Investment Postcards from Cape Town

This post is a guest contribution by Bennet Sedacca*, President of Atlantic Advisors Asset Management.

“The national budget must be balanced. The public debt must be reduced. The arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced. If the nation doesn’t want to go bankrupt, people must learn to work, instead of living on public assistance.” - Cicero, 55 BC.

Is Debt The New Equity?

I have been negative on credit for what seems like an eternity now. I have stated many times that, “if you are not being compensated to take risk, particularly credit risk, do not take credit risk”. And so for a long time we have been void of credit risk and to be frank, remain so. But for those that must take risk, the credit market is starting to seem like a far better bet than do equities.

Before the equity market began its descent this spring, I believed the credit market was sniffing out something that the equity market was not. Please click the link for more on “The Tale of Two Markets“. When asked why I believe the stock market has corrected so swiftly, my answer has been, “it had a lot of catching up to do”.

The big question on my mind these days is whether or not the equity market has corrected enough in order to make equities cheap relative to other asset classes, particularly credit. My answer is a resounding NO!

I have stated and still believe that we are in a secular bear market in equities that will not end until 16-year trailing returns for the Dow Jones Industrial Average and S&P 500 are in negative territory. In other words, this would mean that when we marked the high for the S&P in March of 2000 at approximately 1500, a secular bear low assuming a -4% annualized trailing return for 16 years would place us at around 795 in 2016. Pretty sobering, right?

Looking at the graph below, courtesy of Ned Davis research, we can see that secular lows have been established in the DJIA when the 16-year trailing return range is between -4% and 0%. Considering that the secular bull market party that went on from 1982-2000 was the greatest on record, one must expect the secular bear to accompany it to be the nastiest on record as well.

Notably, in the secular bear market, lows stemming from the Great Depression (the most similar pattern I can come up with for the mess we face today) and the 16-year annualized trailing returns in the range of -4% seem to be the most appropriate level to use. Since this credit unwind may actually be more painful this time around, I think that is the best we can hope for. So, while equities may seem “cheap” to most, I can accept that they will rally from time to time, perhaps fiercely, but the sad truth is that the “buy and hold” approach that has scorched so many during the past eight years is still not the best risk/reward proposition. This leads me to ask, “what is the better proposition?” Debt. Yes, that 4-letter word I have been avoiding for so long.

Click here for Bennet’s full report.

* President of Atlantic Advisors Asset Management, Bennet Sedacca brings with him more than 26 years of securities industry experience. From 1981 to 1997 he worked for several major investment banks, specializing in high-grade fixed-income securities marketing, trading and portfolio management. While working for PaineWebber as a Senior Vice- president, Bennet was a member of the Chairman’s Council for four consecutive years. During his years with Salomon Smith Barney as a Vice-president, he established an institutional fixed income presence in Central Florida.

In 1997, Bennet formed Sedacca Capital Management focusing on portfolio management for high-net worth individuals and small to mid-sized institutions. He is also a contributor to the financial website, www.minyanville.com and is regularly quoted in Wall Street Journal Online, Barron’s and Bloomberg.

Bennet graduated from Rutgers University in 1982 with a degree in Economics and was a member of the International Honor Society of Economics.

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This post is a guest contribution by Bennet Sedacca*, President of Atlantic Advisors Asset Management.

It is often said that “hope is a poor roadmap to success”. Hoping is as useful in investing as it is in nearly every other activity that I can think of. I must admit that I have found myself hoping that an investment or trade gone badly would come back. I must also admit that I cannot recall a time when I have been rewarded with success just because I hoped for it. That is also why I have learned to take losses when they are still manageable - as they say, “good traders know how to take gains, but great traders know how to take losses”.

I am not saying that I am a great trader, only that I recognize that admitting defeat when you are wrong about a trade or investment is the key to investing. Simply put, if I find myself wrong-sided, I “cut my losses and run”. Quickly. Better to lose 10% and have to earn 11% to get to break-even than losing 50% and needing to earn 100% just to get back to break-even.

If you think hoping is a poor roadmap to success, praying that your asset will magically come back in price is even more dangerous. This is the single biggest mistake being made around the globe these days - “living on a prayer”.

What is wrong with the global markets?

As equity and debt markets sink around the world, I am constantly bombarded by questions about why prices are falling. I could write pages and pages about why I believe prices have sunk so much and will continue to sink (not in a straight line of course) over the next couple of years. Simply put, markets are sliding down the “slope of hope”. Bull markets are said to climb up the “wall of worry” and, in direct contrast, bear markets slide the “slope of hope”. When investors give up on hope and capitulate to the point of despondency, enough fear has been placed into the system that the market can then climb the “wall of worry”.

The “slope of hope” has some easily identified characteristics; low cash levels in the mutual fund complex, low levels of short selling activity, and most importantly, a serious case of denial, or the “I don’t want to open my brokerage statement” syndrome. Another symptom of the slope of hope is that consultants and advisors that have been wrong-sided the whole way down will wish to stay the course as markets rise over the longterm, dollar cost average, etc. This sort of activity continues until the road to capitulation begins and fear takes over. With fear comes high cash levels, loads of short selling and a general disdain for stocks in general.

When I walk in to a bar or restaurant and see ESPN on rather than Bloomberg TV, Fox Business News or CNBC, I know that we are getting closer to a bottom. When I see a bear on the cover of major financial publications, I will know that we are getting closer to a time to take risk again.

The main point I wish to make is that when earnings expectations have fallen enough that they are likely too low, then it will be hard to disappoint investors. The biggest problem in the markets at present is that earnings estimates are woefully too high. This is otherwise known as a “value trap”.

Click here for Bennet’s full report.

* President of Atlantic Advisors Asset Management, Bennet Sedacca brings with him more than 26 years of securities industry experience. From 1981 to 1997 he worked for several major investment banks, specializing in high-grade fixed-income securities marketing, trading and portfolio management. While working for PaineWebber as a Senior Vice-president, Bennet was a member of the Chairman’s Council for four consecutive years. During his years with Salomon Smith Barney as a Vice-president, he established an institutional fixed income presence in Central Florida.

In 1997, Bennet formed Sedacca Capital Management focusing on portfolio management for high-net worth individuals and small to mid-sized institutions. He is also a contributor to the financial website Minyanville and is regularly quoted in Wall Street Journal Online, Barron’s and Bloomberg.

Bennet graduated from Rutgers University in 1982 with a degree in Economics and was a member of the International Honor Society of Economics.

Related articles:
How low, how bad, how long?

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This post is a guest contribution by Paul Kedrosky*, market commentator and venture capitalist who also blogs about financial matters of the day on the Infectious Greed site.

Honestly? Wall Street doesn’t care. Yes, I know that’s not the answer anyone wants. People want to believe that Wall Street is obsessing over the presidential race the way most of the country has been. It seems only right somehow, sort of mirrored pathologies. There is a pathology going on, however, but it’s much, much stranger.

There is no denying that there is a relationship between presidential elections and the markets. You would have to be delusional to believe that choosing, say, Mao or Mussolini wouldn’t cause the markets to implode the morning after. But that’s an extreme case. To be somewhat more practically-minded, there is data showing that Democratic presidents are best for the markets. But then again, data also shows Republican presidents turn in the best Dow Jones numbers between the election and the end of the year. And then there are those positive numbers on how Dow Jones returns look for Democratic presidents who control Congress, but only have a small majority in the house. Let’s not forget, of course, the cheerfully nuts claim that the main reason the stock market sold off to the point of nothingness in September was that Barack Obama went from being tied with John McCain to having a clear lead in the presidential race.

Should you care about all this psycho-babble data? No. It is small-sample silliness intended to give nonsense the patina of truth, which it isn’t. Here is the reality: Markets generally don’t know what to make of presidents. Such people rarely do what they say they are going to do, which makes discounting the future difficult; and such things as they do that turn out to matter to markets often have their economic significance missed for years. Who would have thought Reagan would be as progressive as he was, that Clinton would be such an unrepentant free-trader, and that Bush II would be so tone-deaf on economic matters? None of them seemed that way going in, and yet that’s what happened. On the other hand, while many people thought that Sarbanes-Oxley was overreach, who would have thought it would lead, in large part, to the near complete disappearance of initial public offerings in the US. Even its most scathing critics didn’t expect that outcome.

Please click here for the rest of Paul’s article.

* Paul Kedrosky’s bio is here.

Source: The Daily Beast, November 6, 2008.

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This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.

My big worry at the moment is what is happening to (some) hedge funds. Clearly, 2008 has been to hedge fund investors what 1992 was to Queen Elizabeth II – Annus Horribilis (see chart 1).

Chart 1: Selected hedge fund strategies (YTD performance)

Source: The Economist

Merrill Lynch did a study recently, showing that the 30 biggest US equity holdings amongst US hedge funds were amongst the poorest performers in the S&P500. In other words, it is likely that much of the recent sell-off in equity markets around the world can be traced back to hedge fund liquidations.

There is no question that hedge funds are downsizing at present. The problem is to obtain precise data on the phenomenon. If we estimate that the global hedge fund industry controls about $2 trillion of capital, and we assume that 15-20% is going to be pulled out between now and year-end (which is not far from the truth according to our sources), $3-400 billion must be returned to investors between now and 31st December.

Deleveraging continues
That is not the whole story though. The average hedge fund uses leverage, to the tune of about 1.4 times (see chart 2). This is down significantly from a year ago, but it still means that hedge funds need to liquidate investments of at least $500-550 billion in order to meet current redemption requests. And the real number is probably higher because some of the worst performing strategies this year are the ones using the most leverage. The real number is therefore more likely $6-800 billion, and that is a big enough sum of money to put downward pressure on the markets.

Add to this the fact that some hedge funds (mostly the bigger ones) have been selling credit default swaps (CDSs). A CDS is an insurance against corporate default. The buyer of a CDS supposedly makes money if the underlying credit blows up. I say ‘supposedly’ because the payment is a function of the seller’s ability to pay up. That was why Morgan Stanley had to be saved at all cost. MS has been, and continues to be, one of the largest players in the CDS market.

Chart 2: Average hedge fund leverage

There is no way we can establish precisely how many CDSs hedge funds have on their books, but please consider the following: The CDS market is a $50 trillion market (give or take). Before they blew up, AIG were one of the biggest sellers of CDSs with approximately $500 billion on their books. They ran into problems (partly) because they were heavily exposed to the financial services industry which is already in recession.

Recession in the early stages
The rest of the economy, however, is not yet in recession – or rather, we do not have the statistics to prove it. Corporate defaults are still low, both here and in the US. But corporate defaults will go up as they always do in recessions. If AIG, one of the largest and most sophisticated financial institutions could get themselves into trouble with barely a 1% share of the global CDS market, what will happen to the sellers of the remaining 99%?

Who ‘owns’ this risk? Is it hedged or not? Is it even possible to hedge the risk, knowing that your counterparty might not be able to pay up? What we do know is that only the larger hedge funds have participated in the practise of selling CDSs. Right now it feels very good not to be invested in those types of hedge funds (as you may be aware, our focus is on alternative investment strategies away from mainstream hedge funds). I also suspect that the extreme volatility in recent weeks is somehow related to this phenomenon. Investor redemptions are not the whole story.

Conclusion
I pointed out several months ago that the world’s stock markets would present several ‘false dawns’ before we could finally declare victory against the bear market. Last week’s more upbeat tone was one such ‘false dawn’, in my opinion. There are three reasons for that:

Firstly, investors have not yet fully capitulated, and that is a necessary condition for markets to turn around. It is best illustrated by a survey conducted by BCA Research at the end of their two-day investment conference held in New York on 20-21st October. Only five or six of the more than 250 people in the room expected the stock market to be lower a year from now. Not consistent with capitulation! Having said that, it is perfectly normal to experience powerful rallies in the midst of a major bear market. The sharpest rallies in history have actually been bear market rallies.

Secondly, de-leveraging has a long way to run yet, not so much in the hedge fund community where I suspect that much of the damage will be behind us once we pass the next major redemption hurdle on 31st December, but in society more broadly. Governments, banks, (some but not all) companies and, most importantly, the majority of households are more leveraged than good is. I have borrowed Chart 3 below from BCA Research, and it shows total US bank loans as a percentage of US GDP. Unfortunately, the picture would be much the same for many of the European countries. We are now facing a major de-leveraging cycle and it will suppress economic growth and put a lid on the stock market for years to come.

Chart 3: Major deleveraging cycle ahead

Source: BCA Research

Thirdly, whereas I fully agree that the worst of the financial crisis might now be behind us, bear in mind that we have not yet seen the full effect of the economic crisis. We are only in the first or second innings of this recession, and the emerging market story has the potential to wreak further havoc. So do credit default swaps - or something else. Recessions are by nature quite unpredictable. There is one thing I am sure about, though. Just as for New Year’s Eve, the more extravagant the party, the bigger the hangover. Prepare for this one to linger for a while yet.

* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

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