In a recently published research paper in the Journal of Applied Corporate Finance, Tim Adam (from the MIT Sloan School of Management) and Chitru Fernando (from the University of Oklahoma Michael F. Price College of Business) report in their research paper "Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers" that during the 10 year period of 1989-1999, the gold derivatives market was characterized by a positive risk premium that resulted in short forward positions generating positive cash flows. The authors found that the gold mining companies that hedged their production during this time realized an average cash flow gain of $11 million, or $24 per ounce of hedged gold per year, compared on average to an annual net income of only $3.5 million without hedging. Of interest is that as a result of the positive risk premium that resulted from a positive spread between the forward price and the realized future spot price, short derivatives positions did not result in significant losses, even when the price of gold increased. In summary, hedging helped increase profits.

Also of interest in the article was the finding that there was also a significant level of volatility in corporate hedge ratios, implying that some managers were incorporating market timing into their hedging strategies (no surprise, as hedgers will sometimes begin to speculate). The authors found that attempts to time the market by "selective hedging" were futile and unprofitable, even causing the company to consistently lag the markets as they attempted with little success to successfully adjust their hedge ratios in response to expectations regarding market direction.

In summary, hedging helped profits, but the benefits were from hedging, and not from the risk managers ability to predict price moves as they set their hedge ratios. Therefore, one can expect, at least for the gold mining companies, that while earnings and profits may remain volatile, those investors holding longer-term investments should see higher returns from companies that successfully implement and execute a defined hedging program that do not try to engage in market timing. While it is difficult to know when any company that you are investing in begins to move from hedging to market timing, at least knowing that a company is hedging will give you the potential for higher returns as long as you can weather a few up or down moves that may temporarily reduce profit margins.

In case you have not seen it, Rick Santelli, reporting for CNBC from the floor of the Chicago Board of Trade, gives his two cents regarding the recent housing bailout (CNBC video here). I would not be surprised to see future bailouts, and subsequent rants, get worse going forward. Given that housing often leads us into and out of recessions, there is no doubt that the housing problem needs to start being resolved before people will begin believing that the economy will recover. Unfortunately, there is no easy answer. Just about any of the proposed solutions that has the slightest chance of speeding up the recovery seems to reward bad behavior, while at the same time further penalizing those that acted responsibly. Do we continue bailouts, or simply let the chips of capitalism fall where they may? Santelli, as well as many others, seem to have already chosen sides.

Although the DJIA and S&P 500 were each down over 10 percent in January, the Credit Suisse / Tremont Hedge Fund Index was up 1.09 percent (also see Investment News article). The January returns were the first time the index was up since May 2008. Top strategies for the month were convertible arbitrage (returning 5.72 percent), dedicated short bias - no surprise (up 3.69 percent), multi-strategy (up 3.35 percent), and global macro (up 2.33 percent). Managed futures took the biggest hit for the month, falling 0.56 percent.

T. Boone Pickens, who as of last November had holdings in 26 energy companies within his BP Capital Management, now holds shares in nine companies as of its latest filing (see Bloomberg article). The fund fell an astonishing 97 percent during the final three months of 2008, declining from $1.29 billion to around $40 million. As for individual holdings, BP Capital reduced exposure to Occidental Petroleum, Transocean, and Suncor Energy, while selling all of its holdings in Schlumberger and Halliburton. The fund added shares of Chesapeake Energy and Peabody Energy.

Real Estate Investment Trust are designed to give investors an opportunity to invest in real estate, which over the long-term has performed pretty well as an asset class, the last year notwithstanding. Last week (2/2 - 2/6) even saw a pretty nice move in the REIT market, below the returns of the Nasdaq and S&P 500, but slightly above the DJIA.

Source: Wall Street Journal

Of course, the days of easy credit, structure real estate products freeing up capital, and rampant building may be over, most likely taking with them above average returns. Nonetheless, there may still be some opportunities in REITs as the housing mess unfolds and sorts itself out, and the Treasury department finally starts addressing the housing issue (see WSJ article regarding a proposed loan modification program - details later). Note: Citigroup and JP Morgan have agreed to a foreclosure moratorium for 90 days (see WSJ article), in anticipation that additional details of the Treasury plan will be available within the next three months.

For those considering investments in REITs, it is important to remember that not all REITs are created equal, nor are they all the same, but instead come in many flavors. Reported data for REITs is also different. Instead of sales, REITs report rental income as revenue. An advantage for REITs is that much of this income is relatively consistent given that long-term leases are often in place. Obviously, when dealing with rental income, the higher the occupancy rate, and the easier the ability to raise rates, and the higher the reported revenue. While the ability to raise rates is probably not currently in the cards for most REITs, some may begin to see an increase in occupancy rates, or at least a level of stability not seen in all markets (more on this later).

Valuation of REITs is a little more difficult, or at least different, compared to traditional equity valuation. While Book Value per Share can be used, in active markets such ratios can produce extreme values. A common approach that is often used instead begins with using Funds from Operations per Share, which includes net income, along with depreciation and amortization, minus any gains or losses from any asset sales. It is worth noting that both depreciation and interest rise significantly with increased financing, with REITs often having debt-to-equity ratios above 50 percent.

Even with a valuation approach in hand, and data one can trust, it must be remembered that not all REITs are likely to benefit in each unique market. One strategy which individual investors are utilizing in the current market is to purchase unfinished homes, often at a steep discount after builders either choose, or were forced, to move on (see SeekingAlpha article). After investing a little more money to finish the home, such properties are being rented out. Even in poor real estate markets, such as Florida and California, the rental market is doing well, and offering such rental opportunities - after all, as the thinking goes, people need to live somewhere. While individual investors may not be able to make the same large investments, there are various REITs that invest in residential rental real estate. Some of those listed in the aforementioned article include CMG Realty (CGMRX), Third Avenue Real Estate Value (TAREX), Avalon Bay Communities (AVB), Essex Property Trust (ESS), and Camden Property Trust (CPT), yet most of these REITs have their own issues and require additional due diligence.

To support the rental argument, the Real Estate Channel (see article) has recently stressed how "apartments continue to be the product of choice in national investment circles," while Apartment Investment & Management announced in its latest conference call that "the multi-family investment market continues to be relatively liquid." Yet, not everything is rosy, as others feel that Apartment REITs are susceptible to the downturn, no matter how they might be positioned to other REITs (see InvestmentNews article). Other REITs, like commercial REITs, may also not do as well, and are being recommended as good shorts, even at these depressed levels (see SeekingAlpha article). Like just about everything else in the market right now - enter at your own risk. Trying to catch a bottom, especially after a relief rally and a detail-free plan from Treasury, is always risky.

The EU is looking at potential caps on the amount of leverage that banks can have on their balance sheets (see Financial Times article). What is unique, or at least of interest, is how there may be less differentiation between long-term investments and assets on shorter-term trading books. Charlie McCreevy, EU internal market commissioner, highlighted the need to considering both types of risk when he mentioned that "While the probability of default might be lower on a trading book because of the shorter time during which the assets are held, the impact of default when it happens is the same whether the asset has been held for a single day on the trading book or a whole decade on the banking book.” Commissioner McCreevy also did not hold his dislike for Value-at-Risk models, highlighting how VaR models are “very useful when they don’t matter and totally useless when they do matter”. This has certainly been a difficult year for VaR, but the question remains - What else do you use? Even if short-term trading book assets are given more attention, you still need to have an idea of your potential exposure and loss. Of course, maybe even more relevant is how the business models of some banks will need to change (either due to new regulation or pure survival needs), which will ultimately change the way such banks are valued going forward. While limits on leverage and risk may be good for the solvency of such banks, those that do survive will most likely continue to have their stock punished as investors try to get their hands around the valuation of new lower risk, and likely lower return, business models.

Per a recent SEC filing, and as reported in a WSJ article, the Harvard University Endowment appears to have cuts its holdings of public stock by about two-thirds. This is two-thirds of a position that has already been lowered over the years as a result of an increased exposure to alternative investments. About 70 stocks and publicly traded funds were recently valued at less than $600 million within a fund that was valued in total at nearly $37 billion last June - before losing a reported 30 percent of its value. While it appears that Harvard may have sold some of these assets near the bottom, they may have had little choice given that a significant portion of their portfolio is either managed by external managers and/or is illiquid, such as timber, real estate, and private equity investments (which in some cases could have additional funding obligations) - see a previous post that discusses potential liquidity risk issues at Harvard.

It looks like Morgan Stanley has found a way to reward its top employees without getting in trouble for using bailout money for bonuses. Instead of bonuses, the company will be handing out "Retention Awards" after its merger with Citigroup (see New York Magazine article). I guess the conversation will be something like: "Congratulations, since you are still employed, please accept this cash award." Something tells me that is not going to fly with Congress. Just what we need ........ another hearing.

Insiders at Bank of America (BAC) have been taking positions in the stock over the last few weeks. This includes the CEO Ken Lewis, former President John Thain, and various directors. As seen in the chart below, the stock, while still in a steep down trend, has seen an increase in volume over the last month, and has "rallied" off its recent 52-week low of $3.77 (but still down tremendously from its 52-week high of $43.60).

Source: Bigcharts.com

Ken Lewis was recently interviewed on CNBC. When asked if Bank of America will take addition TARP money beyond the $45 billion that has already been provided to the company, Lewis gave a categorical no. Yet it could be argued that BAC is technically insolvent, and that nationalization may be the next step (see John Brown article at SeekingAlpha), regardless of the CEO's view on existing and future TARP funds. Nonetheless, given the CEO's optimism (and his willingness to back it up with additional purchases), a recent upgrade, and comments this week by Treasury Secretary Geither that are expected to begin publicly addressing potential solutions for the housing and credit problems, this could turn out to be an interesting week for BAC shareholders, and may provide a window for the rest of us as to the viability and direction of the banking sector, the economy, and the market in general (stimulus bills notwithstanding).

As the market has dropped over the last six month, the lower prices have resulted in lower P/E ratios for many companies, even in the face of lower earnings (see WSJ article). While earnings could continue to fall, lower prices are currently offering value investors more opportunities than they may have had in the past as once high-flying technology, energy, health care, and bio-tech companies are now looking attractive. Many of these same stocks were sold-off as hedge funds were forced to liquidate positions in the wake of increased redemption requests. The fact that now both growth and value managers are looking at some of the same companies could produce an increase in buying pressure and stock price appreciation in the short-term for growth companies that were previously widely held.

Consumer spending fell 1 percent last month, while the savings rate rose 2.8 to 3.6 percent (see Washington Post article). Given that consumers have less revenue streams than before - employment (still for most), but less bonuses, dividends, capital gains, and home equity cash - it makes sense that they are saving what income they are receiving, just in case job losses hit their family, or the recession deepens or becomes prolonged. While the benefits of lower energy cost are helping, memories of $4 gas are also still in the minds of consumers. This of course continues to be bad news for consumer retail, and continues to help separate the wheat from the chaff as companies such as Circuit City and Linens 'n Things can no longer take the slowdown, and subsequent lack of sales and profits. I suspect that as we continue to keep hearing about how this is going to be an extended recession and even longer recovery, consumers will do their part to insure that it is indeed long as they reduce spending and save what disposable income they have. Ironically, it may be this prudent saving that helps keep the housing and stock market ATMs that consumers have depended on short of cash for quite a while.

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.

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.