A very good weekly letter from John this week...

Faith-Based Economics by John Mauldin May 15, 2009
In this issue:  Can I Have Some More of that Data, Please? The Fault, Dear Brutus, is Not in Our Stars Faith-Based Economics Is Unemployment a Lagging or a Leading Indicator? An Unsustainable Trend in Debt Some Thoughts on the Health Care Problem
Why does government data need to be revised so often? Is it conspiracy, as some claim, or is it methodology? And if it is methodology that leads to faulty data, then why not change the methodology? Is unemployment a lagging indicator, as conventional wisdom suggests? We look again at the underlying assumptions to suggest that things are not always the same. And finally, we look at unsustainable trends, fiscal deficits, and health care -- there is a connection. But first, a quick note about the latest "Conversations with John Mauldin" that I just did with Don Coxe and Gary Shilling. These two esteemed analysts have different views on whether commodity prices will rise or fall, and are not afraid to make their views known. I edited the final transcript today, and I can tell you that even though I was "at the table" I learned a lot reading it the second time. If you want to understand the nature of what is a very central debate, this is a must-read. This was a VERY lively debate. Most of my friends know that I am not shy, but it was hard to get a word in edgewise as these guys went at it. It was great fun to watch. And if you have not yet subscribed, you can go back and listen to my Conversation with Chris Whalen and Rick Lashley on the banking crisis, and see if you can figure out what motivated the Manhattan district attorney's office to call me asking for clarification. Plus the quintessential piece with Lacy Hunt and Ed Easterling on the fundamentals of the current economic crisis, which many subscribers said was worth the price of an annual subscription. And then there is the Conversation I did with Nouriel Roubini. It is all there for you. The new Conversation will be posted early next week. Subscribers will get an email notifying you when it is up. Also, George Friedman of Stratfor and I are going to start doing a regular quarterly Conversation that will be a separate product, but if you subscribe today you will get it as part of the regular service for a year. Right now, we are offering a subscription for $109, $90 off the regular $199 price. To learn more, you can click here and subscribe, if you haven't already. Insert code JM77 for this special offer. You can enter that code on the final screen of the subscription process. Note: When George and I record that first piece sometime in the next few weeks, the price will rise to $129 a year, so you should act now. As we add more features like the one with George, current subscribers will simply get the new services, but the price for a new subscription will rise. New subscribers will however get access to the previous Conversations, at least for now. Can I Have Some More of that Data, Please? One of my regular reads is the blog The Big Picture. They featured a short piece by Michael Panzner this week. He put together some rather interesting data and then asked a question, which gives me an opportunity for discussing government data. Let's see what he had to say, and then I will make my comments. "Many market-watchers claim that U.S. economic statistics are increasingly being revised downward in subsequent periods, suggesting that the figures initially being reported by Washington are "puffed up," so to speak, most likely for political purposes. "Well, I went back and had a look at the differences between the reported and revised data for various series, including monthly retail sales, nonfarm payrolls, industrial production, and durable goods orders, to try and figure out if the cynics are right. "Using data from Bloomberg, I calculated whether the revised data for each month was lower than the first-cut estimate. Then I tabulated 12-month running totals for each series to see if there has been some sort of systematic bias (in other words, whether the pattern of monthly downward revisions was trending higher instead of undulating up and down). "To make the comparisons easier, I subtracted the 12-month tally as of May 2002 (an arbitrarily chosen date) from the monthly totals for all four economic series so that the starting point for each would be the same — zero. "Based on a quick read of a graph of the data (see below), it does seem as though the pattern of negative revisions has been trending higher lately, especially during the past year or so, suggesting that the cynics may be on to something. "That said, I am not a statistician, and the results may be nothing more than "noise." There is also the possibility that my methodology is lacking (because, for example, the margins-of-error for each month's data are relatively large, or because of certain quirks that crop up when an economy is in transition). Still, you gotta wonder..." Actually, Mike (can I call you Mike?) your last thought is the correct one: "or because of certain quirks that crop up when an economy is in transition." Go back to 2003-04. Notice that the numbers of downward revisions in non-farm payrolls are negative in your graph? Remember all the talk back then about the "jobless recovery"? We can now look back and see there were a lot of jobs being created. They just did not show up in the early statistics. And look at the opposite reaction in industrial production: here they revised strongly downward for a the better part of two years, yet it turned out there was a production boom going on. Was all this a conspiracy on the part of the Bush administration to make things look worse than they actually were? Hardly seems like rational political behavior. The "problem" comes from the methodology. There is no exact data for any of those statistics. They have to get as much data as they can and then make estimates. Part of the process of estimation uses previous trends. It is as if we were using past performance of a mutual fund or stock to project future returns. Even though we look at the past performance, we should know that past performance is not indicative of future results. Just look at some of the top-performing value-oriented mutual funds in the recent bear market, like superstar Bill Miller's Legg Mason Value Trust fund (LMVTX), the after-fee returns of which had beaten the S&P 500 index for 15 consecutive years, from 1991 through 2005. It did rather poorly last year, even in comparison with the S&P, which was horrid. Past performance is interesting, but it can disappoint. And sometimes rather viciously. Now, just as saying that a fund on average will produce a 10% return does not mean that it will yield 10% every year, neither do government statistics work that way. While the methodology for each series of data is different, they all are more or less trend-following. They take past relationships in the data they can gather and use them to estimate current numbers. And -- this is important -- on average and over longer periods of time, they are pretty accurate. They will revise the data many times over the coming years, getting closer and closer to the actual numbers. For instance, I can't remember exactly when, but it was several years later that we learned that we were already in a recession in the third quarter of 2000, at the very time most economists were calling for a robust economic future! (Except for your humble analyst, who was predicting a recession, and had been for some time because of the inverted yield curve, but that's another story.) But in the short run, at economic transitions they are going to get it wrong, because the backward-looking data is mean-reverting. But how else would you do it? One of the keys to economic transitions is to look at the direction of the revisions. Recently, the revisions have all been negative. Things are actually getting worse than the initial data suggested. And during the last recovery the data kept getting revised upward, especially six months and one year later. The Fault, Dear Brutus, is Not in Our Stars Look again at the very useful chart above (great work, wish I had thought of it!). Non-farm payrolls, which for some odd reason everyone pays attention to, is especially wrong at the turns. Anyone trading on non-farm payroll data deserves the losses they will get. One of the reasons that non-farm payrolls are so often revised is that the Bureau of Labor Statistics (BLS) is forced to estimate the number of new businesses being created each month that are simply under the radar screen of government statisticians. This number is called the birth/death ratio. You could not create a useful payroll number without this estimate, yet it is simply a wild-eyed guess based on past trends, which by definition we know will change at economic turning points. Further, almost no one pays attention to the fine print in the data, which talks about margin of error. The statisticians clearly understand the limits of their data, even if the public does not. Often, the margin of error is larger than the number being given, so that a positive number may actually turn out to be negative, and vice versa, when viewed from a few years out. As Cassius said in Julius Caesar, "The fault, dear Brutus, is not in our stars, But in ourselves, that we are underlings." Faith-Based Economics Should we cast aspersions on the data creators? I rather think not. The various government statistics creators are doing their best to give us information that, over time, will be useful. Some is more useful than others in real time. Some has large time lags before it is accurate. To expect the BLS or the Commerce Department to have accurate current data is expecting them to know the future. The very people who are the most critical would never presume to be accurate about the prices of stocks six months out (or even one month), on a consistent basis. Yet that is the kind of prescience they want from government statisticians. Do you really want data from government sources that makes assumptions about economic recoveries and recessions? That is the job of independent economists, and they generally do it pretty badly. There is no need for the government to compound the errors. Again, repeating myself, anyone who trades on government statistics as being anywhere close to accurate in real time deserves any losses they get. They are at best a foggy window through which we peer into the future. Taken together, and with some seasoning of time, they can be rather useful; but to pin hopes of a recovery or a bull-market run on one week's data is hazardous to one's wealth. Reading and watching all the analysts and economists who "see" recovery in one set of data or another makes me wonder what sort of faith-based economics they actually practice. Just as it requires faith to believe in God, it also requires a lot of faith to believe in forecasts made on a single month's set of data, or based on past performance. Are you interested in finding a real green shoot? Let's look for a quarter when the economic data keeps getting revised upward, two and three months out. That will signal a real recovery. As long as the data is being revised downward, the economy is "having issues," as my kids would say. Quick sidebar to those who keep asking: Yes, I think we have seen the worst of the economic data, as far as GDP goes. But that does not mean we don't have further negative quarters in our future. I just don't think they will be a negative 6 like they have been the last two quarters. And we may even see a quarter this year with a positive number. But take it with a grain of salt when the usual suspects declare the end of the recession. Look into the data that produces the numbers. As Gary Shilling points out, eight of the last eleven recessions have had a positive quarter, only to see more negative quarters follow. GDP numbers are quirky. But here's to hoping for a real recovery when we do see the next positive number. Is Unemployment a Lagging or a Leading Indicator? There is a very interesting animated graphic done by Chris Wilson at Slate.com (http://www.slate.com/id/2216238/). It shows the progression of unemployment by US county over the last two years. I reproduce the beginning and ending stages of the graph for you below, and apologize to those of you who are reading this in black and white, as it will not be as dramatic. But if you watch the entire series, it shows how rapid the deterioration in unemployment has been. (It takes about ten seconds.) The first graph shows that there 2.6 million jobs had been created in 2006. The last one shows that job losses were 5 million through March and, if we add in April and estimates for May, it will be close to 6 million. Again, the actual animation is dramatic, and made my daughter go "Ouch!" It's been 50 years since we have seen unemployment drop as rapidly as it has in the current recession. Given that we have a much smaller percentage of manufacturing jobs now, that volatility is breathtaking. Look at the data since 1930 from the St. Louis Fed: The typical pundit keeps telling us unemployment is a lagging indicator, and that the recovery will be well under way before it shows up in the job numbers. Therefore, you should buy what they are selling, because the recovery is on its way. But that may not be the case this time. One of my favorite reads, when I get to see it, is the economic analysis from Bridgewater. They are among the best thinkers anywhere, and everyone who follows them gives them a great deal of credence. This is what they wrote about unemployment being a lagging indicator last month: "Normally, labor markets lag the economy because incremental spending transactions are financed via debt, stimulated by interest rate cuts. But as long as credit remains frozen, spending will require income, and income comes from jobs. And debt service payments are made out of income. Therefore, in a deleveraging environment job growth becomes an important leading, causal indicator of demand and other economic conditions. "... The bounce in the economy and the stabilization in markets reflect government actions that are big enough to impact near-term growth rates, but are not sufficiently directed at the root problem of excessive indebtedness to produce permanent healing. The deterioration in employment markets will continue because companies' profit margins are so deeply damaged that a little bounce in growth won't do much to alter their need to cut costs. This deterioration in labor markets will undermine demand and continue to pressure loan losses, which will keep the pressure on the banks and elevate the cost of capital for tentative borrowers, inhibiting credit expansion." This again illustrates the problem of using past performance to project future results. You have to look at the underlying conditions in order to get a real comparison, and we have not seen a deleveraging recession in the US for 80 years. Using the past data in today's world is statistical masturbation: it may make you feel good, but it is not producing anything really useful, and may be harmful to your portfolio. An Unsustainable Trend in Debt This week, the federal government published two important reports on long-term budgetary trends. They both show that we are on an unsustainable path that will almost certainly result in massively higher taxes. By 2016 we will have to fund Social Security out of general revenues, as the surplus we now have will be gone. And there are no trust funds. They are a myth. It as if I wrote myself a check for $2 trillion and then declared I was worth $2 trillion. The money is just not there. Social Security makes Bernie Madoff look like a small-time crook. And Medicare is in far worse shape. For those with the stomach, you can read Bruce Bartlett's analysis athttp://www.forbes.com/2009/05/14/taxes-social-security-opinions-columnists-medicare.html. He estimates that taxes will have to go up by 81% if we are to pay the obligations as they now stand. Now that is unsustainable. It won't happen. And as the saying goes, if something is unsustainable, at some point it will stop. No getting around it. Long before we get there, change you will not like will be forced on the US. The following headline caught my eye: "Obama Says US Long-Term Debt Load is 'Unsustainable.'" Yet they announced a $1.8 trillion deficit, which is really going to be at least $2 trillion, and are getting ready to pass health-care programs that will mean at least a trillion in deficits for as long as one can project. How will they pay for it? Even getting rid of the Bush tax cuts will only produce a few hundred billion a year, which is nowhere near enough. They project much lower medical costs in the future, because they assume they are going to figure out ways to cut costs and make medical care more efficient. As if no one has ever tried that. Yes, there are some savings on the margin; but the only way you really cut costs is to ration health care, especially health care in the last year of life, which is about 30% of health-care expenses. That is going to be very tough in the US. But when faced with a real budget crisis, the choices are going to be stark. And that crisis is coming if we do not control spending. You cannot propose massive increases in spending without either creating crushing debt that the markets will simply not allow, pushing interest rates much higher and really slowing growth and hurting the economy. It is a simple fact that you cannot increase the debt-to-GDP ratio without limit. We found the limit on personal and corporate debt this past year. We pushed the limits until the system crashed. And now the US government wants to basically do the same thing. They are planning to see where the limits on government debt-to-GDP will be. Unless cooler and more rational heads in the Democratic Party prevail, this is not going to be pretty. Sometime in the middle of the next decade we will hit the wall, and it will make the current crisis pale in comparison. The only way to solve the problem is to grow GDP more rapidly than debt, and for that to happen you have to have policies which are shaped for the growth of the economy or massive savings by consumers. And right now we have neither. Cap and trade is hugely anti-growth. So are high corporate taxes, and Obama is proposing to effectively raise corporate taxes by closing loopholes for income earned outside the US. Much better would be to lower the overall corporate level to a competitive world rate and then require the offshore income to be taxed. A lower rate would actually increase tax revenues. Looming protectionism worldwide is a problem. (See the article at http://www.msnbc.msn.com/id/30758018.) Towns in Ontario, Canada with a population totalling 500,000 have effectively barred US contractors from doing business with them, in retaliation for job losses stemming from US protectionism in the stimulus plan. That movement is spreading. A US steel mill with 600 union jobs will have to close down because its owners are not US-based, and thus it is not technically a US supplier. They are losing jobs to US-owned mills -- but those are US jobs. The insanity goes on and on. As I have written for many years, the one thing that really gets me worried is protectionism. That can make this very significant recession into a depression quicker than you can imagine. Bad ideas have bad consequences. All in all, we face some very difficult decisions, not just in the US but all over the developed world. Ironically, the less developed nations will have fewer problems and on a relative basis will likely grow much faster than the developed world. But, multi-trillion-dollar deficits and massive new programs are not the right answer. Obama is right: the debt load is unsustainable. Let's hope he will do more than talk, and show some budget restraint. Woody Brock has given me permission to pass on to you his recent notes on this very topic of what we have to do to get out of this crisis. It will soon be an Outside the Box. Read it. It is a very sobering and thought-provoking piece. Some Thoughts on the Health Care Problem Now, some positive news. This week I visited the Cleveland Clinic and went through their Executive Health Program (more on that below). I got to visit for several hours with my doctor, Michael Roizen, of YOU: The Owner's Manual fame (not to mention all his subsequent books). They have now sold over 20 million copies, and I highly recommend them. I have long been a student of medical trends, and long-time readers know that I think the next really big boom will be in the biotech world. I asked Mike what three things he thought would have the biggest impact in the next five years in medicine. What he said gave me hope, because he thinks there may be some advances in medicine that could help solve some of the basic health issues we all face, and at the same time give us some relief from the high and rising costs of medical care. I was aware of most of the research, but did not know that we were as close as it appears we actually are. Briefly, he feels there are three developments in late-stage trials that could have major impacts. The first is the development of sirtuin, which so far seems to be delaying the effects of diabetes but also seems to work for a host of diseases that are inflammatory in nature (including many heart-related issues). It essentially delays the symptoms for 30-40 years. While the current trials are for very specific diseases, he thinks sirtuin will have a wide applicability and that it could be huge, as inflammation is the cause of a number of diseases. This could prolong useful life and forestall a number of debilitating conditions. Second, there is a late-stage-three trial due out soon that promises to increase muscle mass. I have been reading about such developments, but was not aware that something might be available within a few years. This promises to help people stay active a lot longer than currently possible, which will be a good thing if we are going to live longer. And finally, there is a study and trial which shows that DHA may delay the onset of Alzheimer's disease, which eats up a significant portion of US medical budgets. I recently spent time with a research doctor at the University of California Irvine who believes that muscular dystrophy and other brain/nerve-related diseases may be conquered within five years. We may just get lucky. Instead of high and rising medical expenses that we cannot pay for without bankrupting the country, we may be able to reduce our medical bill by staying healthier and living longer. Everybody should be like my personal hero, Richard Russell. I hope to be writing as well as he does when I am 85. With some luck, I might just make it. Let me quickly recommend to my readers that they get serious annual physicals. At the Cleveland Clinic this week I saw seven doctors in one and a half days, and went through some serious poking and prodding. The program was tailored to my needs, as it is different for every person. You see professionals who are geared to your physical challenges. They make all the arrangements, and a staff person walks you into see the doctors, who are on very tight schedules. The advantage of the Cleveland Clinic is that they are very oriented toward helping you not get sick in the first place. I am turning 60 this year, and Iwant to be active for a very long time. You have to be proactive. As an aside, I had a colonoscopy. I was really dreading it, but it is one of those things you need to do. As it turns out, it was nowhere near as bad as I thought, and they basically gave me a drug which allowed me to relax and only experience a little discomfort. ("You are going to feel really relaxed in about 30 seconds.") You can learn more at www.clevelandclinic.org/executivehealth. Whether it is there or somewhere else, get a serious physical. I want you to be reading me in 25 years as much as I want to be writing. It is time to hit the send button. I will close by wishing you a very healthy week. Your really an optimist at heart analyst, John Mauldin John@FrontLineThoughts.com

Desperado

Desperado, why don't you come to your senses
You've been out ridin' fences,
for so long - now.
Ohh you're a hard one.
I know that you've got your reasons.
These things that are pleasin'you
Can hurt you somehow.

Don't you draw the queen of diamonds boy
She'll beat you if she's able.
You know the queen of hearts is always your best bet.
Now it seems to me, some fine things
Have been laid upon your table.
But you only want the ones
That you can't get.

Desperado,
Ohhhh you aint getting no younger.
Your pain and your hunger,
They're driving you home.
And freedom, ohh freedom.
Well that's just some people talking.
Your prison is walking through this world all alone.

Don't your feet get cold in the winter time?
The sky won't snow and the sun won't shine.
It's hard to tell the night time from the day.
And you're losing all your highs and lows
aint it funny how the feeling goes
away...

Desperado,
Why don't you come to your senses?
come down from your fences, open the gate.
It may be rainin', but there's a rainbow above you.
You better let somebody love you.
(let sombody love you)
You better let somebody love you...ohhh..hooo
before it's too..oooo.. late.

Here and there 13/05

1.      Quote of the day

In the short run, people are underestimating the impact that these global synchronized stimulus might have as well as how far it could run; while in the long run, we might also be underestimating how prolonging that this resession and its ensuring slow recovery is going to be.

 

2.      PPIP vs. FDIC (See chart 1 FDIC)

On major banks balance sheets, as indicated by the proposal of PPIP, they are marking their commercial real estate loans, both non-performing and performing ones, between 80c - 90c of a dollar.

However, the fact is, the average auction clearing price on the 331 loans the FDIC sold in January and February was49.3%. In March, the number of loans FDIC sold in various auctions increased almost four-fold to 1,328, for a total of $470 million in book values of sales, with the average price dropping even more: the latest being at 46.4%. 

And for those who claim that this price is distorted because it includes several non-performing loans, pls check out the details on chart 1.

 

3.      When banks are all raising capital…

They are now all declaring that they do that aiming to return the TARP fund. However, as said before, even though they do not have to mark those loans on the book to the market, for now. It is still their biggest concern as to the write down of those loan values, while their earning power fades after these great government momentum trade runs out. So if you are as cynical as me, will you think they would rather be returning the money and then come back later to ask for more in case needed, or will it be better off to raise the capital in the name of returning TARP fund, but keep it on your hand when it comes to the hard time?

 

4.      An interesting Chinese P2P student loan website

Basically it is like a Student Loan Alibaba, while students who wants to borrow to pay for their tuition fees and living cost, can actually post out their intended rate and the amount needed, to wait for being matched if there is another side. The website is helping out with the credit history due diligence by conducting a background check on the borrowers.

http://www.qifang.cn/index.htm Can choose the language on the top.

Here and there 12/05

1.      Moody’s view on Fed’s “Adverse Case” – Yes, EVEN MOODY. (See Chart 1)

In this particular case, Moody's focuses on credit-card charge offs; however the same principle can easily be applied to any other axis in the Supervisory Capital Assessment Program. As Moody's says:

SCAP loss rates for credit card assets range from 12%-17% in the Baseline scenario, and 18%-20% in the More Adverse one. We currently expect industry charge-offs to peak at 12% in the second quarter of 2010, which translates, roughly, to 22% on a two-year cumulative basis [TD: their base case]

Therefore, the Fed’s More Adverse charge-off rate assumptions for issuers’ managed credit card portfolios are consistent with our expected range of charge-off rates for related credit card trusts. Our current assumptions are predicated on the observance of surging delinquency trends and also the expectation that the unemployment rate will peak at about 10% in early 2010. Changes in the trajectory of unemployment will have the greatest influence on the actual magnitude and timing of peak charge-off rates.

2.      An interesting Chart from SentimentTrader.com (See Chart 2)

As for the definition of dumb money, well as the saying goes, if you're gonna ask who is the weakest hand on the poker table…

3.    CMBS (See Chart 3)

Not aimed to talk down the market, and am incapable of doing that neither. Just wanna point out 1 thing while we are all cheering.

4.    And one more, God bless US tax payers...

To end, an interesting read.

President Obama's troubling mantra: In debt, we trust

BYRICHARD HENRY LEE

Saturday, May 2nd 2009, 4:00 AM

It is no surprise thatPresident Obamasupports unprecedented spending and borrowing in the federal budget since he has never suffered any consequences from the excessive spending and borrowing in his private life.

And I'm not just talking about the First Lady's $540 sneakers.

A close examination of their finances shows that the Obamas were living off lines of credit along with other income for several years until 2005, when Obama's book royalties came through and Michelle received her 260% pay raise at theUniversity of Chicago. This was also the year Obama started serving in theU.S. Senate.

During the presidential primary campaign,Michelle Obamacomplained how tough it was to make ends meet. During a stop inOhio, she said, "I know we're spending - I added it up for the first time - we spend between the two kids, on extracurriculars outside the classroom, we're spending about $10,000 a year on piano and dance and sports supplements and so on and so forth."

Let's examine how tough things were for this couple using various public records.

In April 1999, they purchased aChicagocondo and obtained a mortgage for $159,250. In May 1999, they took out a line of credit for $20,750. Then, in 2002, they refinanced the condo with a $210,000 mortgage, which means they took out about $50,000 in equity. Finally, in 2004, they took out another line of credit for $100,000 on top of the mortgage.

Tax returns for 2004 reveal $14,395 in mortgage deductions. If we assume an effective interest rate of 6%, then they owed about $240,000 on a home they purchased for about $159,250.

This means they spent perhaps $80,000 beyond their income from 1999 to 2004.

The Obamas' adjusted gross income averaged $257,000 from 2000 to 2004. This is above the threshold of $250,000 which Obama initially used as the definition of being "rich" for taxation purposes during last year's election campaign.

The Obama family apparently had little or no savings during this period since there was virtually no taxable interest shown on their tax returns.

In 2003, they reported almost $24,000 in child care expenses and, in 2004, about $23,000. They also paid about $3,400 in household employment taxes each year. And as Michelle stated, they spent $10,000 a year on "extracurriculars" for the children.

These numbers clearly show the Obamas were living beyond their means and they might have suffered financially during the decline in housing prices had they relied on taking ever larger amounts of equity from their home to pay the bills.

But in 2005, Obama's book sales soared and the royalties poured in. Michelle explained, "It was like Jack and his magic beans."

Without those magic beans, the Obama family would have eventually suffered the consequences of too much debt.

Obama's penchant for borrowing in his private life carries over to his public life.

He gave the Congress virtually free rein in writing the huge stimulus bill. He had no reservations whatsoever about the country assuming so much debt. Other Presidents have tried to work out compromises on spending measures since it is ultimately the President who takes responsibility for the consequences.

Obama did make a feeble attempt to control spending when he announced that his cabinet had found ways to reduce federal spending by $100 million. But this is laughable. Compared to an estimated $3.6 trillion federal budget, it is a minuscule 0.0028%.

To put this into the context of the Obamas' income for 2004 of $207,647, this savings works out to $5.77, or about the price of an arugula salad.

President Obama has never faced consequences in his private life when it comes to managing money. He always had enough money simply by borrowing more and more. And just when things got tight, those magic beans came along to save the day.

But as a nation, we cannot base our future on the hope that some day Jack and those magic beans will also save the rest of us.

Stat Arbitrageurs: Merchants of Volatility

Neil OHara

Statistical arbitrageurs have demonstrated the ability to make money during tough times. “Stat arb tries to remove market risk to a degree that you really don’t see in any other strategy,” says Alain Sunier, portfolio manager of Highbridge Capital.

Like many hedge fund firms, Highbridge Capital Management had an absolutely miserable year in 2008. Its flagship Highbridge Capital Corp. multistrategy fund, which previously had experienced only one down year since Highbridge co-founders Glenn Dubin and Henry Swieca launched it in 1992, fell by more than 27 percent. Its convertible arbitrage portfolios, long a strength of the New York–based multistrategy powerhouse, did even worse, dropping about 45 percent. Between the losses and investor redemptions, the firm saw its hedge fund assets under management plummet from $27.8 billion at the start of 2008 to $17.3 billion when this year began. 

Highbridge, which is majority-owned by banking giant JPMorgan Chase & Co., had one bright spot, however. Its statistical arbitrage hedge fund was up more than 22 percent in 2008, taking advantage of some of the same forces that sent its other funds tumbling. As Highbridge portfolio manager Alain Sunier explains, statistical arbitrage funds profited last year from equity price distortions caused by sudden drops in liquidity and the spikes in volatility that typically accompany them. 

“Stat arbs take the other side of a move,” Sunier says. “We provide liquidity. If it’s a good time to do that, we earn an economic rent as prices return to normal.” 

In a world as desperate for liquidity as most equity markets were in 2008, rents soared for anyone willing to supply it — stat arbs included. And with no sign that equity markets will settle down anytime soon, stat arb funds look poised to enjoy success through 2009 and perhaps beyond. 

Statistical arbitrageurs employ a quantitative rapid-fire trading technique that relies on computer models to detect anomalous price movements among equity securities that normally trade in tandem. Although stat arbs as a group didn’t come close to matching Highbridge’s performance — Morningstar’s statistical arbitrage index fell 6.21 percent in 2008 — they did well in a year when the Morningstar 1000 hedge fund index dropped 22.41 percent and the Standard & Poor’s 500 index declined by 38.5 percent. And though most hedge fund managers suffered their worst losses in the fourth quarter, stat arbs managed to deliver positive returns as the year came to a close: The Morningstar statistical arbitrage index was up 1.44 percent in the final three months of 2008, compared with a 10.62 percent loss for the broader Morningstar 1000. 

It’s a dramatic turnaround for a strategy that had been all but left for dead after the summer of 2007. During the first two weeks of August that year, statistical arbitrageurs — including major players like AQR Capital Management, D.E. Shaw & Co., Goldman Sachs Asset Management and Renaissance Technologies Corp. — suffered huge losses. Goldman’s once–$5 billion Global Equity Opportunities Fund, for example, was down 30 percent; the then–$1.7 billion Highbridge Statistical Opportunities Fund fell 18 percent. For managers like Goldman and Highbridge that were able to hold on, performance snapped back later that month, but those that were forced to liquidate missed the rebound. In retrospect the crippling losses were more the result of margin calls that originated in the credit markets than of any flaw in statistical arbitrage theory, according to Andrew Lo, a finance professor at the MIT Sloan School of Management. 

“There was some kind of unwinding, most likely due to a multistrategy fund that needed to raise cash to meet margin calls for other investments,” says Lo. 

Investors nonetheless were spooked and took flight. Judith Posnikoff, a managing director and co-founder of Pacific Alternative Asset Management Co., an Irvine, California–based firm that manages about $9 billion in funds of hedge funds, estimates that between one third and one half of the hedge fund capital dedicated to statistical arbitrage had fled the strategy by early last year. At the same time, proprietary trading desks at many of the big investment banks also got out of the game. The exodus set the stage for a rebound in 2008. Lo points out that stat arbs tend to be long volatility, which shot up to record levels in the fourth quarter of 2008. 

“Spreads widened, volatility increased, and as a result, the profitability of these strategies grew,” says Lo, who is also founder, chairman and chief scientific officer of Cambridge, Massachusetts–based AlphaSimplex Group, a $700 million quantitative hedge fund manager. “Those were ideal conditions for stat arb.” 

Stastical arbitrageurs behave like quasi–market makers — buying stock at the bid price or selling it at the offer, but not doing both at the same time. True market makers, of course, have an obligation to do both. That makes them vulnerable when stocks are moving quickly; they can end up short in a rising market or long in a falling market. To compensate for that risk — known as being “short gamma” in traders’ lingo — market makers widen bid-offer spreads in volatile markets. Although stat arbs are not required to make a two-way price, they still benefit from the wider spreads. 

“The strategy makes money by providing structured liquidity to the market,” explains Paul Simpson, who co-manages two statistical arbitrage funds for Old Mutual Asset Managers in London. “As volatility increases, so does the opportunity to profit from more extreme price action.” 

Managers credit their fancy computer models rather than market structure as the source of their alpha. Every stat arb fund has a different model — often more than one — but Simpson says the models typically track the relationship between either stocks that normally move in the same direction at the same time (correlation) or stocks that don’t always move in the same direction but fluctuate over time around an observable constant such as a dollar spread or a price ratio (co-integration). 

Simpson knows whereof he speaks. After starting his career in the late 1980s in risk management, he worked as a proprietary trader doing equity arbitrage at several major securities houses, including Deutsche Bank and UBS. He eventually ended up at hedge fund Millennium Capital Management in London, where he and colleague John Dow jointly managed the statistical arbitrage program. In January 2006, Old Mutual hired Simpson and Dow, who together run about $320 million in two statistical arbitrage funds using models they built about seven years ago and continue to refine. Their flagship fund returned 18 percent in 2008. 

Like almost all stat arb funds, the Old Mutual portfolio is market-neutral — meaning its returns owe nothing to movements of the market as a whole. Although some stat arbs may use fundamental information about equities, such as price-earnings ratios, in their models, most — including Simpson and Dow — do not. 

“Our model is entirely driven by relative price evolution,” Simpson notes. “Mean reversion is a well-observed phenomenon in equity markets that exists at every time interval from a few minutes out to several years.” Simpson and Dow’s flagship fund trades large liquid equities on a global basis; the average holding period for each position is typically measured in days, not weeks. 

Old Mutual’s average holding period, in fact, is shorter than that of many stat arbs (Paamco’s Posnikoff estimates the industry average to be two to three weeks). But even a week is practically an eternity for Marek Fludzinski, whose New York–based Thales Fund Management turns over 10 to 40 percent of its $1.2 billion portfolio every day. Flud­zinski, who has a Ph.D. in theoretical physics from Prince ton University, applies mathematical principles to extract tiny distortions from mountains of data and thereby predict market market moves that may last for a few hours at most. 

He has been doing statistical arbitrage since the early 1990s, first at D.E. Shaw and then at Swiss Bank Corp. In 1994 he started Thales Financial Group with seed money from Paloma Partners Management Co., the now–$2 billion Greenwich, Connecticut–based investment firm founded by Donald Sussman. In January 1999, Fludzinski launched the Thales Fund, which had a largely successful run until it hit the skids in August 2007. Thales finished that year down 8 percent and suffered significant withdrawals as a result. Instead of soldiering on with a model that was no longer delivering the goods (it looked for trends that would play out over three to ten days), Fludzinski elected to return investors’ money. He launched a new fund last May using what he says iss an improved model. He shortened the average duration of the trends he looks for and built in an optimization routine that chooses the best time scale for each trade. 

Thales wasn’t the only shop to experience redemptions after the 2007 carnage. In fact, even managers who did well suffered withdrawals, not only at the end of 2007 but all through 2008. Paamco’s Posnikoff says stat arbs offer investors better liquidity than most hedge fund strategies do — they can’t justify long lockups for portfolios that turn over every week or two — so investors who needed cash dipped into stat arb funds as if they were ATMs. 

The credit crunch exacerbated the pressure on stat arb managers, as those who stayed in the game had to cut back their leverage too. Before August 2007 it was not unusual for statistical arbitrage funds to use as much as eight times leverage, says MIT’s Lo. “Nowadays leverage has come down dramatically,” he notes. “You would be hard pressed to find a stat arb manager getting more than five to six times leverage, and the typical leverage being used is probably three to four times.” 

Highbridge’s Sunier says that as a result stat arb was better placed than many other strategies to weather the market storms in 2008. “The supply-demand balance has been quite favorable for the short-term forecasts that lie at the heart of stat arb profitability,” he explains. “I do feel that those conditions will remain with us for some time.” 

Sunier is not alone. Posnikoff projects that the CBOE volatility index, or VIX, a key measure of the U.S. equity market’s expected near-term volatility as expressed by the prices of S&P 500 index options, will remain high through the end of this year, trading between 40 and 60. To protect against the eventual decline in volatility, she favors high-frequency statistical arbitrage funds that turn over their portfolios every two or three days. “The short time frame adapts to changes in volatility more quickly,” Posnikoff explains. She expects these funds to thrive even when the markets calm down and volatility recedes to a more normal range — a VIX of 20 to 35. Her biggest challenge is to find capacity; managers who trade like whirling dervishes can handle only a limited amount of assets. 

Fludzinski, for his part, intends to cap Thales’s gross assets — its longs plus its shorts — at about $2.5 billion. He is almost halfway there, having raised some $300 million in capital for the new fund, which has a leverage target of four to one. “The limitation is liquidity, the need to trade in and out of stocks quickly,” says Fludzinski, whose fund was up about 13 percent last year in just eight months of operation. Thales’s positions tend to be in large- and midcap stocks that can accommodate the frenetic pace of trading. 

Although high volatility usually boosts returns for stat arbs, too much of a good thing can be harmful. In extreme market conditions indiscriminate forced selling overwhelms normal trading relationships and the models stat arbs use don’t work. Jaeson Dubrovay, senior consultant for hedge funds at Cambridge, Massachusetts–based investment consulting firm NEPC, sees the sweet spot for stat arbs in a VIX range of 20 to 40. “Below 20 nothing is moving, and above 40 everything is moving either up or down together,” he says. “Stat arbs need dispersion, where the best stocks outperform the worst stocks.” Dubrovay expects volatility to slide toward that sweet spot later this year and foresees an increase in dispersion too. Not surprisingly, he favors an allocation to statistical arbitrage at the moment as part of a diversified portfolio for clients who invest in hedge funds. 

At a time when investor confidence is low, liquidity is scarce and market volatility remains high — albeit lower than the record levels seen last fall — stat arbs are likely to enjoy a benign environment for some time to come. But in theory, statistical arbitrage is a strategy for all seasons because it depends on short-term relative price movements, not the intrinsic value of securities. The returns it generates are particularly attractive on a risk-adjusted basis even when market conditions are not so favorable. 

“Stat arb tries to remove market risk to a degree that you really don’t see in any other strategy,” says Highbridge’s Sunier.

477.HK A value play

477.HK is a firm in Zhe Jiang, specialized in manufacturing bathroom warming appliance. Its brand Aupu is well recognized within Chinese consumers with a market share of 49.33% in 2008, as well as a number 1 market share for the last 7 years ever since this number started to be published back in 2002 by Chinese Industrial/ Company Information Group. Moreover, its market share is at or more than 4 times as much as the number 2 player for the last 7 years, too. Stock was listed back in Dec 2006, but the company has been running for 16 years, one of the Start firms in that province.

Good and conservative management team, very low debt (Currently at 2.53% of the asset), good product turnover speed, too. Good cash level since listed, for instance last year’s market cap was around 709m HKD (using an average price of 1) while the cash was 359.2m; From the latest report, we saw they invested 288.7m HKD cash into securities which needs to be clarified as to what type of the investment was made. For now, with 498m HKD market cap, 326.6m HKD is in current asset. Unlike other electronic appliance producer in China, according to the latest public conference, they are running the firm on a cash for delivery basis, which of course also need to be clarified with channel checks.

Valuation wise, the stock is trading around 6.85 after a spike of 6% today; Plus, the firm has a good record, albeit short, for dividend payout given its good cash level as well as a management team having a sense of shareholder value. Payout ratio is 139.25% as a result of a special cash dividend, but if we excluded that, still a steady 10%+ yield annually.

Earning is down last year though, with 1Q and 3Q doing ok but 4Q dropped, given it is somewhat related to the new home sales number. Attention needed. The company is well under researched with only one firm covering it, which is its underwriter and the analyst has not updated it for a while, reasonable for a small cap.

Overall, channel checks as well as the usage of that cash investment needs to be checked further; Company earning outlook also needs attention but personally speaking given its dominating position in this kind of the product and it should not be hard for the firm to come back to a steady earning track, if not increasing. Worth buying around 0.6HKD, if those checks have been done and the result is promising. Will follow up on that. And of course, its liquidity is another issue for such a small cap name.