    12. The automakers and the UAW come to an agreement over wages. Under the pressure of late first-quarter bankruptcies, the UAW agrees to bring compensation in line with non-U.S. competitors and exchanges a reduction in retiree health care benefits for equity in the major automobile manufacturers.

    13. The new administration replaces SEC Commissioner Cox. Upon his inauguration, President Obama immediately replaces SEC Commissioner Christopher Cox with Yale professor Dr. Jeffrey Sonnenfeld. The new SEC commissioner recommends that the uptick rule be reinstated and undertakes a yearlong investigation/analysis into the impact of Ultra Bear ETFs on the market. Later in the year, the administration recommends that the SEC be abolished and folded into the Treasury Department. Dr. Sonnenfeld returns to Yale University.

    14. Large merger of equals deals multiply. Economies of scale and mergers of equals become the M&A mantras in 2009, and niche investment banking boutiques such as Evercore (EVR Quote - Cramer on EVR - Stock Picks), Lazard (LAZ Quote - Cramer on LAZ - Stock Picks) and Greenhill (GHL Quote - Cramer on GHL - Stock Picks) flourish. Goldman Sachs and Citigroup announce a merger of equals, but Goldman maintains management control of the combined entity. Morgan Stanley (MS Quote - Cramer on MS - Stock Picks) acquires Blackstone. Disney (DIS Quote - Cramer on DIS - Stock Picks) purchases Carnival (CCL Quote - Cramer on CCL - Stock Picks). Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) acquires Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) at $5 a share.

    15. Focus shifts for several media darlings. Though continuing on CNBC, Jim "El Capitan" Cramer announces his own reality show that will air on NBC in the fall. At the time his reality show premieres, he also writes a new book, Stay Mad for Life: How to Prosper From a Buy/Hold Investment Strategy. Dr. Nouriel Roubini continues to talk depression, but the price of his speaking engagements are cut in half. He writes a new book, The New Depression: How Leverage's Long Tail Will Result in Bread Lines. "Kudlow & Company's" Larry Kudlow proclaims that it's time to harvest the "mustard seeds" of growth and, in an admission of the Democrats' growing economic successes, officially leaves the ranks of the Republican party and returns to his Democratic roots. Yale's Dr. Robert Shiller adopts a variant and positive view on housing and the economy, joining the bullish ranks, and writes a new book, The New Financial Order: Economic Opportunity in the 21st Century.

    16. The Internet becomes the tactical nuke of the digital age. The Web is invaded on many levels as governments, consumers and investors freak out. First, an act of cyberterrorism occurs that compromises the security of a major government (similar to the attacks this year emanating from the Chinese military aimed at the German Chancellery) or uses DoS against media and e-commerce sites. Second, a major data center will fail and will be far worse than the 1988 Cornell student incident that infected about 5% of the Unix boxes on the early Internet. Third, cybercrime explodes exponentially in 2008. Financial markets will be exposed to hackers using elaborate fraud schemes (such as liquidating and sweeping online brokerage accounts and shorting stocks, then employing a denial-of-service attack against the company). Fourth, Storm Trojan reappears. (Same as last year.)

    17. A handful of sports franchises file bankruptcy. Three Major League Baseball teams fail in the middle of the season and seek government bailouts in order to complete the season. The Wilpon family, victimized by Madoff, sells the New York Mets to SAC's Steve Cohen. The New York Yankees are undefeated in the 2009 season, and Madonna and A-Rod have a child together (out of wedlock).

    18. The Fox Business Network closes. Racked by large losses, Rupert Murdoch abandons the Fox Business Network. CNBC rehires several prior employees and expands its programming into complete weekend coverage. Two popular CNBC commentators "go mainstream" and become regulars on NBC news programs.

    19. Old, leveraged media implode. The worlds of leverage and old media collide in a massive flameout of previous leveraged deals. Univision and Clear Channel go bankrupt. The New York Times (NYT Quote - Cramer on NYT - Stock Picks) teeters financially.

    20. The Middle East's infrastructure build-out is abruptly halted owing to "market conditions." Lower oil prices, weakening European economies and a broad overexpansion wreak havoc with the Middle East's markets and economies.

Bookkeeping: Adding to Emergent BioSolutions (EBS)

We said in our weekly missive we want to buy the best charts on buybacks and Emergent BioSolutions (EBS) is giving us a nice opportunity to add at the 20 day moving average (around $23.70). I am going to do so but give a very large caveat that the stock is having trouble getting past $26. So after being the #1 stock of 2008 in terms of performance, the stock might finally be hitting a wall. But until proven otherwise we'll stick with it.

Looking out farther in the chart $21 is the 50 day moving average which has been a line in the sand the stock has not fallen through except on a few of those S&P down 8% type of days. If the stock falls to that level, I'll (a) load up in larger scale... and then (b) if it breaks $21 to the downside we'll head to the exits as the chart will be "broken". But it's been "correct" to buy EBS on every dip for 5 months so until the pattern changes, we keep going with the pattern.

Increasing EBS exposure from 2.3% to a 3.4% stake, adding in the $23.50s. These replace the shares sold on Dec 22nd at $26.16; or a 10% reduction in cost base in a week on this batch of shares. Again, I'd like to stress there could be trouble ahead due to the failure to break through $26.

This is in the context of a portfolio flush with cash and in which I just sold off nearly 2% of long exposure... need to maintain some long exposure in names that have acted the best.

Long Emergent BioSolutions in fund and personal account

Bookkeeping: Cutting Linn Energy (LINE) on Barron's Mention

Linn Energy (LINE) was mentioned prominently in this week's Barron's and is up nearly 20%. I am going to take this opportunity to cut most of the position and we'll try to buy this back on a pullback since such a huge gap in the chart was created. In a bull market I'd probably just let this name run, but in a bear market all gains are to be grabbed and savored. Further, before today's move the stock was stuck under its 200 day moving average, so it's not a promising chart unless today's move is held. I kept it as a major position but only because I felt there was a major disconnect between perception and reality in this stock. So we sort of got a gift today.

  • THE COLLAPSE IN NATURAL-GAS and oil markets has sent the price of Linn Energy plummeting in the past six months, from over $25 in June to below $12 last week. Linn, a modest-sized gas and oil driller, is structured as a master limited partnership, paying out some 60% to 70% of its quarterly cash flow to its shareholders in tax-advantaged distributions. The big fear among investors is that those payouts will soon wither as a result of weak energy prices.
  • And as if that weren't enough, Wall Street worries that frozen capital markets will keep Linn from following its growth-through-acquisition policy that in the past has permitted the partnership to boost quarterly cash flows and therefore unit distributions.
  • Such concerns seem amiss. For one thing, Linn (ticker: LINE) is an astute and disciplined hedger and, as such, was able to lock in favorable prices during this summer's energy-price bubble for its products going out three to four years. In fact, based on its third-quarter distribution of 63 cents per unit (or $2.52 annualized), the company is throwing off a current yield of more than 20%.
  • Citigroup analyst Richard Roy wrote in a recent report that this distribution level is "relatively secure" for at least the next two years or more, even if Linn makes no new acquisitions in the period. As a result, Roy has a one-year price target on Linn of 22, while John Kang of RBC Capital Markets sets an even higher target price of 27, more than double the current level.
  • LINN'S OPERATING PHILOSOPHY is a conservative one, emphasizing yield generation over flashy new discoveries. As such, the company concentrates its acquisition and drilling activity on mature fields that have ample reserves but no longer produce at the high levels favored by the majors or aggressive exploration outfits. "We're looking for bunt singles and not home runs," avers Michael Linn, chairman and CEO of the eponymous company, who grew up in Pittsburgh but now runs the company out of Houston.
  • The company's fields typically have 20-to-30-year lives and undergo slow annual production declines. They also afford ample opportunity to boost production through reworking old bore holes, pumping equipment, water-injection systems and lifts. The geology of the fields is such that Linn generally has a near 100% success rate when it drills.
  • Even in a steady state with no new acquisitions, CEO Linn claims that the company can keep its production levels, and therefore distributions, flat or gently rising through work-overs and drilling additional wells on its existing acreage. The company has identified 4,100 low-risk drilling locations on its properties with promise of boosting production. "That's about 15 years worth of drilling at our current pace, or 200 to 300 wells a year," he says. "We could keep our production going at current levels with just 150 new wells a year."
  • And the company is not without financial flexibility, even in today's severe credit crunch. It opportunistically sold off three different properties so far this year for a total of around $1 billion, taking advantage of the frenzy in oil and gas speculation this summer. A particularly hot item was Linn's Marcellus Shale acreage in Pennsylvania's Appalachian Basin, which Linn adjudged to be promising but too expensive for a company of its ilk to develop.
  • AS A RESULT OF THE SALES, LINN now has about $500 million of borrowing capacity under its credit facility. This is after taking into account a $100 million stock- repurchase plan that the company has instituted but not unleashed. The latter gives the company plenty of potential firepower with which to defend its stock price. The company says it will be able to cover all of its capital spending and unit distributions next year from internally generated cash flow.
  • Crucial to Linn's rich distributions and past growth has been its hedging programs. First off, the company generally hedges, or locks in profit margins, on a higher percentage of its future production than its competitors. It also hedges production for more years in the future than certain of its rivals. Linn's current production levels are hedged 99% for next year, 107% for 2010, 101% for 2011 and 66% for 2012 -- far greater coverage than at most rivals. (this is why we bought it but nobody seems to care until Barron's points it out)
  • As primarily a yield play for older investors, the company tries to be as plain and drab as "an old Chevrolet door handle," in the words of Michael Linn.
I still like Linn for the massive yield.... and oil probably should fall to $25 as its worst case?

Selling Linn Energy in the $14.10s, taking it from a 2.1% stake to 0.1%

6 months ago if Israel was making a fuss over Gaza, oil would be up $10... today it's up a buck or so. Not that there is any oil in these countries but speculators use any excuse in a bull market to run a commodity up. It appears the hedge funds have completely abandoned oil speculation... err, I mean it appears the laws of supply and demand in the "efficient market" seem to have changed materially in the past few months.

[Oct 21: Bookkeeping - Starting Linn Energy]

Long Linn Energy in fund; no personal position

Best Performing Stock of 2008

I used to, and will one day return, to posting the best performing stocks of the week - but the wicked volatility and "student body left" trading of the past 4 months has made it a moot point. Everything must either be bought or sold, as stocks are either deemed "good" or "bad" that hour, day, or month. The herd piles in, or piles out - regardless of sector, style, fundamentals. It's been a market of asset allocation not individual stocks much of the back half of the year. I like to look for relative strength and ride sector/company trends for the longer term - this market is not for that sort of investor. This has been for many months a run and gun daytrader environment; not a place for theme investors.

With that said, I am always curious to see what stocks held up over the long run... folks, no matter what happens (short of 8%+ rally here in the next 3 days) we are projecting the worst year in the markets at least since the early 1930s and perhaps longer than that. So if you are still alive and kicking congrats. The best tuition for the stock market is... the stock market. Textbooks won't help you - living breathing and being in the market is the only way to learn. (or reading super shrewd bloggers) ;) To say this year was a learning experience for all involved is an understatement. But that's what makes the market every fascinating - always new things to learn.

To that end, I am presenting to you 52 stocks that returned at least 15% in 2008. That is quite a pathetic total, but as I said above - we just came off the worst year in (hopefully) all of our lifetimes. What has been even more amazing has been the compare and contrast of the "half years" of 2008 - I ran a similar list in May [May 26: Best Performing Stocks Year to Date] There were 122 stocks that had gained at least 25% with a market capitalization of $2 Billion or more. After a quick scan of THAT list, I don't think a single one ended the year +15% - it was very heavily tilted to commodities which is where I, along with apparently 90% of the hedge fund community, was hiding for the first 6 months of 2008. Frankly that list on May 26th, was the list to short in the 2nd half of the year.

I had to bring down the minimum market capitalization to $750 million just to find 52 names who gained 15% - much of that is so many stocks have lost so much of their market cap; and so many of our US listed companies had negative years. I don't have the data in front of me but there was some staggering analysis on how many stocks in America lost 50%+ in 2008; a massive percentage of all listed shares. This will be a year to be discussed for generations, and I expect 2009 to be quite an interesting one as well.

The criteria for this list are
  • Market capitalization $750 Million+
  • Average trading volume 100K+
  • Stock price $10+
  • Return of 15%+
What strikes so different about this year versus the carnage of 2000-2002 is back then there were at least places to hide out. Even in the equity market.... not to mention bonds. This time around - once we got past mid year all safe havens, regardless of asset class were demolished (excluding US Treasuries).

The top of the list is dominated by the one place I felt relatively "safe" (it's all relative) in latter 2008: healthcare - we own a few of the big winners but certainly did not catch all of those huge moves. But we love relative strength and these are the type of charts we want to hang out in with our larger exposures. In green are the names we own, and in purple are names we once owned or have discussed in the blog. Frankly, outside of Panera Bread (PNRA), Genentech (DNA), Amgen (AMGN), H&R Block (HRB) and Walmart (WMT) I don't see many names the casual individual stock market investor would know about or recognize.

On my own "doh!" list is both Thoratec (THOR) and Allegiant Travel (ALGT) - the former was a major holding of ours that we sold out of after a product scare [Oct 26: Closing Thoratec First Thing Tomorrow] and the stock has simply raced up and up; we've been waiting for a pullback the past three weeks to get back in - but it never comes. The latter is a small airline that is insanely profitable (even at oil $140!) and should be much more so with oil anywhere near these levels; despite a consumer recession. I've been stalking this name for many months - since the upper $20s in fact, but have been unable to pull the trigger thinking surely oil will reverse at some point and all airline stocks will be trashed (they have been the anti oil trade) - it is now nearing $50.

Quality Systems (QSII) is a "down low" Obama play - I've owned this name in the past, basically they do electronic medical records which is part of Obamamania - so it's really no different then jumping head first into infrastructure stocks based on what President Elect Midas will do. Frankly, this one has been off my radar for many years and when I though of "thesis" stocks in medical records I ran to look at Cerner (CERN) which has done little since Obama was elected. Correct thesis, wrong horse - I should of thought of QSII.

Outside of that, no large scale themes outside of "trade down" retailers - i.e. dollar stores and Ross; and re-education (adult education) stocks which have been a big theme late in the year as the unemployed ranks rise. I shall continue to focus on healthcare in 2009, especially the niche high growth names I focus on regardless of sector - and names that generate large amounts of revenue from the US government. These are the revenue streams I have the most amount of confidence in not being threatened. Outside of that, I do expect hedge funds and institutions to run up "early cycle" stocks in various iterations throughout 2009 on repeated "false starts" of the coming (ahem) recovery in 6 months. So we'll be there too, taking advantage of Kool Aid.

Symbol Company Name % Price
EBS Emergent BioSolutions Inc 382.0
SQNM Sequenom Inc 108.4
VRX Valeant Pharmaceuticals Int'l 84.4
ALO Alpharma Inc 77.9
THOR Thoratec Corp 73.7
RGLD Royal Gold Inc 59.9
DLTR Dollar Tree Inc 59.2
VPHM ViroPharma Inc 52.6
ALGT Allegiant Travel Co 45.0
CFFN Capitol Federal Financial 44.3
GTIV Gentiva Health Services Inc 41.8
RNT Aaron Rents Inc 41.0
DSCP Datascope Corp 40.8
FFIN First Financial Bankshares Inc 40.1
CMP Compass Minerals International Inc 39.6
MYGN Myriad Genetics Inc 39.4
FBP First BanCorp (Puerto Rico) 38.6
QSII Quality Systems Inc 38.2
PNRA Panera Bread Co 37.7
ORH Odyssey Re Holdings Corp 37.0
SQM Sociedad Quimica y Minera de Chile 32.2
FDO Family Dollar Stores Inc 30.7
LG Laclede Group Inc 29.3
UST UST Inc 27.5
RKT Rock-Tenn Co 26.1
CRK Comstock Resources Inc 25.1
FNFG First Niagara Financial Group Inc 24.3
VRTX Vertex Pharmaceuticals Inc 23.7
HRB H&R Block Inc 23.1
INT World Fuel Services Corp 23.0
DNA Genentech Inc 22.5
LMNX Luminex Corp 22.0
AMGN Amgen Inc 21.1
CWT California Water Service Group 20.8
STBA S&T Bancorp Inc 19.7
SF Stifel Financial Corp 18.8
EMS Emergency Medical Services Corp 18.7
OCR Omnicare Inc 17.8
STRA Strayer Education Inc 17.8
ROH Rohm and Haas Co 17.7
FNF Fidelity National Financial Inc 16.4
EW Edwards Lifesciences Corp 16.1
PNY Piedmont Natural Gas Inc 16.1
MANT ManTech International Corp 16.1
CBST Cubist Pharmaceuticals Inc 16.1
UMBF UMB Financial Corp 16.0
WMT Wal-Mart Stores Inc 15.9
ROST Ross Stores Inc 15.7
GOLD Randgold Resources ADR 15.6
DCM NTT DoComo Sponsored ADR 15.4
BNCL Beneficial Mutual Bancorp Inc 15.4
NFS Nationwide Financial Services Inc 15.3

Bookkeeping: Weekly Changes to Fund Positions Year 2, Week 21

Year 2, Week 21 Major Position Changes

Fund positions of 1.0% or greater can be found each week in the right margin of the blog, under the label cloud and recent comments areas; I highlight weekly the larger position changes.

Being a long only fund, via Marketocracy rules, the only hedges to the downside I have are cash or buying short ETFs. I cannot short individual equities.

To see historic weekly fund changes click here OR the label at the bottom of this entry entitled 'fund positions'.

Cash (2 positions [SHV/BIL] + cash): 55.0% (vs 52.0% last week)
30 long bias: 35.0% (vs 37.0% last week)
7 short bias: 10.0% (vs 11.0% last week)

39 positions (vs 40 last week)
Additions: N/A

Removals: (BIDU)

Top 10 positions = 20.9% of fund (vs 23.5% last week)
23 of the 39 positions are at least 1% of the fund's overall holdings (59%)

Weekly thoughts
In last week's summary we opined...

Unfortunately, in the past 5-7 days I am starting to read about Santa Claus rallies EVERYWHERE, and on Wall Street rarely does what everyone assume to happen actually happen. So my thesis from early in the month makes me me nervous from "everyone is expecting it" in the past week; so perhaps we either end the rally "now", we rally way past Christmas (straight to inaguaration?), or we do nothing but stagnate. It just seems too convenient for what is now EVERYONE looking for a Santa Claus rally, to actually have one.

As usual, Wall Street does not do what everyone expects.... talk about stagnating. I must be getting old because in previous lives I'd say what a boring market. Last week I was thankful it was so quiet. I'd love to see a very boring market where good stocks separate from bad, and "student body" trading (everything must be bought! sell everything!) ends - but I doubt a new trend is here.

Now if I were a cynic, I'd still cling to my year end "mark up" theory - that is hedge funds using the last few days to push the market up to make their books look a lot better than they are. But since I am so (ahem) idealistic - could it really happen? We've been stuck in this range of S&P 850 to S&P 920 that we've been harping on most of the past month. S&P 870 has been a technical level we sometimes break during the day but by (ahem) "magic" we almost always seem to regain it by the end of a day - amazing how that happens. So within a range of 850 to 920 we're at the lower end and a nice 3 days push of 5% on the S&P would take us to the top of the range - have us close at/near the high of the past two months, we can talk about "great strength to close the year", "January small cap effect", "mustard seeds", "the government will take away most of our ills" and "President Elect Midas is coming". But only a cynic would believe the market could be manipulated like that and clearly we don't see abhorrent behavior like this in the casino. It would be much too obvious....

Whatever happens between now and Dec 31st, we'll let the hedge funds (what's left of them) determine. As I look through the first few months of 2009 this is the pattern we shall see - remember we are pointing to Jan 8th (retail sales) and Jan 9th (employment report) as interesting days a week from now; and earnings season quickly approaches:
  • earnings warning preannouncement
  • earnings warning preannouncement
  • Congress is back! The nanny state will save us with stimulus
  • earnings warning preannouncement
  • earnings warning preannouncement
  • horrific retail numbers
  • awful employment report
  • bad earnings by multinationals - that darn US dollar is killing us
  • bad earnings by multinationals - we're pulling guidance since we have no visibility
  • states begin to realize its a new year and their budgets are due in 6 months; panic ensues as many realize "hey we're no different than California"
  • bad earnings
  • Federal Reserve announced 12,312th 4 letter acronym to save credit system
  • bad earnings
  • occassional "we expected horrific earnings but instead got awful earnings" - time to drive that stock up 40%
  • other bad economic reports than most people just say "is all priced in"
  • bad earnings
  • another 2 companies that have no right to become bank holding company become so
  • bad earnings
  • the best speech in the history of mankind on Jan 20th, from which all people worldwide will forget all ills, and be inspired (to buy stock) and shop/buy homes, be merry - watch the heavens part and gold reigns down (or at least US dollars).... for 48 hours...
  • .... reality returns when people see despite said oratory all the same bills remain
  • earning warnings
  • earning warnings
  • FedEx pulls sponsorship from Washington Redskins football stadium - the Federal Reserve comes in to backstop, and how convenient - they only need to change a few letters. Meet FedReserve Field.
  • The New York Yankees sign the entire Florida Marlins franchise with Federal Reserve backstop. The New York Yankees are now deemed too big to fail, are granted bank holding status and unlimited access to the discount window. At which point they use leverage (with high 5 from Tim Geithner - "now that's risk taking like the old days"!) and lend the Florida Marlins to the Fed in return for US Treasuries which they immediately sell to buy the Boston Red Sox.
  • Congress has come to some agreement! No those darn Republicans are preaching fiscal restraint - as in $1 Trillion is too much; let's be restrained with $700 Billion
  • more pulled guidance
  • talk of stupendous housing relief that will fix everything; the no down, no appraisal; no interest loan starts to be leaked to the Wall Street Journal. Since there is no securitization market, the Federal Reserve will buy these "risk free" assets.
  • more bad news
  • Car companies start to wallow back up to the bar for Round Deuce of the bailout
  • California is in panic mode on budget
  • Stimulus passes and market rejoices, all people worldwide rejoice and forget all ills as backhoes across the country are filled with diesel and former accountants get their first pair of steel toe shoes! The Baltic Dry Index surges 1.2473% at which point Cramer repeats "I told you China had bottomed! DryShips - BUY BUY BUY" Good news and cheer fills the country... for 48 hours...
  • more bad news
  • rinse, wash, repeat - keep repeating "it's all priced in" and "I will ignore all bad news because the nanny state will replace private enterprise and it will all be better in 6 months"
So you get the drift - it's bad news all around except for the "hope phases" and it will all be sentiment and "Washington D.C." driven which unfortunately is what we've been dealing with for a long time and is very tiring. It is one thing to say "it's all priced in" for weeks on end, but can a market really make a sustained move on "we ignore all bad news because a new day is here - that speech Jan 20th should be worth 10% on the S&P" for months on end? I find it doubtful. We'll see this pattern throughout 2009 - we're just waiting for the end game when the US government becomes partner with each underwater homeowner and erases contract law (that's part of the U.S.A.R.) and forgives principal on mortgage loan upon loan across the country. Sending an excellent message to those who actually played by the rules and didn't partake in this real estate Ponzi scheme. Literally we are going to make everything in America, outside the Federal Reserve balance sheet and US dollar, "risk free" to encourage speculation. No one loses (but the grand kids) - please speculate (and shop). Then the "free marketers" on Wall Street can drive the market up in child like glee as the tax payer subsidizes them. One can only wonder how a country weaned onto a system where the government backstops all risk will be weaned off? But that's a crisis for another year. We only deal with the fire on the couch we are sitting on.

As we await this most wonderful of times that shall visit us - let's visit the technicals in the market - we actually have a very easy set up in that we can be pushing chips back on the long side on a close north of S&P 920 - a very obvious line in the sand to the north, and below 850 and especially 820 push chips in on the short side. In between we just call this white noise and fun for daytraders. There are some interesting things going on in individual names but no meaningful moves.

This week we cut back on 3 thesis as the stocks retraced some of the previous moves - these were housing thesis, infrastructure thesis, and China thesis. As always, when a stock/ETF comes back to support and threatens to break through you can play aggressive and buy more (with a tight stop loss) or cut back and only add back when you see the bounce in place. So if we see these support levels hold, we'll jump back in... so let's take a quick look at the charts

Proxy for infrastructure thesis - still solid hope here

Proxy for housing thesis - getting iffy

Proxy for China thesis - if we draw support lines with ball point pen, it looks worrisome; if we draw with crayon we can still see the case for rebound.

So as if we said above, this market puts on a patented move from 872 to 920 to finish the year in a flurry, certainly the hedgies would love to run up all these thesis - and we could see rebounds. We are obviously taking the cautious route (cutting back on danger of support being broken) but flexibility is a key and movement around key support levels like this is very tricky. One day you can break below, and your rules tell you to cut back in case of a much larger move down, but the next day you can regain that support and you have to jump back in. So far, we have yet to see the rebound that would draw us back in but all are on the radar. In an actual fund, a break below these support levels and you'd actually want to short - although there are easier targets out there in clear downtrend for shorting purposes. But the greater point is, these are 50/50 charts - it can break either way and I suspect the general market will have more to do with it than individual stories.

Meanwhile, we are waiting patiently for a sustained pullback to add to positions or add to portfolio the best charts - to wit...(is it whit or wit?)

Contrast to names that are showing very poor action, and frankly are shorts on a rebound until proven otherwise (stop losses at the red lines)

So once more, we are currently running only "half" our strategy since in the current simulation we are locked into short ETFs (with their flaws), as opposed to individual stocks, as our hedging. In the real world, I'd be running in a more long-short book hitting individual equities on the short side, the latter 4 are the type of charts we want to focus on - but something like Apple has been so weak I'd expect at least a cursory bounce soon (which is to be shorted until it can break back above the pretty red line).

I plan to cut out much of this short ETF exposure Monday not because I don't want short exposure, but because in a sideways market these instruments are death by a thousand cuts. Unless I can figure out another way to short from the "long side" we just will have to hold them during the major swoons (and miss out on the first leg of any such swoons) and cash will have to be our hedge. When the market does fall these ETFs can double in 4 days but the paper cuts in between are bleeding us out.

Other than that, we're in a holding pattern, with little economic data and another shortened week, and the cynic in me says "they" try to mark this market up to create good cheer by the 31st ... but I will repeat we continue to go sideways, each and every week we do so, creates an even larger move that eventually comes from sideway churning. The longer said churn remains below key resistance areas the more we point to the conclusion of the churning to be "down". I'm not the best technical analyst out there but I dominated preschool when it came to shapes - and you can see one whopping "triangle" forming in that chart of the S&P 500. Bulls need S&P 920 to be cleared and held - the quicker the better. All non Obama facts would point to a downward move in due time. But Obama (sentiment) > market (for now)

Sunday, December 28, 2008

More Proshares UltraShorts Tomfoolery

The more I look at these double inverse ETFs the more I see how useless they are as even a medium term hedging vehicle. It really leaves those of us who cannot short in an account (which is how is set up as are 401ks/rollover IRAs) in a pickle.

Some of them are hard to analyze directly since there is no specific index they directly short against, but the two foreign ETFs we own show how ineffective they are in any lengthier time frame. These truly are like options in which the time decay is working against you every day you hold them. I've already outlined how poorly they have done as hedges against financials or real estate dropping... here are some more cases.

I bought Ultrashort Emerging Markets (EEV) as a hedge against foreign markets dropping - I began this ETF on November 15, 2007 right near when it first began trading. I've generally held this in a 1-3% stake for most of the past 13 months, although at peak its hit 4-5% of the portfolio. At the time I originally bought, the instrument it hedges against - which is the iShares MSCI Emerging Markets Index (EEM) was trading around $49. Today it is $24 - thats a 51% drop. I made an excellent theoretical call here, and the gain one could gain by SHORTING the long ETF - EEM would be +51%.

Below is what EEM looks like graphically since I bought its DOUBLE INVERSE

In theory an Ultrashort is supposed to give you double that return - at least conceptually. In the prospectus and as documented by other what it guarantees is only each day's inverse return - i.e. the compounding is useless. But at least in concept if you held this ETF you'd think you'd get double the inverse return. Since the EEM fell 51%, you'd think you would of made +102%. Great trade! Not so much.

Ok we say - these instruements are flawed - instead of getting +102%, well maybe you only got 51% - which is not double the inverse but single the inverse of the ETF is betting against. Or maybe it's even worse than that, maybe you only got HALF the inverse - maybe 25.5%. That would be awful but at least you still made money.

Want to see what the Ultrashort Emerging Markets (EEV) has done since bought on November 15th @ $60?

It is now trading at $56. Now granted there were some capital gains distributions but at $56 it's a 7% loss for holding it the entire time (ex capital gains) versus what should be (conceptually) a 102% gain. Let's say the capital gains distributions even led to a 5% gain. That's still rotten versus the CONCEPT of this ETF. So effectively, unless you caught the huge waves when this name really moves (or in fact ANY Ultrashort ETF) every day you hold this you lose money in a sideways market. You didn't get +102%. You didn't get half that - 51%. You didn't get a quarter of that - 25.5%. If you were lucky you got 0%. Despite making a great call on shorting foreign markets. That's terrible - I'm sorry.


I won't go through all the conceptuals with the Chinese ETFs but it's the same idea with iShares Xinhua China 25 (FXI) and its DOUBLE INVERSE ProShares Ultrashort Xinhau China 25 (FXP). The latter is supposed to give you DOUBLE the return of the index (but it only does on a daily basis). We bought FXP a few days after EEV - on November 20, 2007... or roughly at $58. If you were not around at the time October 2007 was the height of Chinese stock insanity[Aug 28: China "A" Shares Bubble] [Sep 1: The Growing Bubble in the Shanghai Index] - which we outlined daily - PetroChina (PTR) hit a $1 Trillion market cap [Nov 1 2007: PetroChina the 1 Trillion Dollar Company? Is *this the top?] , a multitude of Chinese small caps were going up 50% a day as speculators ran in and out of them, and many Chinese large caps had doubles or tripled in the year past... it was a bubble in the making that we were pointing out. The danger is you don't want to get in front of a bubble but by November 2007 the "decoupling" theory (foreign markets will thrive even if the US goes to recession) was starting to show flaws and with this shiny new ETF we had an easy way to bet against China. To nail a long term bubble within a month or two of its top is a heck of an achievement. Let's see how we were "rewarded"

Here is how the iShares Xinhau China 25 (FXI) chart looks from when we began buying the DOUBLE INVERSE ETF - again it was roughly $58 when we bought. Today? Despite a huge rally in Chinese stocks the past month it has only bounced to $28. That's a 52% drop, so it looks like an excellent call!

But only if you shorted the FXI....

Because as you see below, our lovely ETF which should be DOUBLE the INVERSE - again, should of (conceptually) netted us +104%, instead has fallen from $70 (where we started it in late November) to $40. (note: SOME CAPITAL gains are in that number so maybe the real price is $45, or $50). Let's me generous and say the capital gains added a whopping $10 (or 25% of the current value of the ETF).

So the double inverse has dropped from $70 to $50, or 28.5%, while the index it is SHORTING AGAINST has fallen 52%. So not only did we not get the double inverse (compounded) - 104%... not only did we not get a single inverse - 52%.... not only did we get HALF a single inverse - 26%... we did not even get 0%. We lost money. At $50, a "buy and hold" type would of lost nearly 30%...

Unless you are an extremely adapt and nimble short term trader who held this witches brew on the exact right days/weeks and completely sold out all the other days, this is a loser. As is this whole concept of hedging by holding these vehicles - unless you are hedging for only a day or 3-4 days. And the market is going in exactly the right direction and in a very meaningful way.

Now that we have a historical record we have to reconsider how to hedge; in a real mutual fund - I'd be happy to short the underlying indexes and it would made very large amounts of money for shareholders. Both these calls should of made investors 50%+. Frankly even more than that since we've been trading them and had much higher stakes when they really fell off a cliff. Instead, despite some frentic trading to avoid the moves that can sap a month's worth of gains in 6 hours with these ETFs, I'm up only $10K on EEV and actually DOWN $4K on FXP. Despite both indexes I've been betting AGAINST falling 50%+ since I began these positions. I should be up $40-$60K+ in both considering the position size I've had these at, and how much they've fallen.

As a medium to long term hedge these are useless. They feed into the casino mentality and can make big bucks in very short periods of time which makes the gambling types in the market happy (along with run and gun hedgies), but for the greater investment community who are looking for a way to buy insurance for the long term against your long positions - the history shows they are inappropriate. As more suckers... err people, like me figure this out I believe these tools will become abandonded except for the extremely short term oriented crowd and/or during times of extreme duress in the market.


On a personal note - I was aware of the issue here but vastly underestimated how much this issue effected the long term performance. I did realize they only gave double the inverse on a daily basis but I though I'd still catch anywhere from 60-70% of the move once compounded (and I'd give up 30-40% of the gain) due to this liability. I was willing to give up 1/3rd of my gains since I have no other way to short - as long as I was correct DIRECTIONALLY I'd still make money... that was my thinking. Instead I see I am giving up ALL of the move (and in fact one is prone to lose money even if "correct") if your holding period is of any length of time. This was the flabbergasting point. Due to this I'll be cutting back these positions severely because in a sideways market they steal from you each day; and only use them in strongly downtrending periods. For a long term hedge against long positions, I am not sure there is anything out there of use for those who are stuck in "long only" accounts.

p.s. I've taken a quick look at the Ultra (LONG) versions of these ETFs and they have the same problems... I would make an arguement that if you really want to bet against a sector even better than shorting the underlying INDEX is short the Ultra long ETF... because not only do you get the drop from the underlying index, but you get the Proshares ETF "Ultra" or "Ultrashort" structural degradation I've outlined above. So if I could, and I wanted to short Real Estate - short Ultra Real Estate (URE) which would give you a much better return than shorting the underlying index iShares Dow Jones US Real Estate (IYR). Want to see it in numbers? Since November 2007 IYR has fallen from $75 to $35 (a drop of 53%). URE? From $47 to $6 (a drop of 87%). So you get to benefit from the underlying weakness of the sector plus the flaws of the ETF for anyone who holds it medium term or longer. The pain you might suffer when the underlying stocks rallies is compensated by the breakdown in the structure of the ETF. I am beginning to wonder if due to the structure if all these ETFs are destined for a near $0 price in the "long term".

Long Ultrashort Xinhau China 25, iShares Xinhau 25, Ultra Real Estate, Ultrashort MSCI Emerging Markets in fund; no personal position

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