The other shoe is dropping? but will pad the hurt by printing money...

The other shoe (from my column a while ago), seems to be dropping.....

Usually central banks have three options available to repay debt for which they don't have money- print, default, restructure. So when these banks owe debt denominated in their own currency- say a 100 Euros and they only have 50 Euros, then either they can just print another 50 Euros, or they can refuse to pay, or they can say how about we pay you 50 today and 10 in the future and let's call it even.
Now, if both banks choose to "print" (print in quotation marks since they are buying bad bonds but effectively they are printing money to buy those bonds.)

I haven't gathered much data, I am just trying to simply think through the options facing OTHER central banks (debt and assets)/Sovereign funds ( assets)- who need to hold these "stronger" currencies and cannot simply trade them nimbly.
Earlier in the week, when we all were digging a grave for EUR (political confusion means economic death and EUR definitely has more political confusion than USD). It seemed that we will be left with only ONE panic currency to hold- USD. As these central banks and sovereign funds get out of the Euro or just stop buying it , it would be bad for the Euro. Rescuing Greece, Portugal, Italy, Spain etc. (high debt) countries would place a burden on German taxpayers who won't like handing Greeks their money.
Now the ECB has announced a Trillion dollar rescue package and the Euro has bounced back from 1.25 levels back to 1.30 very quickly.
So now we might see ECB seek guidance from the Fed on how to go about buying up every single asset. A few things emerge

1) The EM banks/Sovereign funds have two currencies following quant easing. We will see commodities becoming more expensive since we buy commodities in a currency and that currency is being printed and hence losing value
2) Naturally this is the same as saying higher inflation
3) Mediocre/Low growth. With quant easing I fear that the "weaker" companies won' learn they are weak quickly enough and they will continue to live in a zombie state (see Japan).
3) Higher levels of govt. regulation and control over the markets
4) Lower levels of shadow lending may be the desire (and the high levels of govt regulation will do that) but the banks will continue to be the whipping boys. So lower trading profits from banks
5) Consumers, esp US, are still saving too little and spending too much. I think that will change somewhat as we see lower number of credit cards and home equity loans in their pockets. Thus there may be some enforced savings. Lower student loans.
6) The houses that they bought and are underwater will continue to be so and these consumers won't be as mobile since they don't want to write off their houses. Lower labor mobility, high debt burden - worse labor markets.
7) There will be repeated small panics as some situation or the other (unforeseen as usual) emerges.
8) Haven't thought through the stock market situation. For now I remain bearish for medium term, with choppiness and intermittent panics and rallies - many banks will now NOT want to be short gamma, so expect gamma to be bid up. Vega goes bid too. The reason to not be bearish is high inflation. I do think (see above) high inflation is coming and expected inflation may be a common driver up of commodities stocks as whole. However, UNexpected inflation will obviously drive up commodities but I am not sure about stocks- there may be an interesting trade of long and short baskets of commodity owning and consuming stocks.

Funds withdrawn from long dollar and US equity positions

• Reading the headlines below it seems investors want to be short USD and short USD equities while investing in other foreign equities and US Bonds. The thinking must be that a second shot of Fed stimulus awaits! If so, corporate bonds (Fed made a killing on AIG bonds as the risk aversion dies) will do well AND the dollar will continue to go south.

• If you want to send your money to India and ride the carry train (long INRUSD) not a bad idea.

• I also find it interesting that ETFs continue to become more popular. Wonder if small hedge funds are using them more (since banks are tightening and the easy money to hedge funds may be drying up) or individual investors are.

Fund Flow News Below

1. Bond funds (+$24.6 billion) padded their coffers in December, while stock and mixed-equity funds (-$2.1 billion) and money market funds (-$7.7 billion) were in the red for the conventional funds business.
2. - However, ETFs experienced inflows for both major macro groups: bond ETFs garnered $3.4 billion while stock and mixed-equity ETFs attracted $21.3 billion.
3. - Investors continued to shun USDE Funds in December, redeeming a net $10.3 billion from the group. However, the other equity macro-groups caught investors' attention, drawing in a combined $8.2 billion.
4. - Mixed-Equity Funds (+$3.8 billion) attracted the largest net inflows of Lipper's four equity macro-classifications for the first month in four.
5. - A strengthening dollar and minor concerns over the extended run-up in world markets weighed marginally on World Equity Funds' flows, but the macro-group still attracted net inflows ($2.8 billion) for the ninth consecutive month.

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.