Q408 Asset Class Performance: The Worst Quarter in 20 Years

The following chart depicts asset class performance (based on major indices) for Q408. As expected, returns for the final quarter are quite dismal, even following a year-end rally in most markets in December. The following is of particular interest:

• Investment grade bonds recovered following the October decline ending up 5% for the quarter
• Commodities (on the aggregate), which had a stellar H108 and then plummeted, ended up for Q408
• TIPS returned a -3% during Q408 as deflation expectations weighed on investment decisions
• High Yield (as noted in a previous post) saw yield blown wide open, depressing prices considerably for the quarter and presenting attractive investment opportunities toward the second half of December
• Equity markets saw their worst quarter in 20 years, with emerging market's taking the biggest hit as risk aversion dominated the period
• Real estate, which lead the economic decline still rippling through the global economy, was down another 37% in Q4. It should fall further!

Trade Deficit Narrows

The Census Bureau is reporting that the US trade deficit fell by approximately 28% M-O-M in November; representing a $40.4b deficit (markedly better than the $50.1b estimate).

A majority of the decline can be attributed to a fall in the price of oil imports, although there was an overall widespread pull-back in the demand for most foreign goods (12.0% M-O-M decrease). It is likely that this downward pressure on oil prices will persist, and continue to be a significant factor in the trade balance, as global adverse economic conditions result in further decreases in demand, which have thus far outpaced a reactionary pull back in supply (as I previously argued this dynamic is likely to persist in the near term).

Accompanying the decrease in imports was a 5.0% M-O-M decrease in exports (long gone are the days of H12008 where strong exports provided a significant boost to GDP). We can certainly expect to see continued weakness in the demand for exports as all indicators point towards pro-longed economic weakness abroad accompanied by a continued easing of monetary policy resulting in further increases in the value of the USD.

Source: US Census Bureau

Employment Situation Summary Report: Another Step Toward Double Digit Unemployment

Nonfarm payroll employment declined sharply in December, and the unemployment rate (U-3) rose from 6.8% to 7.2% , the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Payroll employment fell by 524,000 over the month and by 1.9 million over the last 4 months of 2008. In December, job losses were large and widespread across most major industry sectors.

Other takeaways from the report?

• U-6 is now at 13.5% and rising
• Although many reported that initial claims for state unemployment insurance benefits fell 24,000 to a seasonally adjusted 467,000 in the week ended Jan. 3, coming well below market expectations for 540,000 new claims, the perception that this news is positive is flawed (as were the estimates themselves). Intial claims may have come in below expectations, but that fails to consider those that delayed making such claims in light of the holidays.

Unemployment will continue to march toward double digits.

Unprecedented Underperformance: A Bottom for Bonds?

The table above outlines the excess returns by sectors of the bond marketplace over the last 10 years relative to the risk free (treasuries) rate. Not surprisingly, 2008 marked the single worst year of the period, with Q408 (un-annualized) and 2007, marking the second and third worst years respectively for most sectors. With spreads blown this wide, prices are markedly depressed, and I have little doubt that high yield spreads will move downward, equating to price appreciation of bonds in this category. The spread this wide anticipates massive defaults, and although some may occur, diversification in this sector should net some solid gains. Coupled with our orthodox sentiment that debt markets should lead the recovery, look to see Abnormal Return move out of 100% cash in the coming days, and into high yield ETFs.

Fiscal Stimulus - A Long-Term Perspective

The Congressional Budget Office estimates the federal government's budget deficit will grow to $1.2 trillion for the current fiscal year. It is expected that this figure will be revised upward after the enactment of President-elect Obama's enormous economic recovery package (now estimated at $775 billion).

With these extreme levels of debt it is becoming increasingly important that the fiscal measures employed in the stimulus package are capable of providing the economy with not only short-term stimulus, but also long-term social benefits.

The package can hypothetically be structured to increase any of the four sources of demand; consumption, investment, government and exports. Thus far, a significant portion of the package has been allocated to tax cuts ($300 billion over 2 years), which predominantly aims to increase private consumption, as well as capital expenditures (albeit to a lesser degree) in the short to medium term. The jury is still out on whether these tax cuts will be an effective consumption stimulus. My opinion is they will have a moderate effect given the extreme sense of pessimism and risk aversion in the private sector.

With the possibility of increasing exports out of the question (global economic weakness, widespread monetary easing, etc) the remainder of the stimulus package should be focused on government spending on, and investment in, resources and projects that have long-term benefits to the economy and society as a whole. This includes spending and investment incentives directed toward education (and as a result human capital), infrastructure, and alternative energy. Such an initiative would provide the economy with additional short-term support (e.g. increased employment), and more importantly long-term social benefits to the nation. At some point we need to revert back to proper fiscal responsibility and this may be our last hoorah. We need to make it count and in turn be able to realize benefits that reach beyond short-term stimulus and transcend the current economic cycle.

US Residential Housing: Further to Fall

Simple data aggregation coupled with modest assumptions suggest that aggregate US residential housing prices have to fall another ~15% over the next two years before they reach historical median values. This reality alone will place more stress on the household balance sheet and curtail spending for the foreseeable future, but in my opinion we are likely to see prices decline more than to this historical value (measured as median price/median income).

First, a simple example outlines a major demand concern:

Assuming a 5.0% 30-year fixed loan with 20% down, the median household faces:

• $180,000 median house
• $36,000 cash down payment
• 1.44 * $550 PI = $792/mo. * 12 = $9,504
• 1.5% * $180,000 Property Taxes = $2,700 (almost no tax benefit since PIT ~= two-earner standard deduction)
• 2% * $180,000 Insurance and Maintenance = $3,600
• Total yearly outlay: $15,804

This $15,804 annual outlay as a percentage of median income ($53,500), means the cost of ownership on an annual basis is 30% of total income. In other words, the median house is now barely affordable by the median household. Furthermore, this example depends upon both a 5.0% mortgage rate and a $36,000 down payment; a best-case, and highly unlikely scenario. Real homebuyers earning the median income most likely face much higher mortgage rates, have under 10% down payments available, and face additional fees and expenses in the form of insurance penalties.

In a supply environment of record inventory, with this demand enviroment (decline incomes, unemployment, etc.) it is quite likely overshooting such that prices decline much more than 15% from today's levels. As you can see in the following charts, previous downturns almost always resulted in declines below the historical average, and there is certainly no indication that this environment is likely to prevent such an occurance.

Oil is Back

Good news for people who bought hybrids during the days of $100+ per barrel oil prices. The escalating war in the middle east between Isreal and Hamas, growing tensions between Russia and Ukraine and OPECs production cuts have pushed oil prices back over $50 per barrel. The political tensions are prompting buyers to pick up oil at depressed levels as they worry about future supply issues that could result. The market will now have to determine just how high oil should be priced as they weigh the new supply concerns against the economic slowdown that cut worldwide demand.

$5 Billion to GMAC

Its no secret that I have some concerns (if not outright opposition) to the massive, ill planned auto industry bailout. However, it now seems evident that the US government is going to take all necessary steps to keep these lumbering beasts alive (at least in the short run). Therefore, because we, the taxpayer, can not stop the inflow of capital to these companies despite their inability to provide Congress with any real plan regarding how they will re-shape their business models to become more competitive and capital efficient, we must look to where the invested capital will be best employed in a manner that benefits not only the auto-makers, but the economy as a whole (where the evaporated capital/total capital invested ratio will be lowest).

I would argue a $5 billion purchase of senior preferred equity in GMAC is a lesser of two evils. At least we know that a portion of this capital will be used by GMAC to provide financing to a "broader spectrum of U.S. customers." Furthermore, GMAC has said it will lower its credit criteria to include retail financing for customers with a credit bureau score of 621 or above (this is compared to a 700 criteria pre-capital infusion) and offer 0% financing for up to 5 years on some GM cars and trucks. This improvement in credit availability and terms may be a first step in creating some increased demand (albeit it very small given the macro pressure on the US consumer) in GM automobiles, and it is certainly more efficient than giving the money directly to GM, where despite two presentations to Congress, we still have no idea where it would end up.

GE's Credit Rating at Risk

The Standard and Poors rating service says there is a probability of 33% that they will downgrade GE's AAA rating within the next two years. A GE spokesman, speaking on the matter, admits that if they are unable to meet their short-term financial plan rating cuts will come. According the Standard and Poors, GE has has about $10 billion in cash that could be funneled into the capital unit, on top of the $5 billion already contributed this month. Doing this will shore up the capital unit's balance sheet and hold off a rating cut at least in the short-term.

Unemployment Insurance Weekly Claims Report

In the week ending Dec. 13, the advance figure for seasonally adjusted initial claims was 554,000, a decrease of 21,000 from the previous week's revised figure of 575,000. The 4-week moving average was 543,750, an increase of 2,750 from the previous week's revised average of 541,000.

The advance number for seasonally adjusted insured unemployment during the week ending Dec. 6 was 4,384,000, a decrease of 47,000 from the preceding week's revised level of 4,431,000.

FOMC Establishs Target Range for Federal Funds Rate of 0 to 1/4 Percent

The final primary monetary policy move is made:

http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm

Even More Deflationary Concerns

The CPI Index fell by a record 1.7% in November (largest monthly decline since the Labor Dept. began compiling the figure in 1947). The steep drop in the index was the result of a 17% decrease in energy prices and broad downward pressure on AD. The core CPI remained unchanged over October. Furthermore, the CPI rose 1.1% on a year-over-year basis in November, which is below the 1.5% to 2% range thought to be targeted by the Fed.

More Deflationary Concerns

A major guage of economic health in manufacturing in New York State hit a record low in December, a Federal Reserve report (one of the earliest monthly indicators of what is to come for U.S. factory conditions) demonstrated, additionally noting a record drop in a key price gauge exemplifying slipping demand. Furthermore indications from additional reports have showed overall industrial output slid in November.

The New York Fed's "Empire State" general business conditions index fell to minus 25.76 in December, versus minus 25.43 in November. Economists polled by Reuters had expected a December reading of minus 27.25.

The series of reports precede government releases concerning consumer price data for November, which economists expect to indicate prices falling for the third time in four months. This alone should indicate that in the near term, deflation, not inflation, should be the biggest worry and that printing money and spending are becoming increasingly necessary as the US appears to be in the early stages of deflationary trends in prices and wages.

Bernie Madoff Arrested Over Alleged $50 Billion Ponzi Scheme

Bernie Madoff, a former chairman of the Nasdaq stock market, has been arrested and charged with running a multi-billion dollar hedge fund pyramid-selling scheme in New York.

Below: A 2001 Barron's article outlining Madoff's consistent success:

Don't Ask, Don't Tell
Bernie Madoff is so secretive, he even asks
investors to keep mum
By ERIN E. ARVEDLUND

Bernie Madoff might as well hang that sign on his secretive hedge-fund empire. Even adoring investors can't explain his enviably steady gains. Two years ago, at a hedge-fund conference in New York, attendees were asked to name some of their favorite and most-respected hedge-fund managers. Neither George Soros nor Julian Robertson merited a single mention. But one manager received lavish praise: Bernard Madoff.

Folks on Wall Street know Bernie Madoff well. His brokerage firm, Madoff Securities, helped kick-start the Nasdaq Stock Market in the early 1970s and is now one of the top three market makers in Nasdaq stocks. Madoff Securities is also the third-largest firm matching buyers and sellers of New York Stock Exchange-listed securities. Charles Schwab, Fidelity Investments and a slew of discount brokerages all send trades through Madoff. Some folks on Wall Street think there's more to how Madoff generates his enviable stream of investment returns than meets the eye. Madoff calls these claims "ridiculous." But what few on the Street know is that Bernie Madoff also manages $6 billion-to-$7 billion for wealthy individuals.

That's enough to rank Madoff's operation among the world's three largest hedge funds, according to a May 2001 report in MAR Hedge, a trade publication. What's more, these private accounts, have produced compound average annual returns of 15% for more than a decade. Remarkably, some of the larger, billion-dollar Madoff-run funds have never had a down year. When Barron's asked Madoff Friday how he accomplishes this, he said, "It's a proprietary strategy. I can't go into it in great detail." Nor were the firms that market Madoff's funds forthcoming when ontacted earlier. "It's a private fund. And so our inclination has been not to discuss its returns," says Jeffrey Tucker, partner and co-founder of Fairfield Greenwich, a New York City-based hedge-fund marketer. "Why Barron's would have any interest in this fund I don't know."

One of Fairfield Greenwich's most sought-after funds is Fairfield Sentry Limited. Managed by Bernie Madoff, Fairfield Sentry has assets of $3.3 billion. A Madoff hedge-fund offering memorandums describes his strategy this way: "Typically, a position will consist of the ownership of 30-35 S&P 100 stocks, most correlated to that index, the sale of out-of-the-money calls on the index and the purchase of out-of-the-money puts on the index. The sale of the calls is designed to increase the rate of return, while allowing upward movement of the stock portfolio to the strike price of the calls. The puts, funded in large part by the sale of the calls, limit the portfolio's downside." Among options traders, that's known as the "split-strike conversion" strategy. In layman's terms, it means Madoff invests primarily in the largest stocks in the S&P 100 index -- names like General Electric , Intel and Coca-Cola. At the same time, he buys and sells options against those stocks. For example, Madoff might purchase shares of GE and sell a call option on a comparable number of shares -- that is, an option to buy the shares at a fixed price at a future date. At the same time, he would buy a put option on the stock, which gives him the right to sell shares at a fixed price at a future date.

The strategy, in effect, creates a boundary on a stock, limiting its upside while at the same time protecting against a sharp decline in the share price. When done correctly, this so-called market-neutral strategy produces positive returns no matter which way the market goes. Using this split-strike conversion strategy, Fairfield Sentry Limited has had only four down months since inception in 1989. In 1990, Fairfield Sentry was up 27%. In the ensuing decade, it returned no less than 11% in any year, and sometimes as high as 18%. Last year, Fairfield Sentry returned 11.55% and so far in 2001, the fund is up 3.52%. Those returns have been so consistent that some on the Street have begun speculating that Madoff's market-making operation subsidizes and smooths his hedge-fund returns.

How might Madoff Securities do this? Access to such a huge capital base could allow Madoff to make much larger bets -- with very little risk -- than it could otherwise. It would work like this: Madoff Securities stands in the middle of a tremendous river of orders, which means that its traders have advance knowledge, if only by a few seconds, of what big customers are buying and selling. By hopping on the bandwagon, the market maker could effectively lock in profits. In such a case, throwing a little cash back to the hedge funds would be no big deal. When Barron's ran that scenario by Madoff, he dismissed it as "ridiculous." Still, some on Wall Street remain skeptical about how Madoff achieves such stunning double-digit returns using options alone. The recent MAR Hedge report, for example, cited more than a dozen hedge fund professionals, including current and former Madoff traders, who questioned why no one had been able to duplicate Madoff's returns using this strategy. Likewise, three option strategists at major investment banks told Barron's they couldn't understand how Madoff churns out such numbers. Adds a former Madoff investor: "Anybody who's a seasoned hedge- fund investor knows the split-strike conversion is not the whole story. To take it at face value is a bit naïve."

Madoff dismisses such skepticism. "Whoever tried to reverse-engineer, he didn't do a good job. If he did, these numbers would not be unusual." Curiously, he charges no fees for his money-management services. Nor does he take a cut of the 1.5% fees marketers like Fairfield Greenwich charge investors each year. Why not? "We're perfectly happy to just earn commissions on the trades," he says. Perhaps so. But consider the sheer scope of the money Madoff would appear to be leaving on the table. A typical hedge fund charges 1% of assets annually, plus 20% of profits. On a $6 billion fund generating 15% annual returns, that adds up to $240 million a year.

The lessons of Long-Term Capital Management's collapse are that investors need, or should want, transparency in their money manager's investment strategy. But Madoff's investors rave about his performance -- even though they don't understand how he does it. "Even knowledgeable people can't really tell you what he's doing," one very satisfied investor told Barron's. "People who have all the trade confirmations and statements still can't define it very well. The only thing I know is that he's often in cash" when volatility levels get extreme. This investor declined to be quoted by name. Why? Because Madoff politely requests that his investors not reveal that he runs their money. "What Madoff told us was, 'If you invest with me, you must never tell anyone that you're invested with me. It's no one's business what goes on here,'" says an investment manager who took over a pool of assets that included an investment in a Madoff fund. "When he couldn't explain how they were up or down in a particular month," he added, "I pulled the money out."

Automotive Bailout: Demand & Politics

As noted previously, the problems in Detroit stem from a lack of competitive consumer demand exacerbated by cumbersome labor costs and retiree benefit payments. Interestingly, many of the covenants of the "Automotive Bailout Bill" seek to enforce the creation of smaller, more fuel efficient cars by Detroit (despite their best selling and most competitive vehicles being trucks). Robert Z. Lawrence points out that without legislative action to direct or alter consumer demand, such requirements may simply lead the Big 3 back to bankruptcy down the road, by producing cars that no one wants (Americans like SUVs when gasoline is cheap).

On the topic of the recent stall of the Bill in the Senate, Robert Reich provides insight into motives and realities in the political arena.

More Defualts Ahead?

The following chart (from Calculated Risk) depicts household real estate assets and mortgage debt as a percent of GDP:
If a lag exists between the decline in the assets value, the recognition of such a decline, and the decision or need (as a result of the economic downturn that itself has lagged behind the real estate problems) to default, will we see as sharp a downturn in the red line in the next few months?

Validity of the Tax Multiplier Argument Against Above Average NAIRU

Over the course of the past few days the debate over what strategies need be employed in an effort to close a reasonable fraction of the GDP gap that is predicted to occur in 2009(about $900 billion below normal growth path) has intensified. Perhaps as a result of the recent unemployment report (including U-6 at 12%), or perhaps as more is revealed about the Obama Administration's planned infrastructure spending, and more likely a combination of the two. As always, much of the clash surrounds selecting the appropriate model(s) as a backdrop for strategic decision-making, with focus on the tax and spending multipliers.

As noted previously, economists Susan Woodward and Robert Hall have identified five general stimulus-inducing strategies including further expansion by the Fed, income tax cuts with rebates, tax cuts that reduce the prices of consumer goods temporarily, tax cuts that reduce the cost of labor to businesses, and an increase in purchases of goods and services by state and local governments. While I've been consistently in support of continued and expanded government spending, and not quite convinced tax cuts will prove as successful in this environment, Woodward and Hall have expanded their argument to suggest that the spending multiplier is merely 1 for 1, perhaps a fraction of the tax multiplier, leading to the notion by some that the focus should be on tax cuts (most likely in the form of cuts in payroll taxes). This view is counter to the traditional Kenseyian model.

The two suggest, after viewing spending increases from World War II and the Korean War, that the government spending multiplier is about one: A dollar of government spending raises GDP by about a dollar. As noted economist Greg Mankiw points out:

"By contrast, recent research by Christina Romer and David Romer looks at tax changes and concludes that the tax multiplier is about three: A dollar of tax cuts raises GDP by about three dollars. According to that model, taught even in my favorite textbook, spending multipliers necessarily exceed tax multipliers.How can these empirical results be reconciled? One hypothesis is that that compared with spending increases, tax cuts produce a bigger boost in investment demand. Suppose, for example, that tax cuts are not lump-sum but instead take the form of cuts in payroll taxes. This tax cut would reduce the cost of labor and, if labor and capital are complements, increase the demand for capital goods. Thus, the tax cut stimulates demand not only by increasing disposable income and consumption spending (the textbook Keynesian channel) but also by incentivizing more investment spending. A similar result might obtain if the tax cut included, say, an investment tax credit."

I take issue with the notion that the tax multiplier is greater than the spending multiplier, or that tax cuts will be more effective than government spending in stimulating GDP, in the current economic environment. First, as Nobel Memorial Prize in Economic Sciences recipient Paul Krugman points out, significant flaws exist within Hall's and Woodward's argument: specifically avoidance/denail of certain historical realities which understate the findings. Secondly, in this recessionary environment of steep unemployment, significant downward pressure on labor costs already exists. Would further downward forces on the cost of labor truly encourage increased hours, re-hiring, or less firing? Doesn't the spate of downsizing reflect the businesses need to align current revenues with current costs? I'd happily concede that such a tax cut would decrease the cost of labor further, but I'm not convinced the newly employed or re-employed would immediately begin consuming, as opposed to saving and paying down debt. As for the spur in capital investment by businesses that is suggested, one need look no further than where a majority of the TARP money has been positioned: short-term treasuries now yielding .005%.

Rosenberg Confirms a Gloomy Outlook

Merrill Lynch's chief North American economist, David Rosenberg, said on CNBC's Squawk Box this morning that it is likely GDP will contract in all four quarters of 2009. Rosenberg also argued that U6 unemployment, a broader measure of unemployment than the one presented in the financial press, is around 12%.

Furthermore, he joined the ranks of those dismissing inflationary concerns related to expanded monetary and fiscal policy (this argument sounds familiar). Like many other economists he referenced Japan's massive monetary and fiscal policy moves, which did not lead to significant inflation in that nation.

M&A and the Inherent Disconnect: A Contraction of Multiples

In their latest report outlining future Mergers & Acquisitions activity independent research firm, Bernstein Research, forecasts that total M&A volume, including private equity and strategic deals, will decline by 25% in 2009 from the previous year. The United States' largest investment banks bank holding companies, including Goldman and Morgan, have become increasingly reliant on the revenues generated through M&A advisory (fueled by the 2006-2007 LBO boom). This suggests that a significant decrease in M&A activity could put additional strain on these firms, and the financial services industry as a whole (as if they didn't have enough problems).

Most people point to the tightening of the credit markets as the main factor leading to the current, as well expected decrease in M&A deal volume. While this is true, and the so called "freezing" of the credit markets has certainly had an adverse affect on M&A deal volume there is also another factor at work (somewhat connected to the credit environment of course), and as we enter 2009 it is likely to be as, or even more influential than the condition of the debt markets.

There is an inherent and growing gap between seller and buyer valuation expectations. At one end of the spectrum exist sellers with valuation expectations that have thus far remained fairly static despite desolate economic conditions, a decreasing availability of debt, etc. These sellers are still basing their valuation expectations off of the multiples seen in 2006 and 2007 (multiples fueled by massive leverage, 5x and up, as well as a sense of economic optimism). The problem with this is that at the other end of the spectrum are buyers who no longer have the ability, access, or willingness to employ the type of leverage that supports the aforementioned multiples (with senior debt multiplies likely to further contact as we enter 2009, maybe 2x-2.25x). Furthermore, these buyers are (especially in the case of financial buyers e.g. the PE guys) becoming increasingly more risk adverse and conservative with the valuations they place on target businesses. It seems likely as we enter 2009 this gap will continue to widen, and bridging it will become increasingly difficult.

Focusing on the Future

The economic recovery from the most recent economic recession (which ended in 2001) was the slowest recovery since WWII and below the historical average. At some point during 2009 it is anticipated that the economy is likely to hit its lowest point for this recessionary cycle. Just like it was "officially" suggested that the US experienced contraction almost a year after it truly began, it is not likely that we will "officially" know when the economy hit its "trough" and starts to improve until months after it occurs. Trying to time the economic bottom will be as difficult as timing the stock market bottom. As investors all we can do is try to position ourselves to benefit from the recovery when it happens. In that endeavor, historical experiences may be more reliable than they were in identifying the recession.