According to the recent TIM (Trade Ideas Monitor) report, the TIM Sentiment Index (TSI) decreased 5.3% week-over-week from 54.03 to 51.19 (see previous post, youDevise website for additional information on the TIM report). For the five trading days ending July 16th, the number of new short ideas as a percentage of new ideas sent to investment managers increased to 38.63% from 25.90% one week earlier (see last week's post). To date, shorts represent 35.27% of ideas in July, and 41.14% of this year.

As for individual securities in the U.S. and North America, Johnson & Johnson (JNJ), Kraft (KFT), and Intel (INTC) were the stocks most recommended as longs by institutional brokers, while DigitalGlobe (DGI), Fairchild Semiconductor (FCS), and Advanced Micro Devices (AMD) were most recommended as shorts. The materials, industrials, and health care sectors had increased broker sentiment for the week, while consumer staples, utilities, and telecommunications had decreased sentiment.

ProShares is launching the first 130/30 ETF strategy (see Pensions & Investments article, Nasdaq article). The 130/30 ETF (CSM) will track the Credit Suisse 130/30 Large-Cap index. The Credit Suisse 130/30 index was developed by Andrew Lo (CIO of AlphaSimplex Group) and Pankaj Patel (director of quantitative research at Credit Suisse). The ETF has an expense ratio of 95 bps, with a strategy that will offer "investors a transparent, low-cost means of achieving 130/30 beta and, potentially, alpha superior to what a comparable long-only large-cap strategy would deliver over the long run." A First Trust 130/30 Large Cap ETN (JFT) based on the 130/30 strategy was released just over a year ago (see previous post, MarketWatch article).

Not familiar with 130/30 strategies? Basically, the strategy uses leverage to short poor performing stocks and then uses the proceeds, along with initial capital, to purchase shares that are expected to do well. If is a form of the general 1X0/X0 long/short strategy, although the 130/30 ratio funds have seem to generate the most interest, producing a 130% long, 30% short strategy. Investors using the strategy will often mimic an index such as the S&P 500 when choosing stocks for the strategy. You can find additional descriptions of the 130/30 strategy here and here. Lo paper here.

Keep in mind that with such strategies the managers must pick stocks to go both long and short. Often there is feeling that you are market neutral, given that you have both long and short positions, but this is not the case. While traditional hedge fund might utilize a long/short strategy that makes them market neutral (beta close to zero), the 130/30 strategy is usually compared to a benchmark, such as the S&P 500, giving 100% exposure to the benchmark. As a result, the strategies are sometimes referred to as beta-one strategies. Furthermore, if the manager gets it wrong in either, or both directions, you may end up losing more than expected. As with most funds, good management is essential, regardless of the strategy.

Given the market beta exposure, these funds are useful if you have a positive market view and you believe that the fund manager can generate alpha from the short portion of the portfolio. If your view is neutral or negative, a hedge fund with an appropriate strategy might be better. If you have a positive market view but are not confident that your manager can generate alpha from short selling, then a long-only fund, or index fund, would be best. Keep in mind that such funds also trade more often, making them less tax efficient compared to traditional long-only index funds.

Note/Update: As a follow-up, I just ran across an excellent article at Greenfaucet that also provides details about the ProShares launch, and the success, or lack of success of the 130/30 funds. Check it out here.

Trading in sovereign credit default swaps has risen fivefold since the demise of Lehman Brothers last fall (see previous post on tradable CDS indexes, and current Financial Times article). This increase in trading, and general levels of increased government debt, have caused CDS spreads to rise and somewhat fall back to earth over the last year (see figure below).

Source: Markit (by way of the Financial Times)

In the UK, the cost to protect sovereign debt soared to 164 basis points, compared to its pre-Lehman levels of 10bp last February (see Financial Times article). This means that at one point it costs $164,000 to insure $10m of UK debt, instead of the initial $10,000. Eventually, the cost fell back to 75bp as speculators began leaving the once volatile market. CDS spreads in Germany, the U.S., and Japan have seen similar rising and falling trends, although not as pronounced as the moves in the UK CDS market.

Even though the number of outstanding contracts are much less than many big companies, the moves are is still raising some concern, and highlight how investors now see "risk-free" government debt. And while it is also unlikely that sovereign CDS are being used for hedging in any direct, or large-scale way (after all, if there is a massive government default, good luck finding the counterparty), the markets do still provide information, even if the participants are not actually expecting large established governments to default.

So why waste a good financial product? Here is a suggestion (tongue in cheek - sort of). Given that governments around the globe are looking to rein in risk-taking by placing curbs on executive pay in companies that take on too much risk (see WSJ article), might it also be possible to do the same for governments that are spending too much and creating too much debt? In a rather ironic twist, maybe the sovereign CDS market could be used to place curbs on Congress? Now that is some market regulation that even Wall Street could get behind.

A recent AP article by Martin Crutsinger introduces and then answers the question "How did (the) $1 trillion deficit happen?" (see full AP article). Some highlights from the article include:

  • The government's annual budget deficit has topped $1 trillion. With three months left in the budget year, it will get even worse. The administration is projecting that the deficit will hit $1.84 trillion for the current budget year. This is four times the size of last year's budget deficit.
  • The deficit spending began with the 2001 recession, and got deeper with the 9-11 terrorist attacks as war spending started to ramp up.
  • Until 2008 the deficit had been shrinking, hitting a five-year low of $161.5 billion in 2007, but was followed by the record deficit of $454.8 billion in 2008 as the current recession and financial crisis hit.
  • The size of the deficit started to ramp up with the initial $700 billion TARP (about half spent in 2008, half in 2009), along with the recent $787 billion economic stimulus.
  • In addition to stimulus spending,"automatic stabilizers," such as food stamps and unemployment compensation, are also increasing. Government outlays are up 20.5% through the first nine months of this budget year.
  • All of this spending is occurring just as tax receipts are falling. Government revenues have fallen by 17.9% during the October-to-June period compared with one year ago.
  • While large in dollars, current deficits are still not the largest in terms of GDP, but are the largest outside of WWII. Currently, the CBO is forecasting the budget deficit will equal 13% of GDP. As a comparison, the deficit was 6% of GDP in 1983 as we moved out of another recession and ramped up cold war spending, and 30.3% of GDP in 1943 during World War II.
  • The CBO is projecting that the deficits will remain large for the foreseeable future, coming in at $1.43 trillion in 2010 and not falling below $633 billion over the next 10 years, ultimately adding $9.1 trillion to the national debt.
To tackle such deficits and debt, either spending needs to be curbed, or tax receipts need to increase - and quickly. Either way, the debt needs to be dealt with (see previous post), but the exit strategy will require hard choices (see Greenfaucet article). Given continued weakness in the economy, along with both health care reform and new global warming initiatives (such as carbon trading) on the docket, it does not appear that spending is going to slow down anytime soon (see previous post). The leaves tax increases on the wealthy and corporations, or additional tax cuts such as those recently targeted for the middle class. Expect the Supply Side - Keynesian debate to begin in earnest once again.

As pointed out in a recent Financial Times opinion piece by Nassim Nicholas Taleb and Mark Spitznagel (see FT article, concepts also expressed in a recent CNBC interview), the core economic problem that we are facing "is that our economic system is laden with debt." In fact, as pointed out by the authors, the debt load is about triple the amount relative to the GDP levels of the 1980s. Given that Tabel and his colleague have been betting on debt-induced hyperflation becoming the next black swan event (see previous post), and making them even more coin in the process, it might be easy to dismiss this as someone simply talking their book - which is probably somewhat the case. Yet the levels of the deficit spending and debt are unprecedented, and scary. Of course, what is possibly even more shocking is how making these levels know and pointing out their consequences is still looked at as a revelation, or at least finally drawing serious concern. It is simply no longer enough to point out the irony of using debt to solve a problem caused by too much debt. That train has already left the station. The focus is finally shifting to those trying to slow down the train before we all get run over.

As pointed out in the FT article, Taleb and Spitznagel believe the only solution to the debt problem is to immediately convert debt to equity. After all, companies in bankruptcy do this all the time - then again, I am not sure what that says about a country and its credit rating [Note: As a follow-up, see the recent Felix Salmon Reuters blog post about the unsustainability of debt-to-equity conversion]. To bolster their case, the authors given three reasons for their concern and reasoning. First, debt and leverage cause the system to become fragile - i.e., there is less room for error. Second, globalization has caused the system to be more complex, which in turn has caused business parameters to be more volatile. Third, and somewhat novel in perspective, is that debt is "highly treacherous." Loans hide volatility since they do not really vary outside of default. Such risk is hidden even more in highly complex derivative products, such as swaps and CDOs.

So what additional steps can governments do to reverse the trends? Tabel and Spitznagel list two options: deflate debt or inflate assets (once again, the authors are betting on the later). What have governments done? Deficit-based stimulus spending. And they are considering more (see previous post). Besides adding more debt, stimulus spending is likely to over- or undershoot since it is difficult to get just right in size and timing. This of course leaves economies vulnerable to inflation, and in some cases creates hyperinflation. Therefore, unless the levels of consumer and government debt are dealt with, and we consider other approaches for dealing with current problems, we are likely to experience another black swan - even one that is large and can be seen flying right towards us.

Hedge fund firm AQR Capital Management has launched a set of indexes designed to capture the returns of stocks that have positive momentum (see WSJ article). In addition, the firm launched three no-load mutual funds that will track the new momentum indexes. The AQR Momentum Fund, AQR Small Cap Momentum Fund, and AQR International Momentum Fund will track the AQR Momentum, Small Cap Momentum, and International Momentum indexes, respectively.

The new AQR indexes are constructed using the top one-third of stocks that have outperformed other stocks in their grouping over the last 12 months, with the stock weightings based on market capitalization. The large-cap index examines the 1,000 largest U.S. market cap stocks, while the small-cap index will examine the next largest 2,000. The indexes are rebalanced quarterly. The designers of the funds hope that investors will use them to represent the growth portion of their portfolio since momentum-based portfolios tend to do well when value strategies are not in favor. Pure growth strategies also tend to under-perform momentum strategies over time according to a principal at AQR. Nonetheless, each momentum strategy needs to be somewhat specific, making it difficult to do a direct momentum for growth substitution, but could still prove useful for those looking for diversification with their momentum investing.

Meredith Whitney was recently on CNBC (the video is provided below) discussing the banks and financials. Some observations from the interview include:

  • This will be a tactical quarter for the banks.
  • She has a bullish call on Goldman Sachs, but a bearish call on financial stocks in general.
  • A huge refinance wave will create the "Mother-of-all" mortgage quarters, boosting earnings for the quarter for many banks, even though business in general is not getting better.
  • Core earnings numbers may not be very good, but below the line numbers will be good due to all the mortgage activity. This will result in huge moves in tangible book value for the banks, even with unimpressive earnings numbers. These stocks trade on multiples of tangible book.
  • A move from $18 billion in incentives to $75 billion in incentives to modify mortgages, with less modification liability, could cause some banks move 15% short-term.
  • Mortgage modification numbers will increase logarithmically, causing past dues to become current, and allowing the banks to receive fees for the modifications.
  • As a result of the fees and less litigation due to the current legislation, banks may even seek to modify mortgages which have not yet defaulted, or are not yet past due.
  • Bank of America (BAC) is the cheapest of the banks, based on tangible book value (excluding Citi).
  • Bank solvency has been off the table for a few quarters now, but main street has not been helped by the financial bailouts as much. A lot of refinancing is occurring, but not a lot of new lending. The new legislation and increased risk aversion is actually providing less access to credit.
  • The next couple of years will be debt market-focused due to the tsunami of debt issuance needed to pay-off current spending.
  • She also mentioned in the discussion (not included in the CNBC online video) that unemployment could reach toward 13%.

    Source: CNBC Video

The following graph from the Congressional Budget Office shows the projected output gap between actual and potential GDP with and without stimulus spending, i.e., the American Recovery and Reinvestment Act (see full CBO presentation). The CBO presentation highlights the implementation lags of fiscal policy, and illustrates why a stimulus package that stretches over 2 or 3 years seemed justified given that the CBO expected the GDP output gap to persist for longer than one year. Projections have only 24% of the money being disbursed in fiscal year 2009, 74% disbursed by the end of FY 2010, and 91% disbursed by the end of FY 2011.

Source: Congressional Budget Office

Given the back-loading of spending, and the realization that the recovery is not taking hold as quickly as most would want (except possibly by politicians up for re-election next year and looking for an election year boost), this is creating a problem now for both the administration and Congress. On the one hand, quicker, and more front-loaded stimulus seems warranted, yet data such as that provided by the CBO has been used to justify the huge delayed spending in coming years. Therefore, if the projections are correct, then patience is in order, but something tells me that is not going to fly as unemployment nears 10 percent.

So how do you speed things up? As outlined by the CBO, you could waive environmental reviews, award contracts without competitive bidding, or simply not dole out money by jurisdictions, but instead give money to those who can most efficiently spend it (shovel-ready project). The first one is a non-starter given the environmental shift of the current administration, the second is going to be difficult given the criticism that no-bid projects received in the last administration, and the last one is simply unacceptable to anyone in Congress - given their parochialism and the fact that it actually makes some sense (and of course, you need shovel-ready projects on a rather large scale - most are probably already funded).

So on the short-term, what needs to be done? The quickest way is through changes to taxes. This could come in rebates (which are relatively quick in non-tax months, but also somewhat ineffective when people are scared and the savings rate is increasing), or through lowering withholding (currently tried with the middle class, but not having the desired effect). This leaves suspending some income taxes for a period of time, or lowering income taxes on everyone, including the wealthy and corporations. Suspension is difficult to sell given the state, or perceived state, of social security and medicare needs, not to mention the growing deficit (even though lower rates can bring in higher receipts), while reducing taxes on corporations and the wealthy is anathema to most of those currently in power.

The limited real and political choices available has now caused the discussion to come full circle - backed to considering another stimulus. I forget - what was that definition about doing the same thing again and expecting different results? If President Obama is not able to convince the American public and Congress to be patient, we may find out the answer rather quickly.