Fifteen Notes on the State of the Markets

1)  Start with the pessimists:

2)  Move to the optimists:

3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at  “Splutter”).  I began toting up a list of notable losers, but it got too big.  One positive note, many of the large quant funds bounced back from their mid-August stress.

4)  When muni bonds get interesting, you know it’s a weird environment.  It starts with the fundamental mismatch of muni bonds.  Muni issuers want to lock in long term financing, but most investors want to invest shorter.  Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.  When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.  (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)  When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.  That didn’t last long, but munis are still a good deal here.

5) Large caps are outperforming small capsForeign exposure that large caps have here is a plus.

6) Not all emerging markets are created equal.  Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)  Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)  I would be more concerned about the first group.

7) Are global banks cheap?  Yes on an earnings basis, probably not on a book basis.  We need to see some writedowns here before the group gets interesting.

8) I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.  This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.  What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.  Poring over the SFAS 159 disclosures will be required as well.

9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

10) Hedge funds do better if the managers went to schools that had high average SAT scores?  I would not have guessed that.  Many of the best investors I have known were clever people who went to average schools.

11) My but bond trading has changed.  When I was a corporates manager, hedge funds weren’t a factor in trading.  Now they are 30% of the market.  Wow.  Surprises me that volatility isn’t higher.

12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.  His call for outperformance of quality assets seems to be happening.  Now the question is whether the cost of capital is going up globally or not.  If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.”  Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

14) Morningstar moves into options research.  Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.  They make a good point that most people use options wrong, and get the short end of the stick.

15) Oil is amazing, but wheat is through the roof.  I’ve seen articles about bread prices rising.  Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

With that, I bid you good night.