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.

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.

Like the Harvard and Yale endowments, the endowment at Dartmouth is feeling the pain of the slowing economy and falling market, losing 18 percent, or to $3 billion over the last year (see Bloomberg article). The losses are resulting in spending cuts of 8.6 percent. Of interest is that like its bigger Ivy League members, Dartmouth had only about 12 percent of its assets in US stocks. Like Harvard and Yale, it also had a number of illiquid assets (such as private equity) whose values have not been updated. To its credit, trustees at the college projected early last year that the US economy was entering a recession and subsequently lowered its exposure to corporate bonds and MBS, and began purchasing additional TIPS. Eighteen percent is painful, but foresight and diversification seem to have helped to ease the pain at Dartmouth.

Hedge Funds Review is reporting that hedge fund managers are investing less in distressed debt than one year ago, down 12 percent (48 percent to 36 percent) from last year (see article). This is somewhat counter to other reports that have discussed how other notable managers, such as John Paulson, are seeing distressed debt as an area with excellent opportunities. Many of the managers that are investing in distressed debt appear to be investing primarily in secured loans, utilizing a "loan-to-own" strategy. The feeling is that secured loans are less risky and provide more opportunity since if the company files for bankruptcy, the debt investors may have the ability to acquire control of the company if the borrower seeks to deleverage by exchanging debt for equity. Of course, this strategy seems viable only if there is an expectation that the levered company will eventually recover, and could explain why both the banking and energy industries are two of the more popular industries for employing the loan-to-own strategy. There is an expectation in the market that energy companies will continue to generate interest and capital, while the banking industry is likely to receive federal support to prevent total collapse.

There is an interesting article in the Times Online that discusses potential changes in the hedge fund industry. Given the current shake-out, the article predicts that in the future there will be more multi-strategy funds as smaller and medium size hedge funds begin to consolidate, effectively organizing in a way to help reduce exposure to a single market strategy. This will allow hedge funds to mimic an investment banking model in that there will be numerous trading operations under one roof, essentially allowing the large multi-strategy funds to operate as a fund-of-funds. While the large multi-strategy funds will act like investment banks, smaller boutique hedge funds will continue to attract high net worth investors due to both their focus and their ability to adapt quickly to changing market conditions. While significant, such changes seem natural and present an opportunity for the industry. No longer would we need to talk about a Lehman or Goldman acting too much like a hedge fund. Now the hedge funds will be compared to the investment banks. What's old is new again, or do I have that backwards?

There have been a number of stories over the last few years of academic endowments moving into alternative investments, in particular hedge funds, private equity, real estate, and natural resources, such as timber. While many of these funds have been hurt during the recent downturn, many still found their portfolios falling less than the general market (see previous posts here and here). While losing "only" 20 percent is not as bad as 30-40 percent (although many with budgets getting cut would disagree with losing any money), other consequences of the move into alternative investments are often overlooked, including the valuation of such assets, funding commitments, and issues with liquidity.

A recent WSJ article highlights some of these difficulties. For one, hedge funds often have lock-up periods, keeping endowments in these investments at a time when shrinking budgets and donations are calling out for liquidity (see previous post here). In the case of private equity, the consequences of liquidity risk are even worse since not only is your investment "tied-up," but as a result of previous funding agreements, new capital calls may force you to commit another 50-75 percent of your initial investment, once again at a time when liquidity is tight and budgets are shrinking. While such need for liquidity is challenging for any fund, it is even more difficult for a fund that has decreased equity exposure to the 10-20 percent range, or lower, and has nearly all but eliminated interest bearing fixed income from the portfolio.

As with any shock to the system, strategies will be re-evaluated, and changes will be made. Unfortunately, for many academic institutions this will involve not only changes to the composition of their endowment portfolios, but also an evaluation of their capital improvements, expansion plans, operating budgets, and financial aid for students.

The Basel Committee on Banking Supervision is considering requiring banks to hold more capital to protect against losses on complex financial products (see Bloomberg article). Banks that do not thoroughly investigate the types of risks they are taking with certain complex instruments would also be required to increase capital requirements. The reaction is not really a surprise. Of course, while such changes seem to make sense and be expected - after all, many banks were taking too much risk and were not properly capitalized - the worry of too much regulation must be considered, especially in an environment in which there are on-going efforts to help increase lending and unfreeze credit. Many are critical of the Basel II regulations, but the criticism is somewhat two sided, with those wanting either more or less regulation citing the ineffectiveness of the regulation for preventing the current crisis. Something in the middle, that considers better regulation and not necessarily more or less, will hopefully enter the discussion and help prevent any over-reaction in either direction. Either way, there is no doubt that the Basel regulations will present a moving target for US banks as they implement the standards, and will continue to put into question the earning power and valuation of such firms.

A commodity analysts at Goldman Sachs is expecting a "swift and violent rebound" in energy prices during the first half of this year, with prices expected to rise to $65 a barrel (see Bloomberg article). The analyst also believes that the strategy of using supertankers to store crude oil to take advantage of the contango trade (see previous post) is “near the end of this process,” believing that the contango will likely flatten as OPEC and other producers cuts supply, decreasing the availability of cheaper crude oil for immediate delivery. OPEC in particular is beginning another round of cutbacks, with cuts expected to fall somewhere between 3-4.2 million barrels a day, help to meet a goal of reducing production to under 25 million barrels a day. If OPEC is able to continue with planned cuts, current crude oil and gasoline prices should find a bottom and show some strength. Whether the move is sustained after any "violent" snap back will certainly depend on the health of the US economy later this year - in particular how the economy responds to the proposed stimulus plan, as well as how both inflation and the dollar react to additional borrow and spending/taxes. Given the size of the proposed stimulus plan, along with previous TARP spending, both inflation and a weaker dollar seem poised to help support higher crude oil prices over the next year.

Some leading technical analysts are continuing to be worried about the major indexes potentially falling another 30 percent. Ralph Acampora believes that if the DJIA falls below the low of 7,552.29 it reached on November 20, that it could fall further to 6,000 (see Bloomberg article). John Murphy also believes that the November lows represent "a very, very significant area," since this is near the point where the market began to recover when the bear market ended in 2003. If we are to break these levels, the trend is expected to become very negative. Recent market action has not been encouraging. Louise Yamada expressed similar concern during an appearance on Fast Money late last year, where she also expressed concern that the DJIA could fall to 6,000. She had successfully predicted before the recent sell-off that the Dow could fall to the 8,000 range. Just last month, her website posted the following:

"The overall market picture still looks troubled. Both the S&P 500 and the DJIA have seen each recent rally (and potential bottom evidence) fail at a slightly lower peak. This progression of lower highs is evidence of supply -- price cannot rise to a slightly higher level because supply is being sold into the rally. ...... The recent pattern of sellers entering into each rally is characteristic of a downtrend, i.e., the failure of the rallies to get above the prior peak. In the study of supply and demand, which is the basis of technical analysis, this pattern represents aggressive supply. Contrarily, in a bottoming process or in an uptrend, higher lows are followed by higher highs, representing aggressive demand. .... Now, however, there is a confluence of sectors rolling over together, which is problematic. The majority of stocks are showing topping patterns."

Technicals are never the whole story, but they certainly help you to know where you have been, and how much trouble you may have getting to where you want to go. The data is certainly not encouraging for the bulls.

There is an interesting Business Week article on Zombie Debtors that is worth reading. These are basically companies that probably need to fail, but are being kept alive by taxpayers and the government. The problem with such companies is that not only do they consume tax money, capital, and labor that could be deployed better within growing industries and sectors, but they also make it harder for the viable companies to benefit from their natural competitive advantages - preventing Schumpeter's "creative destruction" from allocating capital and resources to those areas that can be most profitable and productive. Japan suffered from such companies in the 1990s, and the US will no doubt feel their effects from non-selective TARP bailouts, and those of any future homeowner bailouts, long into the next decade. That is not to say that government interaction is never useful for helping healthy companies overcome current difficulties (after all, isn't that what Chapter 11 is for?). But unless the hard decisions and selections are made now with regard to the next round of government funding, the guaranteed unintended consequences of such inaction will force the decisions to be made later - most likely at a much greater cost.

Firms are rushing to secure supertankers in order to profit from growing contango spreads as crude oil prices continue to fall compared to futures prices (see Times Online article). Frontline estimates that about 80 million barrels of crude oil are currently being stored in tankers (see Bloomberg article), with 30-35 very large crude carrier storing 2 million barrels of crude each. Not surprisingly, a rush into the contango trade is causing tanker rates to increase about $75,000 a day. In some cases, shipping rates have fallen over 90 percent within the last year, with crude oil storage rates falling nearly 80 percent. Teekay (TK) is now trading about $19 a share after coming off its recent low of just below $11, Frontline (FRO) is trading near $31 a share, after coming off a low of $25 a share, and Overseas Shipping Group (OSG) is trading around $41 a share after a recently low of just over $28 a share in late November. Drybulk shippers have also seen rates rise recently, as much as 20 percent (see Yahoo!Finance article). DryShips (DRYS) fell to below $4 a share, after reaching $116.43 back in May. The company is currently trading over $15 per share. Diana Shipping (DSX) has come off its low of $6.85 to trade over $12 per share. Nonetheless, although there are some signs of improvement (see SeekingAlpha article), the contango spread and potential increased demand may not be enough to turn-around the industry, not just yet anyway. Exports from Asia have fallen off a cliff, and will no doubt continue to put pressure on cargo rates, leaving numerous companies at risk of failing. Until global demand begins to increase, or capacity begins to decrease, it may be a little longer before any rally can be trusted with confidence and expected to continue, the contango trade notwithstanding.

The Nasdaq is planning to launch a series of trading and investment products based on companies receiving TARP money (see WSJ article). The first is the GRI (Government Relief Index), tracking 24 companies that received over one billion dollars in bailout assistance. The index is being pushed as a way to track the effectiveness of the TARP, yet it seems that for the index to be successful (profitable), it either needs to be widely followed and reported, or used as a vehicle to be traded against. The first seems unlikely (since many will argue that the success of TARP is not based simply on the individual companies doing well), and the second seems counter-intuitive, or at least counterproductive. Given a potential ETF product, it is not exactly clear how making it easier to short the companies in trouble and needing assistance helps the recovery. Maybe a simple "dead or alive" count would be easiest, but even that is difficult to gauge. Is Bear dead or alive? How about Merrill? Fannie or Freddie?

Crude oil is currently in contango as futures are trading at a significant premium to spot prices (see WSJ article). As of yesterday's close, spot prices were around $43 a barrel as May futures were trading near $50 a barrel. Unfortunately, to profit from the difference, you need to store the crude somewhere, yet the number of available tankers is decreasing fast. In fact, demand is causing shipping prices to rise nearly 50 percent recently, causing a increase in the Baltic Dirty Tanker Index.

Fund managers are gearing up for a fight regarding short selling disclosure rules (see Financial Times article). The FT article discusses how the fund industry would be damaged by such timely and public disclosures, basically arguing that no one would pay for investment advice or money management when the relevant information can be had for free a day or so later. Yet, this argument may miss the most interesting point - that a ban or disclosure rule is certain to have some unintended consequences.

Bans on short selling have had a goal of trying to limit funds from manipulating the market, but making short selling positions public could just exacerbate the problem. Non-public disclosure would allow regulators to monitor positions and funds, insuring that market manipulation was not occurring, yet by making the short data public, others would now be tempted to jump on the momentum train, increasing their short positions, and the selling pressure on the shorted security. In the end, this may do nothing to decrease market manipulation, while still allowing the funds to profit from the falling prices.

If increased selling is the potential fall-out of public disclosure, then why should funds care? I suspect there are two reasons. First, if they are taking a large (but allowed) short position, it may take more than a day to enter or exit the position. One day of disclosure could potentially reduce the profitability to the fund as others front-run the trade. Second, and maybe more critical, is that any short momentum trades that result in a large sell-off or company failure will still ultimately get blamed on the funds, causing regulators to once again implement short-selling bans. For the funds that have strategies that rely on being able to take a short position, such a ban affects viability as much as it does profitability.

Currently, longer disclosure periods are being discussed, such as two weeks or even a month. While this may help with the first problem of having enough time to enter and exit a position, it will do less for the second unless the disclosure period is long enough to limit profit opportunities for those who later try to mimic the trade. Too short a disclosure period, and you encourage copy-cat trades and additional selling pressure. Too long, and the disclosure simply becomes a record of what companies were short. Anything in between provides the potential for market manipulation with little benefit to market efficiency over what non-public disclosure would most likely offer.

I have been posting a lot recently about Yale's endowment fund, along with the views of its chief investment officer, David Swensen. Below is a recent interview he did on the Fox Business channel.

Source: FOX Business

Following the recent comments of Yale's endowment investment chief, David Swensen (see previous post), over half of a group of recently surveyed asset managers believe that high-quality corporate credit is currently trading at cheap levels and will likely rally in 2009 (see Financial Times article). Many feel that the rush to the safety of Treasuries has caused all grades of corporates, even high-grade bonds, to be oversold. On the other hand, many of the same analysts, including Pimco's Mohamed El-Erian, feel that US Treasuries will face considerable pressure after their recent fear-driven price appreciation, which in some cases drove yields to near zero levels for some shorter duration issues. Given the current desire by the incoming Congress and the President-elect to fund numerous public sector and infrastructure projects, the government will be forced to increase its issuance of debt, putting further pressure on Treasury prices.

Margin debt at NYSE member companies fell 37.6% for the year through November, down to $201.48 billion (see WSJ article). This is no doubt that some of this reduction came from forced margin call selling over the last few months. While rampant speculation may not reenter the markets anytime some, the reduction of speculative investments, along with past hedge and mutual fund redemption selling, is helping to clear out the excess in the market, allowing it to find a bottom and begin building a base. January is often used as a bellwether for things to come in the markets, and the market action on the first trading day was encouraging - yet one day does not make a market. Nonetheless, January will certainly continue to generate interest as the confluence of a new year, a new president, a new congress, a new stimulus bill, and an unfolding credit crisis continue to intertwine in what will continue to generate some interesting times, not to mention opportunities in the market.

The Yale University Endowment is looking for opportunities in the credit markets and distressed debt, including bank loans, investment-grade debt, and lower-grade bonds (see Bloomberg article). David Swensen, the Yale endowment investment chief, believes that distressed corporate securities will produce "equity-like" returns. He also mentions in the article how corporate governance helped the Yale endowment steer clear of the Madoff investment mess, and believes that others need to take a similar direct and transparent approach to investing. Of interest is Swensen's views on Funds-of-Funds. The Yale Investment chief states that "the reason I don't like funds of funds is that they facilitate the flow of ignorant capital." Of course, the same could be said for most mutual fund investments, and Swensen states as much, stressing that most investors should stick with passive investments like index funds since attempts to outperform the market are usually unsuccessful for retail investors. Yale recently announced that its endowment had fallen 25 percent since June (see previous post), not unlike the 22 percent loss at the Harvard endowment (see previous post). Nonetheless, even with some of the luster off the past outstanding returns from both endowments, each fund is still outperforming the general market - although, with an increasing amount of capital in alternative investments, and an equally shrinking amount in equities, comparing against traditional benchmarks such as the S&P 500 is becoming less reliable.