Humble Student of the Markets

In defense of the Fed

2012-01-26T00:38:00.000-08:00

Instead of being one of another million bloggers discussing the Fed's decision to hold interest rates low until 2014, I wanted to write about the Fed's role in the conduct of monetary policy. There has been a lot of criticism of the Federal Reserve from Republican quarters during this presidential primary season. Much of it stems from the likes of Ron Paul. Marketwatch reports that:

Compounding the criticism of the Fed is the role the central bank has played in the political career of Ron Paul.

“Paul’s position hasn’t changed in decades. He’s opposed to the Fed as an institution, preferring a gold standard and free banking,” said Michael Bardo, an economic professor at Rutgers University.

Other Republican presidential candidates have been just as hostile:

Texas Gov. Rick Perry started the attacks off by threatening bodily harm to Federal Reserve Board Chairman Ben Bernanke and accusing him of treason.

Front-runner Mitt Romney has since said he would fire Bernanke. Former House Speaker Newt Gingrich also said he would fire Bernanke and went further to propose a commission to examine returning the U.S. to the gold standard. And Texas Rep. Ron Paul has reveled in his unwavering stance of simply ending the Fed.

Why the Federal Reserve? Why now? According to Marketwatch:

[Mark] Calabria [director of financial regulation studies at the Cato Institute] thinks the Republicans anger might coalesce behind legislation to end the Fed’s twin goals of low inflation and low unemployment in favor of a single low-inflation mandate.

In praise of the dual mandate
Libertarians such as Ron Paul have long been advocates of abolishing the Federal Reserve in favor of the market discipline of a gold standard. Notwithstanding my opposition to the gold standard (see my previous comments here and here), consider what changing the Fed's dual mandate to a single anti-inflation mandate might mean.

First of all, you get the ECB, which until Draghi era began, stood aside while Europe burned.

In addition, good quants know that optimizing a system to a single objective function without considering other factors can lead to perverse results.

For instance, investors generally construct portfolios to maximize their risk-adjusted returns (however that`s measured), which is comparable to the opposing objectives of the dual mandate of the Federal Reserve. What would happen if they were to move to a single mandate by trying to either just maximize expected return or minimize risk?

If they were to maximize expected return, their portfolio would be two holdings, one long and one short. If they were to minimize risk, then the portfolio would be all cash.

Does that kind of portfolio make sense? I have frequently disagreed with many decisions taken by the Federal Reserve, but the idea of either abolishing the Fed or to move it to a single mandate sounds ludicrous to me.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Global healing, 2012 vs. 2009

2012-01-23T00:40:00.000-08:00

Further to my post last week detailing signs of global healing, I have had a number of discussions with investors about the market outlook based on the events of 2008-2009. If we are indeed in a period of global healing, then can we expect the kinds of returns from stocks that we saw coming off the March 2009 bottom?

The answer is a qualified no.

Consider this chart of US equities spanning the periods in question. In 2008, the market crashed in the wake of the uncontrolled collapse of Bear Stearns and Lehman Brothers. In 2011, the European authorities manage to stem the panic. Both episodes are marked in the red boxes below.

In late March 2009, the Asset Inflation Deflation Trend Model moved from a deflation reading, indicating maximum defensiveness, to neutral. The same thing happened about two weeks ago.

Here's the difference. In 2009, the market crashed. In 2011, the market didn't. Moreover, many professional investors were positioned for a crash but their performance was hurt by the confusion over the political and economics of the eurozone crisis. As a result, hedge funds and the average long-only manager had a terrible 2011.

The road ahead in 2012
So what happens now?

I would like to discuss the outlook for return and risk for risky assets such as equities. First, because the market didn't collapse in 2011 as it did in 2008, it would be foolhardy to ascribe near triple digit returns for equities going forward. If there are no accidents, such as a US recession, or a Chinese hard landing, investors should enjoy either high single digit or low double digit returns from a diversified stock portfolio.

The changing risk map
What has changed in 2012 is the map of risk. The actions of the ECB, Federal Reserve and other global central banks have effectively minimized tail risk for investors. Instead of having to worry about a market with a bimodal distribution, which Pimco manager Vineer Bhansali wrote about here, and is shown in the graph on the right below, I believe that stocks and other risky assets have returned to the classic unimodal bell-shaped return distribution shown in the graph on the left.

In other words, instead of worrying about catastrophic events, such as a Creditanstalt-like collapse, we just go back to worrying about earnings, recessions, growth, interest rates, etc. Bimodal distributions are much more difficult for professional managers to deal with because there is a single decision or event that can lead the market in two different directions. Will X default? Will the FDA decision be favorable for the company? How will the court rule in this key case that affects the survival of the company? It was largely these circumstances that led to the poor hedge fund and professional manager performance in 2011.

Unimodal return distributions, on the other hand, are far more manageable and much easier for professional investors to deal with. Modern portfolio theory is based on bell-shaped return distribution functions. Managers are well trained to manage risk in such situations and virtually everyone does it well.

What are the risks?
While I believe that equities are poised for reasonable returns in 2012, there are significant risks to the market. In the short term, I agree with Cullen Roche at Pragmatic Capitalism when he pointed out that investors appear to be overly complacent and due for a corrective pullback, a conclusion also shared by Mark Hulbert.

In the medium term, believe that there are two major macro risks that face the market in 2012. First, there is the risk of a recession in the US, which has loudly trumpeted by ECRI. While the high frequency economic releases have generally been coming in above expectations, which points to a weak but non-recessionary economy, what bothers me is that respected investors who are not permabears, such as Jeremy Grantham and Jeffrey Grundlach, have been cautious.

If the American economy were to move into recession as per ECRI, then we should be seeing its effects now. I would be watching carefully corporate guidance and the body language of management as we go through Earnings Season. Last week, earnings were generally upbeat with the exception of GOOG.

The second major macro risk facing the market is a hard landing in China. While the Chinese economy is showing signs of slowing, the authorities are also taking steps to cushion the slowdown. Most worrying though, is analysis from Patrick Chovanec that indicates that Chinese GDP growth would have been 6.6% had growth from the property sector been flat - which is a brave assumption given the sad state of the property market today. A Chinese GDP growth rate of 6.6% would likely freak out the markets as it is in hard landing territory.

What about Europe?
Conspicuous by absence in my list of macro risks is Europe. I respectfully disagree with John Mauldin when he wrote this week:

As this letter will suggest, I don't think this is the year you want your portfolio in typical long-only funds. There is a lot of tail risk this year coming from Europe.

In the worse case, consider what might happen if Greece experienced a hard default inside the euro, given that the ECB et al appear to be ready to fight the fire:

Greece defaults.
Banks have to mark to market their Greek paper and Credit Default Swaps get paid out.
Banks become insolvent, but small depositors can get their money because of limited deposit guarantees up to X.
Insolvent banks either get merged with strong banks (not many in Europe), get taken over by their sovereigns and restructured into good bank/bad bank (i.e. taxpayers take the hit), or go bankrupt.
Some investors will get hurt, but there will be no mass panic because of ECB liquidity.
The inter bank market would likely freeze up under such a scenario until there is more clarity about which banks live and which die. In the meantime they live on emergency ECB life support.
Risk premium migrate to the sovereign bond market.

Any crisis will get contained if the ECB prints. The Germans, if they object, will be faced with a choice of a catastrophic failure vs. QE. In the end, I believe that they would choose QE.

This sounds more like a Long Term Capital Management crisis whose effects was contained, rather than a Creditanstalt event that takes down the banking system and set into motion the second leg down in the Great Depression.

Don't worry, be happy
For now, my advice is to relax. Stocks look reasonably priced, barring catastrophic accidents. Even David Rosenberg is sounding somewhat bullish (or at least less bearish) these days:

We have a situation now where the P/E ratio, based on the trailing 12 months of earnings, is a mere 13. That may not be a classic trough by any means, but only 20 per cent of the time in the past quarter-century has the multiple been this low. That is something for investors to consider.

The multiple based on estimated earnings for the next 12 months – the “forward” P/E – is less trustworthy than the trailing P/E because it depends on analysts’ ability to accurately forecast the coming year. But as it stands, the forward multiple is now just a snick below 12.

In the past quarter-century, we saw only one other time when it was this low on a one-year forward basis, and that was the first quarter of 1988. A year later, the S+P 500 rallied 15 per cent.

That, too, is something to mull over.

For now, my Trend Model is showing a neutral reading and I anticipate some short-term choppiness as the market consolidates and digests the recent gains from the October lows. Beyond the short-term choppiness, equities should show some reasonable returns for the remainder of the year.

Don't worry, be happy.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Solving the Chinese piracy problem

2012-01-20T00:14:00.000-08:00

There has been a lot of hand wringing over the years about the problem of counterfeiting and copyright piracy in China. The Chinese, it is said, have no respect for intellectual property and will copy anything. Many have advocated tough solutions to deal with the piracy problem.

Things are changing because the Chinese economy is moving up the value chain. Patrick Chovanec wrote these words back in 2010:

Back when I was a private equity professional investing in China, I’d say that 9 out of every 10 opportunities I saw involved what I would call “commodity” manufacturers — factories that churned out a standardized, low value-add product that virtually anyone could make, and competed solely on price. Even though they accounted for a big chunk of China’s productive capacity, and often were making good money, we did everything we could to avoid such investments. We figured that, whether in one year or ten, these companies would inevitably lose their purely cost-based competitive advantage as China’s economy developed. They represented China’s past, not its future.

In other words, Chinese companies were commoditized manufacturers competing on their low-cost producer status. The new breed of companies are moving up the value chain:

At least one out of every ten Chinese companies we looked at, though, had more promise. Either they were making something unique, or they were doing something markedly better than their competitors: achieving higher quality, reaching more markets, building a brand name, etc. Often their costs were higher. Among other things, they had to hire better, more expensive employees, not just in production, but in sales, marketing, and customer service. They had to invest in training and sometimes even in partnerships with local schools to ensure a steady stream of qualified workers as they expanded. Like any investment, it was a risk, but it had the potential to pay off by setting them apart from the low-cost, low value-add pack. These are the companies we were betting would own the future.

The trend that Chovanec wrote about is starting to show some results. The Economist reports that Chinese consumers are starting to pay more attention to brands and shun counterfeiters:

Counterfeiters are no longer popular. Not long ago, Chinese shoppers applauded the fakers for saving them money. Now they scorn them. If it’s a fake, the well-heeled sneer, you can’t flaunt it...

Still, as China grows richer, life is growing harder for fakers. A recent study of China’s luxury market by Bain, a consultancy, concludes that “demand for counterfeit products is decreasing fast.” McKinsey, another consultancy, found that the proportion of consumers who said they were willing to buy fake jewellery dropped from 31% in 2008 to 12% last year. This is good news for all brands, not just the blingy ones. “Consumers are looking for the real thing, and they are increasingly willing and able to afford it,” say the authors.

That's because the Chinese have moved up the value chain:

Another reason why fakers are under pressure is that Chinese firms now have intellectual property of their own to protect. Brands such as Lenovo (a computer firm) and Haier (a maker of everything from fridges to air-conditioners) are highly valuable and therefore worth defending. The more Chinese innovators gripe about fakery, the more strictly the government enforces the law. It just announced that it aims to stamp out counterfeit software in government offices by the end of this year.

The Chinese are on a well trodden path followed by other Asian economies that have migrated up the value chain, such as Japan (those of us old enough still remember the ridicule of the cheap Japanese imports from the 1960's), South Korea, Taiwan, etc. The latest five year plan calls for more balanced growth and high value-added exports. While the jury is out on the first objective, they seem to be fulfilling at least on the second part.

This story illustrates the indirect way to fight intellectual piracy as the problem of is going away naturally of its own accord. Yes, Greg, people do respond to incentives.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

"Unofficial" money fleeing China

2012-01-17T00:14:00.000-08:00

There has been much angst over the latest report of China's quarterly decline in forex reserves, which has been described as "hot money" fleeing China. A more important sign of China's health is how much "unofficial" money from tycoons and wealthy officials have fled. If corrupt officials were to take money out of China , than it would be an important sign of the metaphorical rats leaving a sinking ship.

One rough way of monitoring the "unofficial" money flow is to watch gaming revenues in Macau. The Economist discusses Macau's success as a gaming destination [emphasis added]:

Macau’s success is not built purely on the Chinese love of gambling. It is also fuelled by a stampede of nervous money fleeing the mainland. A look behind the scenes at Macau reveals a lot about Chinese corruption, and also about how scared many Chinese businessfolk are about the political climate back home.

The article went on to explain how money can be laundered:

Many come to elude China’s strict limits on the amount of yuan people can take out of the country. A government official who has embezzled state funds, for example, may arrange to gamble in Macau through a junket. When he arrives, his chips are waiting for him. When he cashes out, his winnings are paid in Hong Kong dollars, which he can stash in a bank in Hong Kong or take farther afield.

Using figures from Macau's Gaming Inspection and Coordination Bureau, I compiled the former Portuguese colony's gaming revenues for the period 2009-2011.

The charts show that gaming revenues have been steadily rising over the last three years. However, a look at the rate of change shows that the year-over-year change in gaming revenues have been falling since peaking last summer.

The picture is the same whether you look at it from an absolute basis or on a percentage basis:

My initial conclusion is that using the crude measure of Macau gaming revenues is to remain cautiously optimistic about the prospects of a Chinese soft landing in 2012. While there may be substantial funds leaving the country through Macau, the lack of acceleration in gaming revenues showing that the unofficial (and smart) money is not panicking over the situation in China.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Global healing

2012-01-16T05:51:00.000-08:00

I've been pretty bearish in the last few months, but it may be time to change my outlook. Last week, the Asset Inflation-Deflation Trend Model moved from a deflation to a neutral reading. As a confirmation of this trend, my review of the charts show a picture of global healing after the trauma last year of a near banking crisis meltdown in Europe.

Is LTRO the Draghi Put?
Most notable is the performance of the banks. The relative performance of the Banking Index shows a pattern of a rally through a relative downtrend. The ECB's LTRO program of providing unlimited liquidity for up to three years to eurozone banks has bought the politicians time and created the perception of a Draghi Put for the market. The recent relative performance of the BKX, which is heavily weighted with the large TBTF banks, is reflective of this relief.

Similarly, the performance of the Euro STOXX Index shows a pattern of global healing. Despite all of the financial stress evident in the eurozone, this index formed a wedge and the wedge resolved itself to the upside.

In addition, we have been seeing positive European price action in the face of bad news, which is bullish. I wrote last week that European banks have been testing a key support but that level has been holding up, despite all of the bad news in the last few months. Italian 10-year bond yields, which is a key measure of investor confidence, has stayed below the important 7% level in the face of the downgrades.

Inter-market analysis confirms the turnaround
Sectorally, I am seeing signs that the market expects a cyclical rebound, at least in the US. The chart below shows the relative performance of the Morgan Stanley Cyclical Index against the market, which has been rallying and is now in the process of testing a relative resistance level.

The Industrials are also showing a similar pattern of relative strength as the sector began a relative uptrend in October.

So have the Materials sector, which show the familiar pattern of rallying through a relative downtrend:

...while defensive sectors such as Utilities have lagged the market and is now in the process of testing a relative support level.

Constructive on commodities
Commodity prices are also showing signs of global healing. The chart below of the CRB Index shows that commodities have rallied through a minor downtrend and it tested the longer term major downtrend, which remains intact.

The commodity heavy Canadian market is also showing a similar pattern of rallying through a short-term downtrend, though the longer term major downtrend remains intact.

Regular readers know that I am a long-term commodity bull. These charts indicate a constructive outlook on the commodity complex. Mary Ann Bartels of BoA/Merrill Lynch recently showed that large speculators (read: hedge funds) have unwound their crowded long in commodities and readings have retreated to a level where previous bull phases have begun in the past:

Positive breadth divergence
Tom McLellan, writing at Pragmatic Capital, has confirmed my observation of a market turnaround. He wrote that the Ratio Adjusted Summation Index is showing strength:

So all of this leads us to the current RASI reading, which at +618.2 is above the +500 level but still below the peak of +763 seen on Nov. 15, 2011. So it is a divergent lower high, but it is still high enough to say that the uptrend which started in October 2011 is not over. There can be ordinary pullbacks along the way, but the message of the RASI is that the final highs of this current new uptrend have not yet been seen.

Not out of the woods yet
To be sure, it's not up, up and away here for stocks and numerous risks remain. Greece is edging closer to a default as talks with creditors appeared to have broken down. The situation in Hungary remains volatile and has the potential to take down the Austrian banking system. Just because there is a Draghi Put in the market doesn't mean that investors are immune from losses, but I would encourage investors to think of the Draghi Put as an insurance policy with a deductible where you have to incur the first X% in losses.

In addition, China isn't out of the woods. While the Chinese leadership is making noises about stimulus, the property bubble in China is deflating in a dangerous way and it is unclear whether the authorities can achieve a soft landing. The Shanghai Composite has been rallying in line with global equity markets but the index remains in a downtrend. The one silver lining for the bulls is that there appears to be a turn-of-year effect in Chinese equities. The current rally is consistent with the pattern of market updrafts seen starting at about the time of past Lunar New Years.

Since China's economy remains a major engine of growth in a growth-starved world, this is one indicator to watch carefully. The bulls can also take solace in the Hong Kong market, which formed a wedge that resolved itself to the upside recently:

In addition, Nomura believes that Chinese real estate may be in the process of forming a bottom. The firm's analysts pointed to a positive divergence between land purchased by property developers and new construction activity:

Cautious short-term, constructive medium term
Putting it all together, what does this all mean?

My inner trader tells me that in the short-term, the rally looks overdone. Over the next few weeks, continue the strategy of buying weakness and fading strength. Indeed, Macro Story confirms a high risk level for equities by pointing out that AAII sentiment is at a bullish extreme, which is contrarian bearish.

With US equities now testing a resistance level, expect some short-term weakness but be prepared to buy the dips:

Longer term, my inner investor tells me to expect a period of sideways consolidation, likely followed by a bull phase in equities with an expected return of 5-15% in 2012 - assuming that there are no accidents.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Which Merrill sentiment indicator to believe?

2012-01-13T00:36:00.000-08:00

A former Merrill Lynch colleague pointed out to me last week that the Sell Side Indicator, a contrarian indicator based on the average recommended equity weighting of Street strategists, is edging towards a buy signal:

The record of the Sell Side Indicator has been fairly decent:

On the other hand, Surly Trader also pointed out that the bull-bear ratio based a survey of institutional managers compiled by BoA/Merrill Lynch is flashing a sell signal:

Which sentiment indicator should we believe? It's hard to be a contrarian investor when two sentiment indicators tell completely different stories.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The ECB's exclusive party

2012-01-11T05:45:00.000-08:00

I came across this chart from Bank of America/Merrill Lynch showing how central bank balance sheets have expanded

The report states that balance sheet expansion does not necessarily represent quantitative easing, but the result of liquidity operations such as LTRO:

The ECB’s balance sheet quietly reached a record size of €2.7tn in late December, with a growth of over 40% in the past six months. Both the size and pace of the balance-sheet expansion have attracted the market’s attention since the start of 2012. Questions have been raised as to whether such an expansion should be regarded as quantitative easing or not. We highlight below that the ECB’s bond purchase program was not the major driver of the expansion but that, instead, increased bank borrowings played a more important role. Also, we note that unlike the Fed, the ECB does not have full control over the size of its balance sheet. The latter could continue to grow in the coming months but it could also shrink on lower reserve requirements and improved funding conditions.

Such liquidity operations they are. Joseph Cotterill at FT Alphaville pointed out that banks can now get instand and unlimited liquidity by issuing themselves unlisted bonds and then use those bonds as collateral at the ECB:

[W]e said the ECB’s decision in September to accept unlisted bank bonds — i.e., bonds that the banks could have issued purely to themselves solely in order to pledge them as collateral for central bank funding — was “potentially very significant”.

Is this an exclusive party, by invitation only?
It's obvious by now that the ECB is throwing a liquidity party. What's more significant, like the Sherlock Holmes story about the dog that didn't bark, is that we haven't heard a thing from the Germans despite the rapid expansion of the ECB balance sheet and tsunami of liquidity unleashed on the market.

The effect of this liquidity pump has been to support European banking system. A look at the Euro STOXX 600 Banking Index shows that, despite Unicredit's well-known troubles with its share price, the index is testing a critical support level.

These developments begs a couple of questions:

Are European banks a screaming buy at these levels? The extraordinary intervention of the ECB has taken the risk of a catastrophic banking failure off the table.
Why aren't there more institutions at the ECB's party? The last LTRO auction saw 523 banks at the ECB's party. In the wake of the Lehman Crisis, the Fed's liquidity dump saw everybody and his brother turn themselves into banks to feed at the Fed and the Treasury's troughs. In today's Europe, why haven't we seen more institutions of financials and near financials, e.g. Allianz, Munich Re, the finance arm of auto companies, brokerage firms such as the European operations of Goldman Sachs, even hedge funds, etc., turn into banks to avail themselves of cheap LTRO money? Is the ECB throwing a highly exclusive party, by invitation only?

The answer to question 1 depends on the answer to question 2.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Distilling alpha with factor betas

2012-01-09T00:10:00.000-08:00

One of the hardest questions any portfolio manager has to answer is, "What can go wrong with your strategy?" If he doesn't know, then it's a sign that he hasn't fully thought out all the nuances of his investment approach.

How to untangle alpha using factor betas
Here is one example of how I used to evaluate investment strategies when I worked at and with hedge funds.

A couple months ago, we were approached by an experienced bond portfolio manager with an idea for a bond strategy for the Canadian market. The idea involved overlaying a call option writing strategy on the US Treasury market on top of a Canadian bond portfolio. The resulting portfolio had the following benefits:

Same duration exposure as the benchmark, i.e. no significant interest rate directional bets;
Higher credit quality compared to the benchmark
Significantly higher realized return than the benchmark

I interviewed the portfolio manager and found out that the most significant risks of the strategy are, in no particular order:

Basis risk between the US and Canada yield curve
Currency risk
Volatility risk as it relates to option pricing

Disaggregating the alpha using factor betas
He had been running a "live" paper portfolio in real time for a little over a year. The backtest looked good as it added an alpha of over 3% in that period. Given my assessment of his risk exposures, I wanted to see whether the outperformance was the result of a favorable factor beta exposure, i.e. the strategy bet on a certain kind of exposure and it worked, or the alpha was relatively independent of factor beta.

We got the weekly returns of the paper portfolio and I made the following table:

I averaged the weekly alpha of the strategy under different scenarios. On the first line, I asked, "What is the average weekly alpha when the US long bond price is up, down or relatively flat?" In that case, the strategy underperformed when the long bond rallied, largely because it was selling call options at the long end of the yield curve and the premiums weren't enough to offset the gains in bond prices, and outperformed when the long bond price was either flat or falling.

Similarly, I performed other forms of scenario analysis. What happens to the alpha when the Canada and US curve diverge? What happens when implied stock volatility (I didn't have a good proxy for bond volatility) moved up or down?

Stress testing factor beta exposures
I used scenario analysis to project an annual alpha. The average case analysis assumes a Gaussian distribution where 50% of the time exposure to that factor beta is neutral, 25% of the time it is favorable and 25% of the time unfavorable. Using the example of the long bond price factor, I calculated an expected alpha assuming that 25% of the time, the bond price was falling, 25% of the time it was rising and 50% it was neutral. In this case, that came to an expected alpha of 3.90% per annum.

I wanted to stress test the strategy some more. What if the market gods aren't with us?

In the second column labelled "Adverse Case", I assigned weights of 50% neutral, 33% unfavorable and 16% favorable. Using the example of the long bond price factor, the expected alpha came to 0.80% per annum.

What happens if a catastrophic scenario? In the third column labelled "Worst Case", I assigned weights of 2/3 neutral, 1/3 unfavorable and 0 favorable. (Remember that these are weekly alphas and it would be difficult to believe that, in the case of the long bond price, it would fall for a single week in an entire year and would be rallying 17 weeks out of 52 weeks in the year.) The expected alpha in the worst case analysis for the long bond price factor came to -2.13%.

Conclusion
Putting it all together, the strategy looked pretty good. We could expect an alpha in the order of 3.0-3.6% a year - which is an astounding figure for a bond portfolio. In a typical bad year, we could still expect outperformance of 0.8% to 1.8%. If the roof caved in and everything went wrong, alpha deteriorated to between -2.1% and a positive 0.2%.

This is an example of a simple method of evaluating any investment strategy using scenario analysis with factor betas. This is another way of asking the question, "What can go wrong with the investment strategy and how badly could things fall apart?"

Ultimately, we passed on implementing the strategy not for investment reasons, but for business ones. If anyone is interested in further details or in funding such a bond strategy, please contact me at cam at hbhinvestments dot com and I will be happy to refer you to the bond manager.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Will good news be good or bad news?

2012-01-06T00:18:00.000-08:00

In the wake of the "beat" by the ADP release and as traders wait for the Non-Farm Payroll figures due out at 830 Eastern Time, here is something to ponder.

Is good news (better growth) good news or bad news?
The most recent string of economic releases have been pointing to an American economy that is growing, albeit slowly at a 1-2% real rate of growth. The WSJ reports that primary dealers are expecting that QE3 is on the way:

The primary dealers also see a 60% chance of the Fed adding to its System Open Market Account holdings — embarking on QE3, in other words — in the next two years. That also gibes generally with what many on Wall Street seem to expect.

In addition, Zero Hedge has reported that Deutsche Bank believes that the market has discounted $800b in QE3:

Analyzing historically the reaction function of real rates to QE announcements, we find that USD19bn of new QE tend to reduce real rates by 1bp. Based on this estimate and on the model dislocation, we find that the 10Y real yield was fully pricing in Operation Twist in September and that since then the dislocation has increased to price in another full QE package, similar in size to QE2, of about USD800bn (excluding reinvestments of maturing agency and MBS holdings).

Here's the Big Question: Supposing that the high frequency economics releases are right and GDP is growing at a 1-2% rate. Wouldn't that restrain or delay QE3? (As an aside, star bond manager Jeff Grundlach said during the Q&A after yesterday's presentation that he doesn't believe that we will see QE3 between now and the election.)

How will stocks react? Positively because organic growth is rising, or negatively because the Fed won't be unleashing a tsunami of liquidity that accompanies quantitative easing?

Are the markets already to price in such a scenario? Ed Yardeni wrote that while the Street consensus revenue estimates have been ticking up, earnings estimates have been falling. This sounds like an environment of good news is bad news for the markets and bad news is good news.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

A stark reminder of the north-south eurozone divide

2012-01-05T00:05:00.000-08:00

The FT had an interesting article highlighting the north-south divide in the eurozone:

The starkly contrasting economic trajectories of countries inside the eurozone were highlighted on Tuesday as Germany reported unemployment at 20-year lows while Spanish jobless figures rose for the fifth consecutive month.

Moreover, there is an interactive graphic in the article showing the different unemployment rates by country.

While the latest eurozone seasonally adjustment unemployment rate is 10.3%, compared to 10.1% a year ago, there are vast gaps in unemployment rates between member states. Most notable are Germany at 5.5% (vs. 6.8% a year ago), the Netherlands at 4.8% (vs. 4.4%) and Austria at 4.1% (vs. 4.2%). The underperforming PIIGS are suffering vastly higher unemployment, with Greece at 18.3% (vs. 13.9%), Ireland at 14.3% (vs. 14.2%), Portugal 12.9% (vs. 12.3%), Spain at an astounding 22.8% (vs. 20.5%) and Italy an outperformer at 8.5% (vs. 8.4%). As a point of reference, the unemployment in France, which is the other major partner in the eurozone leadership, stands at 9.8% (vs. 9.7%).

How badly will austerity bite?
Please note that these unemployment figures are dated October 2011, before the full brunt of many announced austerity programs have been felt. As the effects of these cutbacks start to wind their way through these economies, will unemployment go up or down?

How long before the elites are faced with a political backlash?

The Guardian reported that the new Greek government is fed up with new demands and playing a game of brinkmanship again [emphasis added]:

Greece was promised a second emergency bailout worth €130bn (£108bn) in October after it became clear that the first rescue package, agreed in May 2010, was not enough to stabilise its debts.

But talks about this second deal, including a writedown for Greece's private-sector lenders, are still continuing. Kapsis told Greek television: "This famous loan agreement must be signed, otherwise we are outside the markets, out of the euro and things will become much worse."

Reports have emerged since the weekend that the troika could demand fresh austerity measures from Athens in exchange for a new loan to ensure that it meets its targets for reducing the deficit. But Kapsis also said imposing more cuts on a recession-hit nation could be very difficult.

They have threatened to leave the euro within three months unless they get relief:

The Greek government has stepped up the pressure on its eurozone paymasters by warning that unless a new bailout for the recession-hit country is agreed within the next three months it will be forced out of the single currency.

No doubt much of this rhetoric is typical of the posturing that goes on in negotiations, but as austerity programs begin to bite all over Europe, investors will start to worry about and price in the tail-risk of social upheaval and political instability.

The ECB's LTRO program of unlimited liquidity has bought the politicians some time. Don't be too surprised if that window of time may be shorter than expected.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Buy the dips & sell the rallies

2012-01-04T00:33:00.000-08:00

I recently wrote that 2011 was a choppy market where it was very difficult for institutional investors to beat the market and for hedge funds to make any money because of the tendency of the market to whipsaw. In that case, my inner trader has observed that there is potential for nimble traders to profit from trading the swings of a range-bound market by buying the dips and selling the rallies.

The chart below shows the relative performance of SPY, which represents US stocks and the risk-on trade, against TLT, which represents long Treasury bonds and the risk-off trade. I have overlaid on top a short horizoned RSI indicator of 7 days. Note how it has been profitable to sell stocks and buy bonds when RSI approaches the 60-65 level and buy stocks and sell bonds RSI goes below 30.

Where are we now? With the opening day rally yesterday, the SPY/TLT 7-day RSI stands at 55, which is very near the sell zone for stocks, indicating that the upside is limited - unless you believe that stocks are on the verge of a major upside move.

My short term liquidity measures is also telling my inner trader to sell this rally. Measures of MZM growth are flattening out, which is generally not conducive to a sustainable equity rally, after an uptrend that largely coincided with QE2 earlier last year.

This chart of the growth of broader monetary aggregates also tell the same story. Money supply growth is now either flattening out or decelerating after a period of acceleration that began in mid-2010. Everything else being equal, an environment of slowing money supply growth usually provide headwinds to further advances in equity prices.

My inner traders is telling me that the upside in stocks is limited at these levels and to fade this rally, but to be prepared to buy the dips.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Have a plan for 2012

2012-01-03T00:27:00.000-08:00

Sometimes the investment process is more important than the investment decision. In the past few days, I have outlined:

My bull and bear cases for the stock market (see The road ahead: bull & bear case);
The difficult environment for active managers (see A terrible 2011 for hedge funds); and
How it's likely to change (see Back to fundamentals in 2012).

I urge all investors to have a game plan for the year ahead and beyond. Despite all of our best efforts, our forecasts can and will fail and how you react to the change in direction is more important than the decision you take today.

Strategies for different parts of the cycle
Barry Ritholz recently showed a series of charts of the economic cycle and how investors should react to them, two of which I show below. However you approach the market, whether it's asset and sector rotation, or stock picking, recognizing your investment environment is key to alpha generation. This chart shows the analytical framework for the asset and sector rotators:

And this one is a framework for the stock pickers:

Be tactically aware of the investment environment
My approach is to become more tactical in my asset allocation using my Asset Inflation-Deflation Trend Model. An article in Registered Rep shows how many investment advisors are turning to tactical asset allocation as an investment solution to dampen portfolio volatility:

Following the twin market implosions of the past decade—first tech, then real estate—many retail financial advisors are looking for more tactical, meaning active, asset allocation solutions for client portfolios to dampen volatility, improve total returns and avoid market catastrophes. At least some of them fear that if they don’t dramatically change the way they allocate client portfolios, moving away from traditional buy-and-hold investing strategies, they could lose clients. So say a handful of advisors and an investing expert.

Not becoming more tactial could pose a business risk:

Things could get especially bad if another bear market hits, says Ron Carson, founder and CEO of Carson Wealth Management Group. “[Investors] are hanging on by a thread right now, and I don’t think they’re going to forgive.” A Natixis Investor Insights Study found that 63 percent of investors are now paying more attention to risk than ever before. If the market nose-dives, advisors are going to want to have a different story to tell. They can’t just tell clients to hang on and wait it out like many of them did in 2008.

The movement to tactical asset allocation has turned from a trickle to a flood:

According to a survey by Cerulli Associates, the number of FAs using either a pure tactical allocation or strategic allocation with a tactical overlay is now at 61 percent, up 8.3 percent from 2010. A Jefferson National survey from September 2011 found that 75.5 percent of advisors believe that active portfolio managers can outperform an index over the long term. In Jefferson National’s 2010 survey, 66 percent of advisors said clients were more confident with a tactical asset management strategy, while only 34 percent said clients were more confident with a traditional buy-and-hold strategy.

Are you betting the farm?
Stocks didn't go anywhere in 2011. In fact, they haven't gone anywhere since the NASDAQ peak in 2000. In the current low-return environment, advisors find that clients are less forgiving of draw-downs in their portfolio.

In days past, the practice of overweight a portfolio with a manager to make a big style or macro bet that "looks through the economic cycle", e.g. a value manager, was perfectly acceptable. The downside to managers that make such style bets is they tend to badly underperform during certain periods when their style is out of favor - and investors are far less tolerant of such draw-downs in the current volatile and low return environment.

As an example, there were numerous managers who were wary of internet stocks during the Tech Bubble runup. I had watched many good managers and strategists go down in flames because they were one or two years early because their investors couldn't stand the underperformance. Today, investors are highly intolerant of negative volatility, largely because of the low return environment that we have been stuck in for the last decade.

Have an investment plan
The message is clear. Take control of your portfolio. Be aware of the investment environment. Your investment philosophy and objectives are up to you. However, you should make sure that you have engineered your portfolio's risk profile sufficiently so you survive to get to your objective.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Back to fundamentals in 2012

2012-01-02T00:24:00.000-08:00

Imagine playing a football game in a driving rainstorm on a muddy field. Players slip and slide all over the place. The quarterback has trouble throwing the ball. Receivers can't grip thrown balls. Running backs are virtually skating on the field and can only occasionally get good footing. Kickers can't judge the wind as it shifts at a moment's notice.

That was the story of disappointing returns in 2011 for many hedge fund and active investment managers, which I wrote about last week.

Consider the experience of star hedge fund managers like Mark Kingdon and John Paulson, who can be described as the proverbial smartest guys in the room. The Wall Street Journal reported that Kingdon and Paulson were whipsawed by the market action in 2011:

Like other high-profile investors, Kingdon has been whipsawed throughout the year by stock market swings that have been hard to predict, turning on a dime. John Paulson (who had a terrific 2008) has had the most humbling year of his own storied career, with his largest funds sinking in value amid wrong-headed bets on an economic recovery.

Indeed, the chart below of the S+P 500 shows that the stock market was trendless in the first half of the year and trendless and marked by extreme volatility in the second half. Investable swings, shown in red, were few in number. Many of the swings seen in the second half, shown in green, lasted less than a week – and woe to anyone who tried to invest on news flow in the second half as whipsaw would be the inevitable result.

2011 was an extremely unfriendly environment for investment managers because politics and policy, not fundamental and economics, drove market returns. The market began to worry about an extreme tail-risk, or black swan, event such as a Lehman-like crisis in the second half of 2011. Every news headline moved the markets and it, in a binary risk on/risk off framework, it was virtually impossible for an investment manager to discern direction.

It is therefore no surprise that managers with the freedom to be long or short performed poorly in 2011 because of the lack of a trend, or direction in the market. On my previous post, I showed that the worst performing hedge fund managers were Market Directional, Equity Hedge, or long-short equity managers, and Fundamental Value.

Bimodal distributions and multiple equilibria

Like the metaphor about the football players, the reason why hedge fund managers had disappointing returns in 2011. The environment was unfriendly to their approach. Like the football players, it didn’t matter how skilled they were, they kept slipping in the rain.

That’s because most managers are trained to focus on fundamentals and economics while largely ignoring politics. In a year where politics and policy decision dominated the investment environment, it is no wonder that managers showed disappointing returns.

Moreover, the investment term “multiple equilibria” or “bimodal distribution” began to pop up in year-end letter to investors. As an example, Pimco manager Vineer Bhansali wrote about this topic in an article entitled Asset Allocation and Risk Management in a Bimodal World. In the article he wrote:

For example, the policy risk that pervades the markets today causes high correlations among asset classes and a temperament of “risk on/risk off” among investors. This phenomenon can be traced to the connectedness of markets, the ease by which market participants can access these connected markets, and the speed of assimilation of information in response to political events. (See V. Bhansali, The Ps of Pricing and Risk Management, Revisited, Journal of Portfolio Management, Vol. 36, No. 2, Winter 2010.) This environment creates the possibility of multiple equilibria in the market, as well as trends that move markets between these equilibria, and once settled, restraining forces that trap markets in those equilibria (See V. Bhansali, Market Crises -- Can the Physics of Phase Transitions and Symmetry Breaking Tell Us Anything Useful?, Journal of Investment Management, 2009).

Even though predicting which force will win is next to impossible given the real-time evolution of the interaction between markets and policy, we can still ask an important question: What would happen if the distribution of returns from a hypothetical portfolio looked more like the one shown in the chart on the right of Figure 1, i.e. a “bimodal” distribution with more than one peak? The bimodal distribution has two peaks, and interestingly, even though it is generated as the result of mixing two normal distributions, each from a different regime, it can exhibit both fat tails (a higher probability of larger losses due to unusual events results in a “fat tail” on the left side of the distribution curve) and skewness (a lack of symmetry between the left and right sides of the peak).

In other words, classical investment theory posits that investment returns follow a bell-shaped distribution, like the figure above on left. In the current environment where investors oscillate between a “risk-on” and “risk-off” trade, the true distribution may look like one with two peaks like the figure on the right. Under these circumstances, techniques used to manage funds assuming a bell-shaped distribution will not work in a multiple equilibrium world (like 2011).

The outlook for 2012
What happens now? Will the environment of 2011 persist into 2012 and the future?

The market should return to focusing on fundamental and economics in 2012. The financial market was largely driven by European news in 2011 as it was concerned the possibility of a Lehman-like market crash. When the news flow indicated that the Financial Apocalypse might be near, stocks sold off. When the European governments tabled a plan that indicated that the day of execution might be delayed, the markets rallied.

The events of 2008 are instructive for evaluating the current market environment. In 2008, the markets were concerned about the housing collapse and its effects on the markets and economy. Fast forward three years, the problems with the US housing market hasn’t gone away, nor have the concerns about the weakness of the American consumer and his balance sheet. But the fear of another Lehman-like Apocalypse in the United States is gone today.

Similarly, the ECB’s Long-Term Refinancing Operation (LTRO), which offers to lend eurozone banks unlimited amounts of money for up to three years, has largely taken the risk of Lehman-like event off the table. The long term problems of over-indebted eurozone sovereigns, weak European banking system and the competitiveness and productivity gap between Northern and Southern Europe remains.

Is the panic getting overdone? Probably. Given that the ECB has taken the market crash scenario off the table, the markets can now go back to focusing on what matters, such as earnings, growth outlook, interest rates, etc.

Under these circumstances, fundamentally driven investment strategies that depend on traditional techniques such as valuation, growth, momentum and trend spotting are likely to perform better in 2012 and beyond.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The road ahead: bull & bear case

2011-12-31T10:11:00.000-08:00

As 2011 draws to a close and we 2012 dawns, it's time to consider the bull and bear cases for the stock market and risky assets. I had already outlined my bull case for the market on December 19 (see The bull case for stocks). The bull case consists of:

The coordinated central bank liquidity injection of November 30 has taken a Lehman-like event off the table.
In the US, the Fed does QE3 in the 1H, which would send asset prices flying.
In Europe, the ECB is already engaged in a form of QE though the back door using LTRO, which should heal banking balance sheets over time.

Go and read my previous post, there is little more to be said.

The bear case for stocks
From a macro viewpoint, the three regions to watch are Europe, the US and China and the emerging markets. The market was focused on the possibility of a European banking crisis during much of 2011. No, the bear case for stocks in 2012 does not rest with Europe. I believe that market's focus will shift from Europe to the other regions of the world in 2012.

Europe: From heart attack to cancer
The ECB's LTRO program, which offered banks unlimited liquidity for up to three years, has virtually eliminated the possibility of a banking failure. In addition, coordinated central bank intervention that offered unlimited USD liquidity also showed that central bankers around the world are well aware of the risks of a Lehman/Creditanstalt credit event and have taken steps to address the problem. Nevertheless, problems remain and all Draghi & Company has done is bought time for the politicians to address the long term issues.

What is the market saying about Europe? Scott Grannis wrote in his PIIGS Update that conditions in the bond market are normalizing, though far from ideal. The ECB's balance sheet expansion does not appear to be leading the eurozone down the hyperinflation path, but problems remain. In other words, Europe has gone from avoiding the imminent heart attack to a lingering but treatable cancer. We will have to watch and see how the politicians address the longer term problems of the competitiveness disparity between North and South, as well as the debt situation of the PIIGS. No doubt, we will continue to have crises and summits, but the risk of a catastrophe is lower than it was in 2011.

A US recession in 2012?
One thing that investors shouldn't forget that stock prices depend on fundamentals, i.e. earnings, growth outlook, interest rates, etc. An American recession would affect the outlook for earnings and therefore depress stock prices as a result. The question for the bears is, "Will the US experience a recession in 2012?"

Certainly, a recession would not be out of the question here. This post from Pragmatic Capital shows that the US was in recession 18.3% of the time in the 2000-2011 period and a whopping 30% of the time if you consider the 1855-2011 time span. The likes of ECRI and John Hussman have been trumpeting their recession forecasts for the American economy. On the other hand, recent economic releases have largely been coming in ahead of expectations, which point to an economy with subpar growth, but no signs of a slowdown.

Should the US experience a recession, the S+P 500 could easily fall to the 900-1000 level, though it is unlikely to revisit the post-Lehman panic low of 666.

Watch out for China
I believe that the bear case for stocks rests largely with China and the emerging markets. I wrote on December 13 to watch for the China is slowing stories to emerge (see A "China is slowing" scare?). Whether China slows to a hard landing, i.e. sub-5% growth, or not is less relevant to the markets as the scenario of the markets starting to discount the possibility of a Chinese hard landing.

Since I wrote that post, the scare stories are starting to appear. Consider:

Patrick Chovenac: China Data, Part 1A: More on Property Downturn
Zero Hedge: China insolvency wave begins, Nation's biggest provincial borrowers defer loan payments
Pragmatic Capital: Understanding China's property bust
Advisor Perspectives: Vitaliy Katsenelson on Krugman's missed call (and China's pending property crash)

I could go on, but you get the idea. More worrying is the fact that other analysts are starting to pile on, not just the China is slowing story, but the prospect of slowing growth in the emerging markets. As an example, Stephen Roach recently penned an article entitled Why India is riskier than China.

I wrote here that the stock indices in India and China are not behaving well. I believe that the biggest risk for the stock markets is a rising level of risk aversion as investors price in the increasing likelihood of a slowing growth from the emerging market economies.

Listen to the markets
In the end, I stand with the bears on the recession, or economic slowdown, call. Commodity prices remain in a downtrend, which is a signal of slowing global demand for raw materials.

The CRB Index is liquidity weighted, which means that it is more energy heavy. As you can see below, oil prices have been behaving relatively well lately.

We can get a even better picture of global commodity demand from the Continuous Commodity Index, which is the CRB Index on an equal weighted basis. The picture of the CCI looks even worse than the CRB as it has undercut its October lows and remains in a well-defined downtrend.

As well, you can tell a lot about short-term direction by the way the market responds to news. In the past couple of weeks, we saw a couple of important signs that much of the good news is priced into stocks. The first occasion occurred when the market sold off in the aftermath of a better than expected LTRO at €489 billion. The second was when it sold off again when Italy sold six-month bills at yields that were roughly half of what they were in November.

When the markets go down on good news, the bulls should be wary. In addition, signs of a global slowdown are on the horizon.

That's why I stand with the bears.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

A terrible 2011 for hedge funds

2011-12-27T00:21:00.000-08:00

I started this blog four years ago and my first post was about how hedge fund returns have been correlated with stock returns. That correlation hasn’t changed.

That’s because hedge funds and stocks are all part of the risk trade. Hedge funds take risks and so do stock investors. In the current environment where the market oscillates between “risk-on” and “risk-off”, it’s not unexpected that hedge funds returns be correlated with stock returns. The chart below shows the returns of the HFRX Global Hedge Fund Index, which is a representative index of all investable hedge funds, compared to the S+P 500.

Even though hedge fund returns were correlated to the S+P 500, the above chart shows that they tended to be less volatile than the S+P 500. What that means is that when stock returns are down, hedge fund returns should be counted on to be down less and beat stock returns. In 2011, the chart below shows that they didn't and lagged the S+P 500 instead.

A funny thing happened in 2011. First of all, hedge funds had a terrible year as they substantially underperformed the S+P 500. On a year-to-date basis to December 16, 2011, the HFRX Global Hedge Fund Index was down -9.0% after fees compared to -1.3% for the S+P 500.

The negative performance occurred across the board. The chart below shows the YTD returns of the various HFRX sub-indices. The Global Index was down 9.0%, but every single category of hedge fund returns underperformed the S&P 500.

The poor performance of hedge funds in all categories is illustrative of the headwinds faced by active managers in 2011. Nothing worked!

Two categories that performed particularly poorly were directional strategies, namely Market Directional and Equity Hedge, which allowed a manager to go long or short. Fundamental Value was the laggard at -23.6% for the year.

The carnage in hedge fund performance can be seen anecdotally from the headlines. John Paulson's Advantage Plus flagship fund's performance through December 16 is down -9% in December and -52% on a YTD basis. Legends like George Soros exited the business of managing money to focus on his own funds. I could go on, but you get the idea.

I am working on a much longer post analyzing why hedge funds performed so poorly in 2011. More on than later.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The ECB's non-party: What does it mean?

2011-12-22T00:08:00.000-08:00

What happened? The ECB throws a party but no one shows up?

The size of ECB's LTRO was far ahead of expectations at €489 billion (see my previous discussion here). That should have been bullish, right? Instead:

The EURUSD exchange rate fell
Yields for Spanish and Italian debt rose across the yield curve
Shares of key troubled banks (SocGen, Credit Agricole, Comerzbank, Intesa and Unicredit) are mostly down on the day
European stocks retreat and US stocks retreated but rallied to finish the day roughly flat

Why?

There are a number of plausible explanations for the market reaction, but they could amount to little more than rationalizations. First, the EBA effectively nixed the carry trade by requiring banks to mark-to-market, so much of that €489 billion amounted to liquidity injections into the eurozone banking system. If the banks need that much liquidity, what could they be hiding? Or does this just show that the European banking system is just getting by on ECB life support?

Ambrose Evans-Prichard wrote that the size of yesterday's LTRO wasn't enough:

Roughly €300bn of today’s eagerly awaited LTRO tender is recycled old money from earlier support operations. The new money is €200bn. This alone is not going to shore up the sovereign states of southern Europe as they grind deeper into recession/depression.

He wrote that European banks need to shore up their Tier 1 capital base to the tune of "€2.5 trillion adjustment according to the BIS’s Global Stability Board". In addition, "Eurozone sovereigns must raise €1.6 trillion in 2012, and banks must raise another €700bn."

The LTRO was a liquidity injection operation that took a Lehman-like event off the table. Maybe the markets are now finally focusing on what typically matters, such as earnings, growth, interest rates, etc. and it didn't like what it saw? Indeed, Christine Lagarde of the IMF warned emerging market economies to prepare for a downtrun in Europe.

A glass half-full
Putting on my technician's hat, I would say it doesn't matter what the explanation or rationalization is. The market's inability to rally on good news, namely €489 billion in QE from the ECB, has to be interpreted bearishly.

When I look at the one-year charts of most markets, I see the charts mostly forming triangles indicating indecision. The direction of the next break will likely determine the next intermediate term move. This chart of ACWI representing the All-World Index is a typical example.

Going around the world, a similar pattern can be found in the US stock market:

..the UK market:

...and the European market:

A bearish tilt
There are clues of which way the market might break. Much the evidence points to a bearish break. For example, commodities are in a downtrend. If there was a triangle, they experienced a downward break in early or mid December:

Similarly, the yield on 10-year US Treasury note shows a similar pattern of a downtrend and break downward in early to mid December:

The commodity sensitive Canadian market is also not behaving well.

The Chinese market, as represented by the Shanghai Composite, has broken down decisively and is in a well-defined downtrend.

In sympathy, Hong Kong experienced a downside break in its triangle in the last week.

India isn't behaving well either.

The South Korean KOSPI experienced a downside break recently, but that could excused because it could be viewed as a special case of a market reaction to geopolitical tensions.

Bullish data points are few
To be sure, the picture isn't entirely bearish and there are a couple of bullish data points. The Brazilian market rallied above a downtrend line in October.

The Australian All-Ords Index is showing a similar pattern of broken downtrend and sideways consolidation.

Both Australia and Brazil are major supplier of resources to China. So these chart patterns must be regarded as somewhat supportive that a hard landing may not be in the cards for the Middle Kingdom.

However, the weight of the evidence suggests that while the trend breaks have not shown up definitively, the bias for the next intermediate term move is to the downside.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

ECB's LTRO experience a cautionary tale for the Fed

2011-12-20T00:04:00.000-08:00

The markets have been anticipating the onset of QE3 by the Federal Reserve. Indeed, Deutsche Bank believes that the market has already discounted $800 billion in QE3 purchases, which is anticipated to be concentrated in Mortgage Backed Securities (MBS).

Recall how the focus on MBS came about. QE2 involved $600 billion in the purchase of Treasuries, which pushed down the Treasury yield curve, flooded the system with liquidity and prompted investors to take more risk. The net effect of QE2 was to push up stock and commodity prices, but didn't do very much for the real economy. In effect, it found that it was pushing on a string. In response, the Fed wanted to concentrated on risk premiums where it mattered, such as mortgage rates, in order to stimulate the housing market. Thus the impetus for QE3 was born. Target MBS, it was said, and you will push down the cost of home ownership and stimulate housing.

Watch out for unintended consequences
The European Central Bank is currently conducting a Great Experiment with its LTRO (Long Term Repo Operation), where it is offering unlimited amounts of three year liquidity to banks, collateralized by paper with credit ratings as low as Single-A.

There was some hope that LTRO would prompt banks to put on the carry trade. Borrow from the ECB at 1%, buy PIIGS debt at 5% or more and earn the carry (see my discussion of LTRO here). The banks repair their balance sheets. The sovereigns get access to loans. Everybody wins!

The program has resulted in some unintended side-effects. Izabella Kaminska at FT Alphaville wrote that LTRO has created a two-tiered market for collateral and the two markets are diverging:

Simply put, back in the pre-crisis days the two markets worked in tandem. Participants engaging with the ECB did not differentiate on the type of collateral they delivered to the ECB versus the type of collateral they held back for use in private funding markets.

The crisis changed all of that.Suddenly the cheapest collateral to deliver became the collateral of choice for ECB use. The most expensive or ‘quality’ collateral was held back for use in private markets.

A tale of two collateral markets
This is how central bank transmission mechanisms began to be compromised.

The private funding markets, dictated by interbank participants, could from now on only be influenced by large quality collateral holdings — which the central banks increasingly lacked. The public funding market, dictated by central banks, became the domain of trash collateral — which no one really cared about.

The central bank monopoly on the ultimate cost of money thus became based around access to trashy collateral, not quality collateral — which remained the preferred funding option for private markets.

Unfortunately, it’s private liquidity which ultimately determines the scale and depth of the eurozone crisis — and it’s in this market where ECB influence is waning.

Lead a bank to liquidity, but you can't make it lend
In other words, you take your ~~junk~~ lower quality paper to the ECB and you reserve your high quality collateral (e.g. bunds) for the private repo market. The problem is that the private repo market continues to seize up because of a lack of high quality collateral and a rising sense of risk aversion over counterparty risk, i.e. you don't trust that you are going to get paid back so you demand really, really good collateral.

No matter how the ECB steps in to inject liquidity into *ahem* second-tier debt market, Kaminska wrote that the market has lost confidence and there is little the ECB can do [emphasis added]:

Private markets must be convinced to lend unsecured or invest money in more than just the last few remaining AAA bond markets.

But as they say, you can lead a horse to liquidity but you can’t make it drink. Which is a shame, because that’s the main problem the ECB and other central banks are now facing: they are leading banks to liquidity but they can’t make them lend in private markets.

The ECB's experience with LTRO should be a cautionary tale for the Fed as it considers a QE3 program of purchasing MBS. You can lead a market to liquidity, but you can't make lenders lend and borrowers borrow.

Beware of unintended effects, Mr. Bernanke.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The bull case for stocks

2011-12-19T00:26:00.000-08:00

I have been quite bearish in these pages lately. As an antidote and to help me think critically, I outline what could go right for the markets in 2012, along with the risks:

The coordinated central bank liquidity injection of November 30 has taken a Lehman-like event off the table.
In the US, the Fed does QE3 in the 1H, which would send asset prices flying.
In Europe, the ECB is already engaged in a form of QE though the back door using LTRO, which should heal banking balance sheets over time.

Global central bankers are worried
The coordinated central bank actions of November 30 to inject liquidity into the global banking system shows that central bankers are worried. No doubt, they learned from 2008. In the short term, liquidity ensures that a major bank failure or Lehman-like failure in the shadow banking systems is off the table and will not bring the global financial system down in a market crash.

Key Risk: The system isn't totally healed. These actions just bought some time for the politicians to act. Indeed, Bloomberg reported that Ben Bernanke, in a closed-door briefing to Republican senators, made it clear that there are limits to Fed policy and it doesn't intend to bail out European banks.

In addition, Bank of Canada head Mark Carney said in an unusually frank speech that the world is in a period of deleveraging. The road ahead is hard and the risks are still high:

The Global Minsky Moment Has Arrived
Debt tolerance has decisively turned. The initially well-founded optimism that launched the decades-long credit boom has given way to a belated pessimism that seeks to reverse it.

Excesses of leverage are dangerous, in part because debt is a particularly inflexible form of financing. Unlike equity, it is unforgiving of miscalculations or shocks. It must be repaid on time and in full.

While debt can fuel asset bubbles, it endures long after they have popped. It has to be rolled over, although markets are not always there. It can be spun into webs within the financial sector, to be unravelled during panics by their thinnest threads. In short, the central relationship between debt and financial stability means that too much of the former can result abruptly in too little of the latter.

Hard experience has made it clear that financial markets are inherently subject to cycles of boom and bust and cannot always be relied upon to get debt levels right.7 This is part of the rationale for micro- and macroprudential regulation.

It follows that backsliding on financial reform is not a solution to current problems. The challenge for the crisis economies is the paucity of credit demand rather than the scarcity of its supply. Relaxing prudential regulations would run the risk of maintaining dangerously high leverage—the situation that got us into this mess in the first place.

The Fed does QE3
Could the Fed still save the equity markets in 2012? Cardiff Garcia of FT Alphaville pointed out this analysis from SocGen showing that the composition of the FOMC is going to turn far more dovish in January 2012.

On that same point, Bloomberg reported on November 29 that vice-chair Janet Yellen that the Fed has the scope for additional asset purchases (read: QE3):

“The Federal Reserve has some scope for action,” Yellen said today. “We are actively considering methods that we could use to provide greater clarity” on the central bank’s pledge to keep rates low through at least mid-2013, and new purchases have the potential to “flatten the yield curve.”

Central banker statements are very measured. Yellen's speech about additional purchases is a definitely signal that QE3 is coming.

Key Risks: We are now in a world of bad news is good news for the markets and good news is bad news. Economic growth has to show that it is indeed deteriorating before the Fed can act. The calls by the likes of ECRI and John Hussman for a recession have to be wrong. The high frequency data is showing the economy is definitely not keeling over. Assuming that ECRI is right, when will the data be convincing for the Fed to act? Would a two month extension of the payroll tax cut for two months just extend the pain?

Moreover, this chart from Scott Grannis shows inflationary expectations are still stubbornly high and rising. The Fed is unlikely to undertake QE3 unless inflationary expectations (and not just inflation) remain elevated.

The Sarko carry trade saves Europe?
Students of market history will recall the policy of forebearance that saved the US banking system during the LDC (Less Developed Country) loan crisis of the early 1980's. After the banks lent to all manner of LDCs that went bust, the authorities pretended that the loans that were on the banks' books remained good for 100 cents on the dollar. At the same time, the Fed began to lower rates in August 1982 and signaled to the banks that they would continue to stay low or continue to fall. Thus, the banks could borrow short and lend long, which repaired their balance sheets over time.

The ECB's long term repo operation (LTRO) announced on December 8 did just that. The ECB announced that it would provide unlimited amounts of liquidity via LTRO and relaxed the collateral requirement for LTRO all the way down to anything rated single-A. Nudge-nudge-wink-wink. If you are a troubled bank, you can bring your *cough* junk, borrow from the ECB for up to three years at 1%, put it into Spanish or Italian debt at 5-6% and earn the spread. If you used leverage, it wouldn't take long for you to repair your balance sheet.

This prompted Nicolas Sarkozy to say that banks could then finance their own country's debt, which prompted some observers to dub this forebearance trade the "Sarko trade":

French President Nicolas Sarkozy said the ECB’s increased provision of funds meant governments in countries like Italy and Spain could look to their countries’ banks to buy their bonds. “This means that each state can turn to its banks, which will have liquidity at their disposal,” Sarkozy told reporters at the summit in Brussels.

The ECB is precluded by mandate from lending directly to sovereigns. LTRO is a backdoor way of doing QE by lending to the banks which then lend to the sovereigns - and the amount is unlimited! It kills two birds with one stone. It repairs banking balance sheets and addresses the solvency problem and it allows sovereigns access to the markets.

Key risks: This is another one of those European plans that sound good in theory but the devil is in the details. First of all, Simone Foxman reports that even though the ECB will take single-A paper as collateral for LTRO, it will require a haircut for lower grade paper inasmuch as it will not lend 100 cents on the euro for lower grade debt:

The details of how the ECB means to relax collateral have not yet been released. The Bank currently accepts collateral rated as low as A-, although debtors must pay a penalty based on asset risk. Were even riskier assets allowed to be used as collateral or if the penalty were dropped, this would provide significant incentive for banks to purchase sovereign debt, particularly given currently high yields on bonds. If it worked, it would be the ultimate carry trade—borrowing from the ECB is now a cheap 1%, so banks could see huge returns on sovereign debts with high yields.

Supposing that a bank uses the LTRO facility and puts up Spanish paper as collateral. Soon afterwards, Spain is downgraded by the rating agencies. Under the terms of the facility, the ECB would ask the bank to put up additional collateral as a "margin call" because of the credit downgrade.

Second, one of the legs of the policy of forebearance is to allow banks to carry doubtful debt at book value and market it to market. If they were the required to mark-to-market, then the bank could be deemed insolvent and would either need to be liquidated, merged with a stronger partner or nationalized. The European Banking Authority (EBA) has recently become progressive tougher on European banks in its stress tests and began to raise its standards from a ridiculously low level (recall that Dexia was declared healthy with a Tier 1 capital ratio of 12% just before it imploded).

The EBA stands in the way of this forebearnce trade. Will the EBA play ball? Can Berlin and Paris twist enough arms at the EBA to get them to come onside?

Third, there is the matter of prudence for bank management, a point that Felix Salmon raised when he wrote that it wouldn't work. This is an all-in bet-the-farm trade for any bank who wishes to undertake the carry trade of tapping LTRO to buy sovereign debt. If this works, you make a ton of money and your bank is fine. If it doesn't, your bank is bankrupt. Here are some key quotes from European bankers:

“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”

That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.

From my viewpoint, the most important technical consideration for the "Sarko trade" to work is the cooperation of the EBA. It will have to happen in very large scale for it to have an impact. I wrote last week that if you put "all the major eurozone countries together, they need to roll over €1.8 trillion in 2012, or 19% of estimated GDP." That's a lot of money.

Moreover, the "Sarko trade" will only work if there are no accidents along the way. There are some key elections coming up in 2012, namely Greece, Italy, Finland and France. In particular, will the new governments in Greece and Italy cooperate with the EU? How badly will austerity bite in eurozone? Can they prevent a European bank failure despite their best efforts? If not, would its effects cascade through the banking system? What about China, will it avoid a hard landing?

That's the trouble with the all-in bet-the-farm trade, if it goes wrong (and plenty of things can go wrong), you're dead.

Many moving parts to the bull case
In conclusion, there are many moving parts to the bull case. For stocks to stage a significant rally, I believe that two material things have to happen:

The US economy and inflationary expectaions have to weaken sufficiently for the Fed to underatke QE3.
The EBA has turn a blind eye and moderate its mark to market rules for bank debt.

Market analysis isn't just about having a single view, but about scenario analysis and the assessment of the probability of those scenarios. How you decide about the likelihood of these events will determine whether you are a bull or a bear.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Are Treasury bonds a crowded long?

2011-12-16T05:50:00.000-08:00

How crowded is the long Treasury trade? Anecdotal evidence suggests that the trade is becoming a crowded long. Ed Yardeni recently wrote:

Last week in Kansas City, one of our long-only accounts was especially concerned that the Endgame scenario is upon us. We discussed the best way to preserve capital in such a calamitous environment. The conclusion was to load up on the US dollar and US Treasury bonds, the scenario that seems to be working so far this week.

What does the data show?
Let's go to the data. Global Macro Monitor showed this chart of who is funding the US deficit. While the latest data shows that there are certain a lot of fund flows into US Treasuries from domestic and international investors, levels are similar to levels seen in 1Q 2010 and below the panic levels seen in the 3Q and 4Q of 2008.

What about hedge funds? These charts from Mary Ann Bartels of BoA/Merrill Lynch shows that large speculators, or hedge funds, are nowhere near a crowded long in the long bond.

What about the 10-year note? This chart shows that while large speculators have been buying the 10-year note, they are also nowhere near a crowded long.

This chart below shows the relative performance of the 30-year Treasury ETF against SPY. Again, it shows that while long bond returns are somewhat stretched relative to equities, relative performance levels are similar to the levels seen during the Summer of 2010 and far below the end-of-the-world levels of the Lehman Crisis.

Conclusion: While investors may be rushing into US Treasuries, the safety trade is nowhere near a crowded long, which indicates that risk-off trade has more room run.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

A "China is slowing" scare?

2011-12-13T15:19:00.000-08:00

It's been a while since we've had a "China is slowing" scare, but we may be due for one. The chart of the Shanghai Composite shows that the index violated a key support level last night, which is an indicator of heightened stress.

The chart of the Hang Seng Index also shows that it violated a key support level in September and attempted a failed rally above the support-turned-resistance line. The index is now testing the bottom of a triangle formation, while investors wait for either an upside or downside breakout as an indicator of near-term direction.

China's deflating property bubble
Much of the stress comes from the faltering property market in China. The Los Angeles Times reports that China's housing bubble is losing air:

Home prices nationwide declined in November for the third straight month, according to an index of values in 100 major cities compiled by the China Index Academy, an independent real estate firm. Average prices in the Shanghai area are down about 40% from their peak in mid-2009, to about $176,000 for a 1,000-square-foot home.

Sales have plummeted. In Beijing, nearly two years' worth of inventory is clogging the market, and more than 1,000 real estate agencies have closed this year. Developers who once pre-sold housing projects within hours are growing desperate. A real estate company in the eastern city of Wenzhou is offering to throw in a new BMW with a home purchase.

Patrick Chovanec, professor at Tsinghua University's School of Economics and Management in Beijing, echoed the accounts about deflating housing bubble:

According to the China Real Estate Index, published by Soufun.com, the average primary market housing price across China’s top 100 cities dropped for the third month in a row in November, by 0.3% month-on-month, with prices in 43 cities still rising and 57 cities falling. However, other real estate agencies reported steeper drops in specific locations. Homelink said that in November alone, primary market prices in Beijing dropped 35% month-on-month, and industry sources told the Legal Evening Post they dropped 16.8% week-on-week in the last week of November, down 29% year-on-year. According to Caijing magazine, Beijing home sales volume (by area) in the first 11 months of 2011 was down 27% year-on-year, to a 10-year record low. A similar fall-off was evident in commercial as well as residential real estate. According to the Beijing Morning Post, sales volume for retail and office space in the capital dropped 18% and 7.4% respectively in October, month-on-month. Homelink’s chief Beijing analyst, Zhang Yue, told the paper he saw a growing supply glut developing.

The downturn was not limited to Beijing. Dooioo, another agency, said that primary housing sales volumes in Shanghai are the worst since 2006, while Chinese Business News reported that in Shenzhen, primary prices were down 10.7% and transactions down 11.3% week-on-week in the last week of November. Business China also reported a drastic drop in sales, despite generous discounting.

Chovanec writes that how the market behaves from now on will be a test of Chinese investor confidence in the property market, largely because property purchases are often fully paid for in cash with no leverage and represent a source of savings for individuals [emphasis added]:

How investors in the secondary market will react to the collapse in primary market prices is the biggest question of all. As I’ve mentioned many times, many people in China buy multiple units of housing in order to hold them empty indefinitely, as a form of savings. They do this because they have few attractive alternatives and because they have faith that housing prices will go up. Since many have paid cash, they aren’t under the same immediate pressure to sell as developers. But they do tend to look to rising primary market prices for assurance that their investments are profitable and safe, and now those prices are now plummeting. A great deal depends on whether they hunker down to weather the storm, or join the fire sale.

He does caution, however, that even though many apartments are paid for in cash, there may be other forms of leverage in property purchases. Depending on how pervasive the level of financial leverage, sales could create a cascade of falling Chinese property prices.

Beijing-based blogger Bill Bishop recently related the story of an email he received, which makes equally interesting reading. It came from a real estate agent representing a condo owner in one of the city’s top apartment buildings, in the Central Business District (CBD). Although he had no mortgage, and owned the unit outright, he was desperate to sell in order to raise RMB 20 million for his business. So it’s worth keeping in mind that, while many Chinese investors may not be directly leveraged on their real estate investments, given the credit explosion that has driven the Chinese economy these past few years, they may be highly leveraged in their business or other ways that could turn them into distressed sellers.

Watch for "China is slowing" stories
As the world has focused primarily on Europe and secondarily on the United States, my sense is that the consensus is that China will escape a hard landing. While I am of the belief that China should survive the next economic downturn in relatively good shape, stories like these will serve to heighten investors' sense of emerging market risk. In addition, we are seeing stories about India slowing as well.
Should European or American economies get into serious trouble in the months to come, there may not be any place to hide.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Will S&P downgrade Europe?

2011-12-12T00:07:00.000-08:00

Last week, Standard and Poor's warned the 15 EMU sovereigns that they may be downgraded. They expected "review of eurozone sovereign ratings as soon as possible following the EU summit scheduled for Dec. 8 and 9, 2011". They went on to state:

Depending on the score changes, if any, that our rating committees agree are appropriate for each sovereign, we believe that ratings could be lowered by up to one notch for Austria, Belgium, Finland, Germany, Netherlands, and Luxembourg, and by up to two notches for the other governments.

Now that the EU Summit has come and gone, what now?

The effects of the "fiscal compact"
I did some projections and assumed a number of problems of the latest "fiscal compact" away, such as the difficulties of treaty ratification, specification of enforcement mechanisms, etc. Using this handy tool from the Economist, I projected a probable path for selected eurozone countries. The blue line represents the base case estimates from the IMF and the red line are my revised assumptions. Since the latest "fiscal compact" amounts to nothing less than an austerity club, I made the following rather conservative changes to IMF assumptions to account for the more immediate fiscal tightening effects of austerity programs:

Growth slows by 0.5%
Inflation slows by 0.5%
Primary budget balance is reduced by 0.2%, which is also a side effect of austerity measures
Interest rate is the average of the current 5 and 10 year bond yield for that country

The results aren't pretty. Consider Spain, a Club Med country. Debt to GDP is project to spiral upwards, worse than the base case estimate from the IMF (blue=oringal IMF assumptions, red="fiscal compact"):

What about Portugal? The only silver lining is that things don't deteriorate as badly as Spain under these assumptions.

Italy, the biggest Club Med country of all, doesn't fare all that well either as its debt to GDP gets out of control rather quickly. The problem of Italy lays the groundwork for another eurozone crisis in the near future.

What about France? Oh, dear! It looks like Sarkozy is likely to lose his precious AAA credit rating.

The only question at this point is whether it will be one or two notches. This chart below compares the France under my new projections with the United States under IMF's base case projections. At least the French are outperforming the Americans...

The only country that fares reasonably well under these revised assumptions is Germany, whose debt to GDP ratio continues to contract. Even then, its deficit to GDP measure won't be below the magic 60% target, which would suggest further fiscal tightening under the terms of the "fiscal compact".

This analysis indicates that the fiscal balance of major eurozone countries will deteriorate under the terms of the new "fiscal compact", which leads to the conclusion that a wholesale downgrade of many eurozone sovereigns is very likely.

Setting the stage for another debt crisis
The next question for me was, "How much more risk would a credit downgrade introduce to the eurozone?"

Using this data from Jason Voss of the CFA Institute, I constructed a spreadsheet for the likely rollover of debt in 2012 of selected eurozone countries as a measure of the degree of funding stress they may have to undergo. (All amounts are in billions of euros.)

In his article, Voss showed the likely rollover of debt as a percentage of GDP for all eurozone countries. I then went to the IMF website and looked up the projected 2012 GDP by country to calculate the projected rollover figure for 2012. Italy is one of the more problematical as it is scheduled to rollover over €300 billion in 2012 (even this estimate may be low as others have cited a figure of €440 billion). Surprisingly, France will need to come to market with nearly €400 billion and the German rollover comes close to €600 billion.

If you include all the major eurozone countries together, they need to roll over €1.8 trillion in 2012, or 19% of estimated GDP. Supposing that we assume that Germany will have no trouble rolling its debt and excluded her from 2012 financing needs, then the eurozone debt market will see roughly €1.2 trillion in sovereign debt issues - an astoundingly large number. The PIIGS alone will need to finance about €700 billion next year.

These are very large numbers. Given that European banks are in the process of shrinking their balance sheets, which will reduce their appetite for sovereign paper, where will the money come from? The combination of EFSF and ESM? But the funding for the EFSF and ESM come from the eurozone sovereigns. Can they loan money to themselves?

What about the IMF? There was some discussion that some sovereigns, e.g. Germany, could lend to the IMF, which when then lend it back to troubled European country, e.g. Italy. However, the total amount of that facility amounted to €200 billion.

The size of the ESM, EFSF and new IMF facility is simply not enough. It's like sending out a riot squad of 10 police officers with helmets and batons to face an angry mob of a thousand people. If the mob stampedes, the results won't be pretty.

What about the ECB? Mario Draghi made it clear that the ECB would cap bond purchases to €2 billion a week (when actual recent purchases have amounted to roughly €1 billion a week). The total cap adds to about €1 trillion a year, which could be a big bazooka if it was un-sterilized. However, such intervention would be sterilized, which begs the question of where the money to buy the ECB's sterilized paper would come from.

This analysis tells me to be prepared for more volatility and crisis summits in 2012, if not before.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Is the eurozone banking system about to collapse?

2011-12-11T00:45:00.000-08:00

The Telegraph sounded alarm bells late Friday that the Eurozone banking system [is] on the edge of collapse. Specifically, the problem is related to a lack of acceptable collateral, or "collateral crunch", for overnight and other short-term bank funding [emphasis added]:

Senior analysts and traders warned of impending bank failures as a summit intended to solve the European crisis failed to deliver a solution that eased concerns over bank funding.

The European Central Bank admitted it had held meetings about providing emergency funding to the region's struggling banks, however City figures said a "collateral crunch" was looming.

"If anyone thinks things are getting better then they simply don't understand how severe the problems are. I think a major bank could fail within weeks," said one London-based executive at a major global bank.

Many banks, including some French, Italian and Spanish lenders, have already run out of many of the acceptable forms of collateral such as US Treasuries and other liquid securities used to finance short-term loans and have been forced to resort to lending out their gold reserves to maintain access to dollar funding.

The eurozone banking system is paralyzed by counterparty ~~fears~~ risk, where banks would rather park their excess funds with the ECB instead of lending to each other:

Bank deposits with the ECB now stand at their highest level since June 2010 at €905bn (£772bn) as lenders withdraw deposits held with their peers and put them into the central bank. At the same time, banks in major eurozone countries such as France and Italy have become increasingly reliant on central bank funding. This follows the trend seen in smaller countries like Ireland where lenders have effectively becomes taxpayer-funded "zombie" banks.

The Bundesbank is running out of money
Izabella Kaminska at FT Alphaville has was on this story early and she has covered it well. She wrote that the problem is becoming so acute that even the Bundesbank is running out of money. She explains that the ECB isn't a single central bank, but a collection of central banks [emphasis added]:

While policy is decided centrally, actual enforcement and implementation of that policy is conducted on a national central bank (NCB) level.

That means every NCB is in charge of providing liquidity to its own particular market. The Irish NCB’s routine distribution of emergency liquidity assistance (ELAs) on a near enough unilateral basis (there’s only the need to notify central command in Frankfurt) is a good example of how the system works.

All payment surpluses and deficits created as a result of these unilateral NCB processes are then balanced out via the so-called Target2 system (Trans-European Automated Real-time Gross settlement Express Transfer system).

Generally speaking, the system ensures that all NCBs carrying surpluses channel them over to NCBs carrying deficits.

The problem is that since the crisis unfolded, the number of NCBs handling deficits has started to outnumber the number of NCBs holding surpluses. One particular NCB — the Bundesbank — has become the key provider of funds to the whole eurosystem.

She pointed to a blog post at VoxEU which summarized Bundesbank's problem [emphasis added]:

In order to fund these loans, the Bundesbank sold its holdings of German assets. Asshown in Figure 1, between December 2007 and September 2011 the central banks of the GIIPS increased their loans to domestic financial institutions by nearly €300 billion. In contrast, the stock of gross German assets in the Bundesbank balance sheet fell sharply to its lowest level in history.

The ominous sign – which might set the stage for Act Two in the unfolding Eurozone drama – is the fact that the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem. At that point, the Bundesbank could sell its gold or increase the deposits it takes from the private sector. Most likely, however, the Bundesbank will face strong pressure from the German public against such action.

The Bundesbank having to sell its gold to fund banking liquidity??? That will make Merkel sit up and take notice.

An acute collateral crunch
Kaminska explained the collateral crunch problem in ECB as Pawnbroker of Last Resort:

While soaring Libor rates were a key indicator of market stress during the credit crunch, the best indicator of collateral crunch intensity is instead the repo rate. The lower the rate, the greater the crunch.

The wider the spread between Libor and the secured (repo) rate, the greater the general distress in the market. The following chart reveals just how good an indicator of general market stress it is:

Also see What the repo markets *want* the ECB to do, specifically the ECB's policy of requiring different levels of haircut for different kinds of collateral:

[W]hile the ECB’s haircut policy might have been seen as prudent at the time, in a single monetary union — where markets are already reflecting preferences for certain types of Eurozone debt — having the ECB treat government collateral differently only intensifes the phenomenon.

The ECB should, by all definitions, treat all government debt the same.

While some of the technical steps the ECB took last week took some pressure of the money markets, they weren't enough. See Nomura on Draghi’s failure to address the collateral problem. Kaminska wrote that bank funding has a greater effect on the perception of the European sovereign solvency [emphasis added]:

[T]here are many reasons to think that the trend towards ‘quality’ collateralised funding is having as much of an impact on the valuation of bonds in both private and central bank funding markets, as the perception that European sovereigns might be insolvent.

This has the makings of a Lehman moment for the European banking system. Here are some of the signs of a imminent bank collapse. First, I would continue to watch for signs of stress in the money market, such as the LIBOR vs. the secured (repo) spread. For investors without access to Bloomberg and other services with money market data, here is a quick and dirty way of watching for signs of rising stress in the banking system.

The Four Horsemen of the Euro Banking Apocalypse
Watch the stocks of stressed banks. There are four that appear to be under severe stress from a list that I detailed previously here. The first is Commerzbank, which has already undercut its Lehman Crisis 2009 lows and is in the prospect of testing its recent lows as another support level. If that low doesn't hold, then that may be one of the first Signs of the European Banking Apocalypse.

I would also watch the shares of Credit Agricole, which has also been subject to rumors of severe banking problems.

Societe Generale, another French bank, has also been the subject of insolvency rumors. In all cases, these banks have undercut their 2009 lows in 2011, but SocGen shares have managed to rally above that level.

The last one to watch is the shares of Intesa, the Italian bank:

In all these cases, the shares have fallen below their 2009 Lehman Crisis lows in 2011. In all but one, they are in the process of testing the 2011 lows as the final support - a sort of final trip-wire to a European banking crisis. As many of these stocks trade in ADR form in the US, many of my American may be tempted to monitor the performance of the ADR instead. I would recommend that you watch the euro-denominated price as that is more liquid and I have provided the Yahoo finance link to those prices.

There are a number of other troubled bank stocks to watch, but these have not undercut their 2009 lows. In no particular order, these include the Royal Bank of Scotland, KBC, Unicredit, BNP Paribas and Banco Santander.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Forcing the heart attack victim on the treadmill

2011-12-08T20:05:00.000-08:00

In a previous post*, I used the analogy of Europe as a heart attack patient:

Imagine that a man (the "eurozone") experiences severe chest pains and looks like he is headed for a heart attack ("Lehman moment"). The protocol is well defined in these circumstances. Take steps to stabilize him ("inject liquidity via the ECB") and then address the causes with a program of diet, exercise and medical treatment ("longer term solutions such as balanced budgets, pro-growth policies, possibly closer fiscal integration, two-speed eurozone, etc."). Berating him about being lazy and overeating ("you lazy Greeks, Italians...") and making him get on the treadmill to work off his Thanksgiving feast ("more austerity and IMF monitors") while he is on the verge of a heart attack ("Lehman like financial crisis") is less than helpful under the circumstances.

If the ECB was supposed to be the Emergency Room doctor, then yesterday's decision by Mario Draghi to rule out further bond purchases was like throwing the patient out on the street with instructions of "take an aspirin and call me in the morning."

What's more, the patient's family then gathered around to berate him for his bad habits over the years and forced him to get on the treadmill (the latest Grand Plan for greater fiscal integration) in order to lose weight and improve his health.

Heart attack time?
The markets promptly responded and Italian 10 year yields shot up an astounding 47 bps.

European stocks took a similar pounding in the wake of the news:

Euro STOXX 50

Fiscal policy does the heavy lifting
Instead of a combination of fiscal and monetary policy to save the eurozone, we now have to rely purely on fiscal policy. Will a new Brussels-on-the-Rhine, even if it were to be ratified by the eurozone governments, be able to do such heavy lifting without plunging Europe and the rest of the world into a deep recession?

There is a tool from The Economist that allows a user to specify economic assumptions, i.e. GDP growth, budget balance, interest rates and inflation, for a country's to see what is needed to stabilize national debt-to-GDP ratios. When I played around with it, getting from A to B looks a tough task once you assume the recessionary effects the combination of an austerity program and credit crunch. (If the tool below doesn't work, try this link instead).

The markets had been focused on ECB action to buy the eurocrats some time to fix the long-term problems. Now, we have a credit and liquidity squeeze occurring in the European banking system that is technically insolvent. These issues need to get addressed now.

As I write these words late Thursday night, it appears that the latest Grand Plan is already falling apart. Maybe Merkozy and the eurocrats can pull a rabbit out of the hat, but I am not optimistic.
The markets are going to take this very, very badly.

* In the past, I mistakenly referred to the December 9 EU Summit as the Marseilles summit. It is being held in Brussels. I apologize for the error.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Immigration: The double-edged sword for America

2011-12-08T00:57:00.000-08:00

Lately, this blog has been focusing on all Europe, all the time. I wanted to step back and write about something else.

With an election year coming up in the United States, immigration is one of those hot-button issues that has been dividing people. But the electorate has to remember that the immigrant experience is part of the American Dream of rags to riches. The trend toward rising barriers to immigration, legal and otherwise, is also raising barriers to job creation and, longer term, barriers to the nurturing of human capital in America.

Consider this story about the blowback in Alabama's tough stance on illegal aliens without proper documentation:

[T]wo foreign workers with the Mercedes-Benz and Honda auto assembly plants in Alabama have run into problems.

To wit, they were caught without proper drivers' licenses and arrested under Alabama's anti-immigration laws:

On Nov. 16, a German manager with Mercedes-Benz was arrested under the law in Tuscaloosa for not having a driver's license with him while driving a rental car.

First Mercedes, then Honda:

Last week, a Honda employee from Japan was detained under the law in Leeds.

Police at a roadblock found him carrying an international driver's license and passport, but not an Alabama license or Japanese license as required by the law.

Great way to attract employers to locate in your state, guys! Auto assembly plants produce jobs - good paying jobs. Stunts like that give locales a reputation for being difficult to do business.

Where does "American" brain power come from?
One of the sources of American competitiveness has been its human capital, but increasing barriers against immigration is drying up foreign sources of human capital to migrate to its shores. Richard Florida recently wrote:

Since September 11, America’s increased concern with security has threatened to undermine its ability to attract global talent. Foreign-born scientists and engineers provide a critical element of America’s talent base: in the last decade, more than half of all Silicon Valley start-ups were launched by immigrants. In 2007, I warned that by making itself less hospitable to immigrant students, scientists, and entrepreneurs, the United States was undermining its own interests. "What if," I asked, "Vinod Khosla, the co-founder of Sun Microsystems and venture-capital luminary who has backed so many blockbuster companies, had stayed in India? Or if Google’s Sergey Brin had decided to apply his entrepreneurial talents in Europe?"

Many startups, such as Intel and Sun Microsystems, were co-founded by foreigners. True, universities like Stanford and Harvard are still the envy of the world, but as top students find it difficult to go to America to study and to work afterwards, how long before their rankings start to slip. Florida wrote that things are getting so bad that some entrpreneurs are trying to find ways around the system by building a "floating offshore Silicon Valley":

Blueseed, a Silicon Valley start-up, is trying to do an end run around the broken immigration systems by dreaming up a "floating startup incubator." It would circumvent immigration laws the same way that gaming businesses once avoided gambling restrictions, by parking their clients on a ship in international waters.

Has it come to this? Trying to figure out ways to game regulations is not a path to long-term sustainable competitiveness. The New York Times recently reported that Despite Economic Slump, Europe Gets More Tech Start-Ups (h/t FT Alphaville). Is this a tipping point?

Is the American electorate being penny wise and pound foolish when it comes to immigration? Is this another American step towards being Argentina? We shall find out after this electoral cycle.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Many moving parts to this Grand Plan

2011-12-06T00:48:00.000-08:00

We have a deal! Bloomberg reports that EU Treaty Rewrite Sought in United Franco-German Crisis Push:

Stocks and the euro rose after Merkel and Sarkozy said that Europe’s two biggest economies were aligned on backing automatic penalties for deficit violators and locking limits on debt into euro states’ constitutions. The French leader said they aimed to reach consensus on the changes required by March.

It looks like Merkel got everything she wanted and the French went along (see the analysis from FT Alphaville). The French and Germans agreed to a Brussels-on-the-Rhine, with hard constraints and penalties for member countries who deviate from the True Path.

The devil is in the details
As I wrote before, the devil is in the details of any Grand Plan. Here are a few questions before we get into a frenzy of celebration:

How do they get all the other countries (i.e. the Dutch, Finns, Irish, Belgians, etc.) to agree to permanently giving up a this level of fiscal sovereignty?
What countries have to agree? All 27 EU countries or just the 17 eurozone countries?
If we just needed agreement among the eurozone members, do they all have to agree, i.e. can we see a two-speed eurozone where you have countries inside and outside this stability pact? Answer: While technically possible, it is not practical. Consider what John Hussman wrote this week about the fallouot from a Greek default [emphasis added]:

Haven't we moved past Greece already? Well, no. Based on reported holdings of Greek debt in the European banking system, the implied losses on Greek debt alone are now enough to put many European banks into capital shortage. Europe could solve Italy's issues tomorrow and European banks would still face a banking crisis.

Who will get to be the monitor for transgressor countries? The European Court of Justice only gets to decide if a country is in breach of its targets, but will not monitor compliance. Who gets that lovely job?
Will this agreement be enough for Mario Draghi and the ECB to start printing? Recall that last week Draghi said, in essence, that he needs a binding compact with hard and fast rules [emphasis added]:

What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.

Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.

We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility.

Will Merkel et al agree to the ECB printing?
Lastly, who takes the hit to eurozone sovereign bad debt? One of the details of the latest Grand Plan is that bondholders they would be safe in any future debt restructuring. Hussman summarized the problem quite succinctly:

Europe doesn't face a liquidity problem. It faces a solvency problem. What investors really want isn't just for someone to buy distressed European debt, but for someone to buy that debt and willingly take a loss on it so the money doesn't ever actually have to be repaid. That isn't going to happen easily. Short of major fiscal improvements in Europe (which appear increasingly hopeless in the face of an oncoming recession) any solution will have to explicitly or implicitly impose losses on someone. In my view, the best "someone" is the investors who willingly made the loans in expectation of earning a spread, and who knowingly took a risk.

The worldwide hope among these investors is that the "someone" taking the hit will instead be the German people, but Germany remains resolutely against printing permanent new euros in order to effectively redeem the debt of Italy and other countries. Despite hopes that the ECB will suddenly shift its policy on this, I continue to expect that any ECB purchases of distressed European debt will follow an agreement on European fiscal union, and that even if initiated, will be on a smaller scale than investors seem to hope. Without airtight fiscal credibility among distressed Euro-area countries, whatever debt purchases the ECB makes will be almost impossible to reverse.

There are still many moving parts to this Grand Plan that have to come into place before we can all celebrate. Are we destined for a repeat of the October experience where as we approached the G20 summit, the market rallied on leaks of the details of that Grand Plan for the EFSF?
By the way, where is the state of the EFSF today?

The emperor has no clothes
Barry Ritholz wrote the following early yesterday morning as ES futures were rallying hard [emphasis added]:

Hence, some caution is warranted. Last week, my client accounts were at 60-65% equity exposure. But on December 1, the tactical component of our portfolios flipped from 100% equity to 100% bonds. It might be bit early to become to defensive, as the year end rally shows no signs of letting up just yet. However, in secular bear markets, capital preservation and risk management should be every investors first priority.

Hence, Investors are advised to watch the quality of this rally — the volume, the market internals, the reaction to news events — and position themselves accordingly.

I agree 100%.

We may be in a situation reminiscent of 2008, as described by Kyle Bass, where the markets do not respond until it actually goes over the cliff. See this rather long video here, where he described the situation in 2008 where senior Lehman bonds were trading at roughly 400 bps over Treasuries a week the firm imploded, when the Treasury Secretary stated emphatically that Lehman was not getting bailed out. One day before the firm went under, senior Lehman bonds were trading at only 700 bps over Treasuries.

Don't get overly distracted by the eurocrat discussion about how the longer problems are getting solved (which they don't appear to be). Hussman wrote this week that a Greek default alone is enough to sink the European banking system and the story about the potential Standard and Poor's downgrade of European sovereigns is just a shot over the bow.

Pay attention to both the short and long term issues facing Europe.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.