Roubini(Gloom) vs. The Street (Great fundamentals for this rally)

Dr. Doom (Roubini) expresses fears of excess liquidity on the "dollar carry trade" i.e. such low dollar interest rates are propelling this boom- the low interest rates and the high liquidity are leading to another bubble.

"So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions"

Street says No rather emphatically and focuses on the fundamentals and says go long stocks since corporates will spend now as they overreacted last time they set budget.

Key defining characteristics of the 7-month and 62% rally have been:
(i) Its “prove it” nature: up on earnings surprises, flat-lining otherwise ;
(ii) Textbook relative sector performance. Financials and Consumer Discretionary up the
most, Energy and the defensives lagged ;
(iii) Lower quality higher beta stocks outperformed ;
(iv) Equity investor underweight positions have unwound but there have been little or no new
inflows into equities

Is this a bear market liquidity-driven rally? We don’t think so.
A positioning unwind can entail a significant rally even in the absence of a perceived change in fundamentals. This in our view would qualify as a bear market rally. In our view, the large unwind of equity investors underweight position was a key driver of the rally, and so on this measure the recent rally qualifies.
But it fails the fundamentals test in that it took place in response to repeatedly better-than-expected earnings. As to being liquidity driven, liquidity can drive equities two
ways—directly through inflows into equities or by liquidity-induced improvements in the
fundamentals or earnings. On the first count, inflows into equities have been limited so it is not as if the liquidity found its way into equities. On the second count, earnings improvement on cost cuts can hardly be attributed to liquidity.
Our take remains that the rally reflected excessively pessimistic expectations of corporate earnings causing investors to cover short
and underweight positions on much better than expected earnings delivery.
What’s priced in: Yesterday’s earnings; not a cyclical recovery yet. On a trailing multiple of
20, equities look expensive. But given that earnings snapped back in H1 2009 from off the
cliff levels of Q4 2008, a better gauge of where we are is provided by more recent earnings.
S&P 500 Q2 EPS came in at $16 or an annualized $64. Our fair value multiple of 16.4 implies
1050 on the S&P 500, around where we are today. So the market has nearly priced in last
quarter’s earnings. Q3 earnings are up sequentially by 6% and seasonally adjusted by 11%.
Thus, Q3 earnings are not yet priced in, let alone a cyclical recovery in earnings going forward

The key drivers and themes for equities the street sees are:
(i) Production to catch up with sales. The large gap between final sales and production
creates strong pressure for a cyclical recovery.
Buy Industrials (Capital Goods, Transportation), Consumer
Discretionary (Autos, Consumer Durables & Apparel), Materials and Tech (Semiconductors,
Hardware)

(ii) Corporate (not consumer) spending the key. Corporate budgets were last set at end-2008, when expectations for the economic outlook were very low. On an imminent increase in enterprise spending, buy Tech (Software and Hardware), the Industrials (Capital Goods), and advertising (Media in Consumer Discretionary).

(iii) Unemployment to peak. Policy uncertainty in a variety of spheres will likely keep the labor market recovery slow, but a peak in unemployment seems near. Buy the Financials (Universal Banks and quality Regional Banks) as a peak in unemployment should be a catalyst for marking a turning point in write-downs. Buy the Temp staffing agencies, which typically
benefit at this point in the cycle, but should do particularly well this time around .
(iv) Equities are cheap on normalized earnings. In a baseline of gradual recovery, equities are
very cheap. Buy the sectors which are cheapest on normalized earnings: Financials (-20%);
Industrials (-10%); Materials (-5%) .

next time : My view!

View from the street: Long high beta sectors but within sectors long better (lower beta/blue chip) stocks

Spot view:The view below is from one of the respected researchers on the street. So far we have seen a grind up in the S&P from 700 levels in March and we are still below last year September's levels around 1150. Personally, I am more concerned about either a grind up or a grind down. I think the Fed has propped up the economy so far but the data being released is mixed- negative (Housing/Durable goods) vs. some positive (consumer sentiment). So we are far from being out of the woods and I wouldn't be surprised if there were another slew of not so good data and a fall back to the 900s.
Vol view:Options traders might like selling short dated far out of the money calls although with VIX at 26-28 range. With the realized vol at 14%-15% and the implied vol at 26% -28% it seems smart to be short vol... However, I would only sell short dated vol- since I am still bearish and there may be a jump up in vol. Worth noting that if I sell short dated vol, I benefit from both the implied vol and the realized vol going down....depending on the instrument used

A persistent question since the March low and the large out-performance of higher beta stocks has been whether the beta trade has further to run? Is it time to rotate to quality stocks (lower beta)?We examine the relative performance of high versus low beta (quality) stocks historically. We do this first for the S&P 500 stocks unconstrained by sector membership, and then explicitly taking it into account. In the first exercise, we compare the performance of baskets of the 100 highest and lowest beta stocks in the index that are rebalanced monthly. In the second exercise, we constrain the baskets to include only the top and bottom quintiles for beta within each sector. History suggests the beta trade has further to run. In previous recoveries, the duration and magnitude of relative outperformance were longer and larger. Over the last two economic and equity market recoveries, from trough to peak the duration of high beta outperformance, was around 16m after both the 1991 and 2002 equity bottoms, compared with the current 7m run. As to magnitude, since 1992 relative performance of high versus low beta stocks has tended to converge to a fixed level. The long and severe underperformance from mid-2007 to early 2009 has meant that despite the substantial recent recovery, relative performance is still well short of this level But within sectors, the beta trade has run too far. When sector membership is explicitly accounted for, the same exercise indicates the beta trade has run too far. To be clear, we note that the recent trend has been for high beta out-performance within sectors but, in our reading, the magnitude of relative outperformance is overdone and thus argues for being cautious Strategy: The beta trade has further to run but look for beta outperformance from sectors not stocks. Stay overweight higher beta sectors, but higher quality names within sectors. On the view of a slow but continued economic recovery (DB economics forecast) that delivers significant earnings growth (our view), with forward equity multiples slightly below fair value, we see further upside for equity markets over the course of next year and maintain our 2010 S&P 500 target of 1260 set in May. A continued trend of beta outperformance but reflecting sector rather than stock beta argues for being overweight the high beta sectors. Who has the beta: by far the Financials; next are Materials, Consumer Discretionary, Industrials and Energy with similar levels; Tech has recently moved to low beta; Consumer Staples and Health Care remain the lowest. Our sector allocation remains in particular overweight the Financials and Consumer Discretionary sectors

Why trading strategies are important? a tale of market index fund vs. momentum

Since 1994 a simple strategy of going long the market yielded not very much- $100 invested in the S&p 500 index fund in Jan 1994 would give you $145 today. Adjusted for inflation that is a remarkably poor return.

A strategy called momentum- long the past month winner and short the past month loser would give you $372 today.... Naturally, these don't include transactions costs that can be big but it is an interesting observation....At this time there are no REALLY well known risk based explanations for momentum in academia...

I will discuss this more soon

Hedge Funds did well in August. Should we worry about EM?

This year has been terrible for funds short the stock market and a great year for those who bought bargain price bonds. It seems that the central bank money is helping out the fixed income funds- convertible arb has had an amazing year with 35% returns YTD.

Below is a summary of the action so far, expect more analysis later.

Credit Suisse/Tremont Hedge Fund Index (“Broad Index”) will finish up +1.68% in August
This is the sixth straight month of positive performance.

Wide dispersion in returns across global equity markets last month- EM in trouble?
Shanghai equity markets closed down over 20% , US and European markets peaked mid-month, reaching their highest levels since October 2008.
-This is concerning. I am going to look at more EM markets and see if we have an EM crisis coming up.... The EM central banks are weaker and cannot print money to support their debts... As the G-10 countries start saving more will the export oriented EM countries have a much harder time?

Small caps in Japan do better after elections
In Japan, markets rose modestly following the country’s national election and Japan-focused Long/Short Equity hedge funds were up approximately +1% for the month on average, benefiting primarily from stock selection and outperformance by the small-cap sector of the equity markets.

As a whole, Long/Short Equity managers had a generally positive month, finishing up an estimated 1.42%, while Emerging Markets returned an estimated 2.18%.

Event driven reaping benefits of special situations area
Event Driven managers returned approximately +2.46% for the month as managers continued to take advantage of tailwinds in equity and credit markets in the distressed environment. The majority of investment opportunities in the space currently appear to coming from the special situations area.

Global Macro, Futures etc. continue to do well
Managed Futures posted returns of 0.79%, representing their second positive month of performance so far this year (the sector was up +0.85% in May). Many managers in the strategy have struggled for most of this year, although trend followers appear to be beginning to show profits as models gain more traction. The Global Macro sector also experienced positive returns in August, posting a +0.94% gain as commodities-focused managers capitalized on rallies in metals, sugar and certain other softs.

Convertible Arb is back over this year after a horrible last year (up 35% over the year)
Convertible Arbitrage extended its run of positive performance to eight consecutive months, finishing up 3.37% in August, as opportunities in the space remained strong. Performance was muted, however, in comparison to returns of the past four months, when the strategy posted consecutive monthly returns of greater than 4%.

Fed helps Fixed Income funds do better
The US Federal Reserve and US Treasury announced an extension of its $200 billion term asset-backed securities loan facility (TALF) program, adding an additional three to six months from its original end-of-year expiration date. This was welcome news to many fixed income investors and relative value managers who had an overall positive month. Fixed Income Arbitrage managers are now up 2.39% year to date.

I will be back! with lower risk premia do we say hurrah?

So I am... passed my generals for the Ph.D. Loads of academic papers read.. few retained :) I am now going to think through this "rally" that has failed to cross 1000. Views on FX where the dollar has gone down against the Euro. Commodities etc. also included.

Interestingly funds have been having a good time..quite a bit of which comes from lower risk aversion- notice how the risk premia has narrowed and closed end fund discount- another measure of risk premium is narrowed down. In fact various risk premia narrowing is the key point/theme in all the "news" below.

- For the third consecutive month both equity (+10.28%) and fixed income (+4.58%) closed-end funds (CEFs) posted plus-side returns. Both macro-groups posted eye-popping returns for the three-month period ended May 31, 2009.
- On the stock side Mixed Equity Funds (+13.81%)-catapulted by Income & Preferred Stock Funds-and World Equity Funds (+13.39%) outpaced the Domestic Equity Funds (+7.76%) macro-classification.
- For the month 99% of all CEFs were able to post plus-side returns, with 100% of bond CEFs and 99% of equity CEFs chalking up returns in the black.
- Bond investors continued to be less risk averse and yield seeking in May, pushing Loan Participation Funds (+7.74%) and Global Income Funds (+7.29%) to the head of the class.
- In May the median discount of all CEFs narrowed 73 basis points (bps) to 7.96%. The largest narrowing of discounts (454
bps) was seen in the World Income Funds macro-group.

Bond Funds getting money and large cap stocks are facing redemptions

- The bond funds macro-group (+$13.8 billion) was the only macro-classification attracting net flows in February, while stock and mixed-equity funds handed back $24.9 billion and money market funds witnessed $6.7 billion of net redemptions.
- Large-cap funds (-$6.4 billion) continued to be the pariah of the U.S. Diversified Equity (USDE) funds group, while small-cap funds (-$1.2 billion) mitigated outflows better than the other capitalization groups.
- In February the Mixed-Equity Funds macro-group (-$3.9
billion) suffered its fifth monthly redemption in eight. The mixed-asset target horizon funds group's inflows (+$2.7
billion) were swamped by the net redemptions witnessed in the mixed-asset target allocation funds group (-$6.4 billion).
- For the year-to-date period World Equity Funds, shedding some $8.9 billion to net redemptions, handed back the largest amount of the four equity macro-classification breakouts.

Em Hedge Funds

Just checking that I can upload graphs now! Yaay...

This is the graph of factor loadings of Emerging Markets Hedge Funds... interesting how much of their returns can be explained by BRIC MSCI, Put Call ratio, Istanbul Index, Fama French Size Factors, and U.S. GDP growth...
We did know that there is little diversification in EM funds, but we didn't know that the EM funds were quite dependent on the U.S. GDP to this extent...

Credit Card Defaults

The S&P is rallying back and we are full of confidence... I am still bearish and think that credit card defaults are a big reason to be so...

U.S. Credit Card Delinquencies At Record Highs: Same Dynamics As Mortgages?
• U.S. credit card defaults rise to 20-year high. Analysts estimate credit card charge-offs could climb to between 9 and 10% in 2009 from 6 to 7% at the end of 2008. In that scenario, such losses could total $70bn to $75bn in 2009. The $5 trillion in outstanding credit card lines (of which $800bn is currently drawn upon) are being trimmed even for credit worthy borrowers with Meredith Whitney estimating that over $2 trillion of credit-card lines will be cut in 2009 and $2.7 trillion by the end of 2010
• Losses are particularly severe at American Express and Citigroup amid a deepening recession. AmEx, the largest U.S. charge card operator by sales volume, says net charge-off rate rose in February 2009 to 8.7% from 8.3% in January 2009 as job losses accelerated and the economy deteriorated. For Citigroup, one of the largest issuers of MasterCard cards, default rate soared to 9.33% in February 2009 from 6.95% in January 2009

What's going on?

The S&P has slipped below 800 to 750 levels with such ease that I fear we are indeed going to 600 as I thought earlier.


Here are the main views:
Real Economy

* Pain in the real side of the economy. Look for S&P to keep going lower

* The stimulus package will be moderately ineffective, inefficient and quite small. I think the market is falling in part because the REALIZATION of Obama's plan was far lower than the EXPECTATION!. We were hopeful but are disappointed that he, the smart new prez, has no magic bullet

- Currency views:

* EUR is under severe danger over the medium term- all the differences in various countries' political economies will come to fore... the interest rates will have to be drastically cut for a longer term than is currently priced in AND the stability of EUR currency itself is threatened.
* The short EURUSD trade has made a lot of money so far. Also long USDJPY may be the trade to get into... with Japan's horrible GDP numbers.

Below is something I read in a publication that shows how badly the small countries are doing...

Dubai Receives Capital Injection To Ease Debt Burden
• As concerns about the emirate of Dubai's financing needs mount, it launched a bond issue, the first tranche ($10b) of which was fully subscribed by the Central bank of the UAE. Dubai is estimated to have $14b in interest and principal payments due in 2009 (EFG-Hermes via WSJ) and it is slated to run a fiscal deficit in 2009
• Central bank of the UAE had $44.5 billion in fx reserves in September (most recent data) but has since provided liquidity to several of the country's banks. Instruments are five-year bonds that carry an annual interest rate of 4 percent
• The loan, the first major step of a long-anticipated support from oil-rich Abu Dhabi via the federal government, should ease the cost of insuring against a default, which in recent weeks saw five-year credit default swaps on Dubai debt rising to levels similar to Iceland (FT) Doing so might also lower risk premia on Dubai banks

JPY view from I Banks

Below is the view of one of the investment banking analysts that is quite respected in the industry-

Essentially the analyst is saying that the yen is done rallying. It may definitely seem that way looking at the fact that USDJPY hasn't moved from the 88- 90 range. My view is that USDJPY will move in that range 85- 92 for a while. ...



Cyclical and Structural Drivers of the Yen

Since the credit crisis broke in the summer of 2007, the Japanese yen has
been by far the best performing major currency. Since its lows in July
2007, the yen has risen by 43% in trade-weighted terms, 37% against the
dollar, 40% against the euro and it doubled against sterling and the New
Zealand dollar. Over this period, the yen outperformed the other risk
aversion currency, the Swiss franc, the second best performer, by a hefty
30%.

This strong performance reflected the confluence of a set of supportive
factors: cheap initial valuation, narrowing yield differentials, rising
risk aversion and, in the initial stages, a strengthening basic balance.
Just prior to the onset of the credit crisis in July 2007, the yen had
cheapened against the dollar to 20% below fair value, which we view as the
boundary in our valuation lines-in-the-sand framework. The yield
disadvantage of the yen narrowed as first the US and then other countries
cut policy rates. The appreciation reflected the risk aversion role of the
yen, outperforming during periods of heightened volatility. The initial
phase of the appreciation also reflected improvements in the Japanese
basic balance, which we view as the medium-term or structural driver of
the currency, as the current account surplus continued to grow and there
were limited FDI outflows from Japan.

Is the yen done? We take stock of valuation and prospects for the cyclical
and structural drivers of the yen.
(i) The yen is no longer cheap against the dollar but it is not unduly
expensive either, while it is near fair value against the euro and
approaching very expensive levels against sterling.
(ii) The policy rate differential has already narrowed (completely)
against the dollar though it has further to go against the euro, sterling
and commodity currencies.
(iii) Equity volatility has fallen from its peaks, but it remains high and
has further to fall over the next two quarters. We expect FX vol to
follow.
(iv) The Japanese basic balance has deteriorated dramatically on the back
of continued FDI outflows, while the trade surplus has given way to a
deficit. While we expect the basic balance to improve as capital outflows
diminish, with the trade deficit persisting through the global recession,
we expect the basic balance to remain well below recent peaks, arguing for
a weaker yen.

Long the dollar/short EUR?

I think it may be time to short the EUR against the USD again...

-I think Europe will sink into recession more than the US and the authorities there have not officially recommended a Zero interest rate policy... So any moves towards that will "surprise" the markets.

- Also, with news like Ireland, Greece etc. being more likely to default the status of Euro as a single currency may be a bit more under siege....

News Below....

The Irish IMF Rumor: Is A Payment Default Or A EMU Break-Up More Conceivable?

• Ireland was at pains to deny rumours that the IMF is about to walk in. Investors are getting increasingly nervous about the prospect of payment default in the euro area, and this is reflected by an increase in spreads and a weakening euro. The Irish spread has now widened to 184bp, and five-year credit default swaps for Ireland yesterday shot up from 193 to 207bp. Greek CDS are now at 250bp. The notion of a payment default among euro members spooks global investors, and the euro duly fell to $1.31 (Eurointelligence)

Hedge Fund Performance Dec 2008

Index / Sub Strategies		8-Dec	YTD	1 Year
Convertible Arbitrage		-1%	-32%	-3%
Dedicated Short Bias		-2%	15%	15%
Emerging Markets		0%	-30%	-30%
Equity Market Neutral		0%	-40%	-40%
Event Driven		-1%	-18%	-18%
Distressed		-3%	-20%	-20%
Multi-Strategy		0%	-16%	-16%
Risk Arbitrage		2%	-3%	-3%
Fixed Income Arbitrage		-1%	-29%	-29%
Global Macro		1%	-5%	-5%
Long/Short Equity		1%	-20%	-20%
Managed Futures		2%	18%	18%
Multi-Strategy		-2%	-24%	-24%

Risk Aversion still rules money markets funds still getting money!

• It seems hedge funds are not the only industry having money outflow problems... ( $150 billion was withdrawn from hedge funds in December alone). We see money coming out of mutual funds as well.
  
• 
  
• The fact that world equity funds are suffering outflows could be bad news for the EM countries- risk aversion means that people continue to withdraw money and are afraid to invest.

• The fresh round of banking troubles can only worsen the situation for small and emerging countries in the short term- lower liquidity means fund withdrawal from their stock and bond markets leaves those emerging markets more subject to shocks and jumps.
  

- The money market funds macro-group (+$127.4 billion) was the only macro-group attracting net flows in December, while stock and mixed-equity funds handed back $27.3 billion and bond fundswitnessed $6.7 billion of net redemptions.

- Large-cap funds (-$5.2 billion) continued to be the flows outcast of the U.S. Diversified Equity (USDE) funds group, while small-cap funds (-$1.0 billion) mitigated outflows better than the other capitalization groups during the month.

- In December the Mixed-Equity Funds macro-group (-$0.4

billion) suffered its fourth consecutive monthly redemption.

The mixed-asset target horizon funds group (+$2.6 billion) just managed to make up for the net redemptions witnessed by the mixed-asset target allocation funds group (-$2.1 billion).

- For the second month in a row the World Equity Funds macro-classification experienced the largest net outflows of Lipper's major equity groups, handing back $15.5 billion.

Happy New Year

Last Year:
So some of my banker friends have become stand up comedians... no really... they have... AND knowingly... as in, these guys intend the world to laugh when they talk ...( the first 6 months of the year when they were saying things and the market was crying...)
That pretty much sums up the year that was... on another note I am very proud of these friends for being creativity and having the desire to pursue other dreams than to structure complicated stuff.

Next Year...

I am a contrarian trader this year as well... still a buyer of gamma/volatility... especially on the 3 month, 6 month front and especially one touch options /wings etc. however, the key idea is to SELL your options when they are worth a lot instead of waiting till expiration date.

Mean Reversion with some downward drift is the theme of the market:
I see that the market has a lot of movement... the last active trading day was a more than 3% movement day.... or an yearly vol of 50% ish...which is a lot. That vol means that roughly an at the money option would cost 12.5% of the notional. However, if you notice, we have been moving in the 750- 950 ish range for a while now; since October 6th we have moved from below 1000 to almost back to 930 now. We have still generated a lot of volatility... how could this be? this can only occur if the market does a lot of mean reversion.... So if you want to trade somewhat contrarian this is the time to do it...

How to trade contrarian?
My view is contrarian with a short bias (i.e. I still do believe that the market is going down overall just not on the same trajectory as most people)... In other words, I buy options when I think they are too cheap, I wait until the market moves in my direction and then I sell the option without trying to exercise it. Interestingly, if I had tried to exercise the options, I would have made $0.00 this year....
A concrete example: I bought Jan 20 expiration 950 strike calls ( on the S&P) when the market had tanked to 815 levels. Then when the market rallied back to 930, I sold my calls. In between, I waited patiently.
Caveats: The waiting can be painful. If the market remains at 815 then I make no money, If the market tanks even more, then I make no money and if the market rises to 930 on Jan 19th , I will still make no money... so select your strikes wisely...
Decay: Naturally, I have to pay the cost of those calls when the market does nothing... that is the decay- the optionality decreases everyday so it can definitely be the case that the market doesn't move and your option decays like a dead horse.

But why might this strategy work? high intraday vol and lots of mean reversion, which you can take advantage of by placing LIMIT orders. Don't run into buy at the market price. In other words, have a view BEFORE hand... put in a price you will be happy to own something at



I think going long the dollar in the next few months may be a smart trade. if wrong , get out of it and wait on the sidelines.

Don't risk more than 5% of your capital on any one trade... especially involving options...Be conservative in these highly volatile times...

Enjoy and Happy New Year!