Hedging Can Cause Volatility in Earnings and Stock Price

Posted by Bull Bear Trader | 1/31/2009 07:31:00 AM | , | 0 comments »

Just last summer as crude oil moved towards $150 a barrel, some companies were being applauded for having had the foresight to hedge their energy and fuel cost by locking into lower prices for future delivery. Unfortunately, as crude oil fell sharply from its summer highs to below $40 a barrel, some of these same companies were now finding themselves on the other side of the profit/loss equation (see WSJ article). Just recently, Delta Airlines reported a $507 million loss on its fuel hedges in Q4, while UAL reported a $370 million hedging-related loss. Southwest Airlines, known in the past for its smart use of hedging, is finding that its needs to post $300 million in collateral with its various counterparties as the price of crude oil and fuels continue to decrease. Not surprising, or maybe surprising to some, it how investors are punishing the stocks of those companies that were considered to be "prudent" in their use of hedging. What is often forgotten by both investors and management is that hedging is not speculation, or at least should not be treated as such when done correctly. A properly managed hedge should theoretically provide a predictable cost, but changes in the price structure of an industry could cause earnings to be volatile, not to mention the company stock price.

For instance, if an airline company has hedged its fuel cost based on crude oil being around $70 a barrel, the company should see some benefit compared to its un-hedged competitors as crude moves above $100 a barrel. Yet if companies in the industry have pricing power, they can pass some or all of this cost on to their consumers. Therefore, higher costs are followed by higher product prices (obviously, never exactly one-to-one, even with pricing power). For the un-hedged company, their profit margin will theoretically be the same, while the hedged company will experience increased profits due to their lower cost structure compared to their competitors. On the other hand, as crude oil prices fall into the range of $30 per barrel, the un-hedged companies could once again adjust prices, but now to reflect their lower cost (and attempt to take business from those paying higher costs who may not be able to adjust prices as quickly). Those companies that are hedged and are forced to pay the higher $70 per barrel price will experience a lower profit margin, lower earnings, and potentially a lower stock price.

So while hedging can help a company "lock-in" to a specific cost structure, if others within the same industry are not hedged, and those companies have pricing power, the hedged company can expect to see higher swings in profit margins and earnings, and subsequently a more volatile stock price. Not only does this surprise investors who were expecting a less volatile stock given that the company was hedged and should experience consistent costs, but it also generates inquiries from management as to why the risk management department suddenly turned into speculators, and more importantly why they made such a bad bet. In reality, the hedging allowed the company to control what it could (the cost), but still left it at the mercy of what it had less control over - industry pricing and investor reaction. Something to keep in mind as you invest in companies and industries that actively engage in hedging, especially in commodity markets that are volatile.

There is an old market rule of thumb that states as "January goes, so goes the year." Often the January Indicator pertains to the first five days of January, other times to the entire month. This year it may not really matter. As it turns out, this is the worst January on record for all of the major indexes, except the Nasdaq - and even the Nasdaq is nothing to write home about. The DJIA was down 8.8 percent, the S&P 500 was down 8.5 percent, the Nasdaq was down 6.2 percent, and the Russell 2000 was down 11.0 percent. The Dow Transports, which are used by some as a barometer and forecast for movement in the industrials and the broader market, was down a whopping 16.0 percent. Certainly, not an encouraging start to the new year.

On the lighter side, at least this weekend we have the Super Bowl to enjoy, along with the Super Bowl Indicator to watch - which states that "a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in the stock market for the coming year, and that a win for a team from the old NFL (NFC division) means the stock market will be up for the year." Given the market action over the last six months, even those market participants that think technical analysis is irrelevant, and indicators are just plain silly, may be saying "Go Cardinals." Yes. I know. I am grabbing for straws.

Note (update): Not that it matters, but apparently the Steelers and Cardinals are legacy teams from before the NFL’s merger with the AFL. Therefore, according to the SB indicator it should be a good year for stocks regardless of who wins the game. Of course, if you are investing based on this indicator, then maybe you should move your money to Treasuries (well, then again .....).

Hedge fund managers are predicting that distressed securities and global macro strategies will perform best in 2009 (see Reuters article). Unfortunately, the support for each strategy is not overwhelming since only around 20 percent of managers choose distressed securities, along with 17 percent picking global macro. A total of 15 percent picked managed futures, which on whole have gained 18 percent in 2008.

In addition to predicting strategy winners and losers for 2009, over 30 percent of those surveyed expected hedge funds to reduce or eliminate management fees in order to retain investors. An additional 15 percent expected cuts in performance fees, indicating that the 2-20 model may gravitate to a 1-10, or something similar.

New draft legislation in Congress is considering two key changes to the CDS market (see Bloomberg article). First, the bill would require that all trading in the over-the-counter derivatives market would have to be processed by a clearinghouse. Second, the draft legislation would ban CDS (Credit Default Swap) trading unless investors owned the underlying bonds. While the CME group, ICE, and other exchanges would certainly cheer the first move, the second could make any added revenue streams disappear.

Given the size of many of the outstanding bonds, the single-name CDS market would have a difficult time existing. At a time when many markets are frozen, eliminating speculation does not seem to be the best course of action for a market that is currently suffering from liquidity issues. Surely, other measures can be taken to curb speculation (such has been done in the futures market with position limits) without further limiting liquidity and price discovery.

While utilizing a clearinghouse would help to define prices in the OTC market (certainly not welcomed news for the investment banks), and seems to make perfect sense, doing so would require some level of standardization. Some worry that a "non-standard CDS" market will still exist, with the proposed legislation simply forcing such trading outside of the US. While this not only forfeits a potential revenue stream for some US exchanges, it may also give up the ability of US regulators to have a say on how this market operates, which also seems counterproductive to the spirit of the draft legislation.

Robert Rubin, less than a month removed from his post as senior counselor at Citigroup, is on record stating that forcing companies to mark down assets every quarter in order to reflect current value has "done a great deal of damage" (see Bloomberg article). While a proponent of fair-value accounting in the past, Rubin feels it does not perform well when there are few buyers willing to trade a particular asset. As an alternative, Rubin proposes a reserve accounting system, where assets are carried at cost, with reserves used to offset potential losses. Unfortunately, reserve accounting is not without its own issues, being linked to an increase in restatements in the past (see SmartPros article), and worries of its misuse for creative accounting (see Wikipedia article).

A recent paper (available here on SSRN) by Andrew Clare and Nick Motson, entitled "Locking in the gains or putting it all on black - An investigation into the risk-taking behaviour of hedge fund managers" explores the issue of whether or not hedge fund managers are adjusting the risk of their funds based on two factors - how the fund is performing compared to its peers, and whether or not the fund is currently above its high water mark, at which point the manager could capture performance fees (HT to a recent Hedge Fund Review article).

The authors find evidence that hedge fund managers do in fact adjust the risk profiles of their funds in response to their relative performance with peers: managers that are performing poorly will increase their risk profiles, while those doing well relative to their peers will do just the opposite and reduce the risk level of the fund. While in some ways this makes perfect sense, it does suggest that hedge funds on average are less worried about targeting absolute returns, the very reason some investors allocate capital to such funds.

The researchers also considered the implied "moneyness" of the manager's performance option to examine the behavior of managers when the fund is above its high water mark. In a sense, the compensation structure for hedge fund managers has option-like characteristics. As the fund performs above its high water mark, the performance option becomes in-the-money. Clare and Motson showed that managers with an incentive option well in-the-money will decrease the risk profile of their fund, possibly trying to lock-in value, especially towards the end of the calendar year. On the other hand, the managers of under-performing funds with options out-of-the-money do not seem to take on additional risk in an attempt to get the fund whole. The authors believe this behavior may be due more to a fear of liquidation from investors if the added risk ends up producing further losses. Preservation of capital (and the 2% fee on top of such capital) seems to be more of a driving factor than taking a shot at trying to capture performance fees. Given that many managers have a significant stake of their own wealth in the funds is also no doubt impacting any extra risk that the managers are willing to take.

So what does this imply for the markets? One could argue that during bullish years (or at least positive return periods), investors in both over- and under-performing funds may see the returns of their funds revert to the mean as we get closer to the end of the calendar year, with the under-performing funds possibly experiencing addition volatility as they try to chase the returns of their peers. On the other hand, when the market is down, both over- and under-performing funds, especially those with less of a likelihood of hitting their high water marks, are likely to maintain or scale-back risk in an effort to maintain capital during difficult downturns. Whether one can, or wants to trade on this behavior is another question.

College Endowments Lose At Least $94.5 Billion

Posted by Bull Bear Trader | 1/27/2009 06:36:00 AM | | 0 comments »

Recent data shows that the aggregate investment loses at college endowments have been at least $94.5 billion (see WSJ article) from the five month period between July 1 and November 30 of 2008.

Source: Wall Street Journal

The loses have resulted in an average 23 percent decline - less than the 29 percent loss by the S&P 500 during the same five month period. Losses from illiquid investments, such as real estate and private equity, are not included in the reported numbers. Such losses are causing many schools to consider spending cuts, and may force some to increase endowment spending rates. On average, college endowments spend 4.6 percent, but this figure could rise to 6 percent, higher than the minimum 5 percent annual payments required of private foundations.

Some of the recent economic data and graphs from the St. Louis Federal Reserve look more like a ski slope or snow boarding run at the X-Games. In some instances the charts look truly scary, or encouraging, depending on the trend and your perspective. For instance, if you were worrying that the Fed was not doing enough to flood the system with liquidity (or worrying that it was doing too much), check out the recent Adjusted Monetary Base chart.

Source: St. Louis Fed

Are you thinking about re-financing, but not sure if rates are attractive? Check out the chart of conventional 30-year fixed mortgage rates.

Source: St. Louis Fed

Have you noticed that it does not cost quite as much to fill-up your car as it did just a few months ago? Check out the move in the energy component of the consumer price index.

Source: St. Louis Fed

Are you wondering whether the unemployment rate is really spiking, and how it compares to other recessions? Check out the following chart (the current loses are large, but not at historical extremes - meaning there is good and bad news - it is not as bad as it as been, but worse rates are not unprecedented).

Source: St. Louis Fed

Have you heard that we are moving from manufacturing to a service-based economy, but have been wondering just how long this has been occurring? Check out the number of manufacturing employees over the last three decades, and the last year.

Source: St. Louis Fed

Given the recent employment numbers in manufacturing and the general economy over the last year, it is not surprising that capacity utilization is falling off a cliff.

Source: St. Louis Fed

Wondering if other consumers have also been taking on extra credit over the last 20 years? Don't fear, you are not alone (well, maybe you should be fearful).

Source: St. Louis Fed

How have Aaa and Baa Corporate Bond Yields compared? The charts certainly seem to be reflecting some risk in the market (compare the two over the last year).

Source: St. Louis Fed

Source: St. Louis Fed

Finally, and even more disturbing, are the number of people that have been unemployed for 27 weeks or more. Given the spike up in extended unemployment, it is not surprising that home foreclosures are also increasing at a rapid rate.

Source: St. Louis Fed

Of course, I have focused on some of the more extreme charts, and even those pictures that truly are "worth a 1000 words" or more don't tell the entire story. Nonetheless, the last year has been interesting, even though some of trends have been in place for a while. While we marvel at the moves, it is also worth remembering that charts and series with such violent spikes or declines are often followed by similar extreme and violent reversals - although for some moves, such as in energy prices, you could argue that this is what we are currently seeing. Finally, I suspect that the picture being painted in each of these charts is far from compete in most instances. Whether we like it or not, the unintended consequences and fall-out from turning-on and then turning-off the liquidity faucet should provide additional topics for discussion months and years to come. Such moves will no doubt also create new challenges and opportunities.