Tuesday, September 28, 2010

Morning Note...

Futures slightly higher (+35bps) on an overnight rally across the pond.  U.S. markets remain somewhat quiet, however, and it’s unclear if recent action represents a simple respite after a +10% month, a near-term calm before the potential GDP revision Thursday, a medium-term calm ahead of Q3 earnings season, a longer-term calm ahead of midterm elections, or all of the above.  There is a bit more action overseas, as Europe rallied from down 1% to now stand slightly positive.  U.S. futures followed this action, and rallied significantly at ~5am on speculation that the ECB was stepping in to buy Irish & Portuguese debt (for the moment).  In corporate news, Walgreen’s (WAG; +7%) beat estimates by 5c and reported revenues that were in-line with expectations.   Blackberry-maker RIMM announced a new “Playbook” for 1Q2011 to compete with Apple’s iPad.  In economic news, the July CaseShiller home price index data was in-line to slightly lower than expected, but has not had much market impact.  Asia weaker across the board overnight.  Gold remains near $1300/oz.  Oil -33bps.  USD down slightly.  Many mutual fund’s fiscal year-end is this Thursday the 30th.  For the purposes of “window-dressing,” (which is clearly unnecessary after this month’s action) some use T+3 as year-end (which was yesterday), and some use September 30th – I admittedly have never been able to get a firm answer on that question. 

Worth noting that the Wall Street Journal posted an article just after yesterday’s close that hints at a watered-down QE2, which might in fact disappoint the market (and perhaps helped futures trend weaker late yesterday afternoon and overnight before catching a bid on the European rally):

Fed Mulls New Bond Approach By JON HILSENRATH

Federal Reserve officials are considering new tactics for the purchase of long-term U.S. Treasury securities to bolster a disappointingly slow recovery.

Rather than announce massive bond purchases with a finite end, as they did in 2009 to shock the U.S. financial system back to life, Fed officials are weighing a more open-ended, smaller-scale program that they could adjust as the recovery unfolds.

The Fed hasn't yet committed to stepping up its bond purchases, and members haven't settled on an approach. After its meeting last week, the Fed's policy committee said it was "prepared" to take new steps if needed.

A decision on whether to buy more bonds depends on incoming data about economic growth and inflation; if the economy picks up steam, officials might decide no action is needed.

The Fed's internal debate about a bond-buying strategy is emblematic of the challenging position in which it finds itself. In normal times, it simply raises or lowers short-term interest rates to guide the economy.

But having pushed short-term rates to near zero, it now has to devise new, untested approaches at almost every turn. A misstep could lead to unintended consequences, one factor that makes officials wary and investors jittery about its every move.

In theory, buying long-term bonds pushes other interest rates down because it reduces the supply of debt available to investors, pushing up the price of this debt and the yield down.

In March 2009, the Fed said it would buy $1.7 trillion worth of Treasury and mortgage-backed securities over a six to nine month period—known inside the Fed as the "shock and awe" approach.

Most Fed officials believe that helped to drive down long-term interest rates and spurred the economy.

Under the alternative approach gaining favor inside the Fed, it would announce purchases of a much smaller amount for some brief period and leave open the question of whether it would do more, a decision that would turn on how the economy is doing. This would give officials more flexibility in the face of an uncertain recovery.
Most economists at the Fed and outside, though not all, believe that the Fed's decision to embark on what's known as "quantitative easing"—buying bonds—after cutting its target for short-term interest rates to near zero helped prevent an even deeper recession.

A move to resume the purchases would be a big step for the Fed, which just a few months ago was talking about how to reduce its portfolio.

In deciding how to resume its large-scale purchases, if it opts to do so, the Fed is considering both the potential benefits of pushing down already-low long-term interest rates and the potential risks, particularly to its credibility in financial markets about its ability and willingness to reverse course if the economy rebounds or inflation accelerates.

Fed officials have done little to dissuade investors that they might do more.

Fed Chairman Ben Bernanke last week reiterated his dissatisfaction with the recovery, saying the economy has failed to grow "with sufficient vigor to significantly reduce the high level of unemployment."

Markets anticipate the Fed will pull the trigger, barring some surprise turn in the economy. Economists at Goldman Sachs Group Inc. estimate the Fed will end up purchasing at lest another $1 trillion in securities, and estimate that would push long-term interest rates down by a further 0.25 percentage point.

A leading public proponent of a baby-step approach is James Bullard, a 20-year Fed veteran who has been president of the St. Louis Federal Reserve Bank since 2008. He says he has made progress convincing his other colleagues to seriously consider that path.

"The shock and awe approach is rarely the optimal way to conduct monetary policy," he says. "I really do not think it is the right way to go except in really exceptional circumstances."

In the heat of the crisis it made sense to jar frozen markets back to life with a big attention-grabbing program, he says. Announcing another big program with a finite end date now, he says, would lock the Fed into a policy that might not prove appropriate several months from now.

Moreover, a large commitment could destabilize markets by unhinging the dollar or creating fears of a big inflation uptick, he says.

Under a small-scale approach, Mr. Bullard says, the Fed might announce some still-undecided target for bond buying—say $100 billion or less per month. It would then make a judgment at each meeting whether continued action was needed, he says, based on whether "we're making progress toward our mandate of maximum sustainable employment and inflation at our implicit inflation target."

There are many open questions. One is size. Mr. Bullard says doing more than $1 trillion of purchases per year would give him "pause" because that's how much net debt the Treasury will issue this year, meaning the Fed would be financing it all. There is also a question of whether the Fed might tie further action to movements in the unemployment rate, inflation or other metrics.

Mr. Bullard currently is among 12 regional Fed bank presidents with a vote on monetary policy, along with the four current Fed governors in Washington. He has been arguing for this kind of approach to Fed policy for several months, but only began to get traction with other officials as the economy slowed down this summer.

The Fed is not of one mind on the issue, though. Some officials are reluctant to resume bond buying to, as they put it, "fine tune" the economy. Others are more inclined to be bold to resuscitate the recovery.

A small-scale approach could be a path to compromise among officials.

"Given the disagreement about the need for additional easing within the FOMC, retaining some flexibility might be critical to the adoption" of more quantitative easing, Goldman Sachs analysts said recently.

The Goldman economists estimate that an open-ended, small-scale approach would have less impact on bond markets than a large one-time approach, because investors wouldn't be certain about whether such a program would continue.

"The more you commit to large amount of purchases up front, the bigger effect you're going to get," says Jan Hatzius, Goldman's chief economist.

The Fed concluded its $1.7 trillion purchases of mortgage and Treasury bonds in March. Researchers at the Federal Reserve Bank of New York estimate that the program reduced long-term interest rates by between 0.3 percentage point and 1 full percentage point.

The Fed took a step toward new purchases in August. It said it would begin replacing maturing mortgage bonds by purchasing Treasury debt to keep the overall level of its securities holdings constant.

Here’s something else interesting from the Journal, as per Bloomberg:

Americans Think Recovery Will Take Years, Survey Shows, WSJ Says 2010-09-28 10:20:48.564 GMT

Sept. 28 (Bloomberg) -- Some 46% of Americans think it will take until at least 2013 for the economy to recover to “normal times,” while 36% expect it will take sooner, WSJ reports, citing survey by AlixPartners…39% plan to spend less on non-essential items in next yr, 48% to keep spending the same. 

AEC to offer 8M shares.  AGNC to offer 10M shares.  ANAD cut at STFL.  CGNX raises guidance.  DLB cut to Neutral at GSCO.  ENTR to offer 10M shares.  JBL beats by 3c and guides in-line.  GSCO ups PHM to Neutral.  RAX to replace ACF in S&P400.  Cramer loves LULU.  TGT cut at CSFB.  CITI cuts HSP.  GSCO cuts KBH.  JPHQ cuts AAI.  UBSS cuts AAI. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 

Today’s Trivia:  Name the only country to have a capital named after an American president.

Yesterday’s Question:  You may know that Al Capone was born in Brooklyn and spent most of his “career” in Chicago…but where did he die?

Yesterday's Answer:  Al Capone died on Palm Island, which lies just off the MacArthur Causeway in Biscayne Bay, between downtown Miami and Miami Beach.   

Best Quotes: 
"The mathematical expectation of the speculator is zero."
-Louis Bachelier

Louis Bachelier was a French mathematician who was, well after the fact, credited with founding the Efficient Market Thesis.  In 1900 Bachelier published his Ph.D thesis titled "The Theory of Speculation."  In his paper, Bachelier discussed the use of Brownian motion to evaluate stock prices.  Unfortunately, his thesis was "not appropriately received", which resulted in academic black-balling and the concept being buried for more than sixty years.

Almost sixty-five years later Professor Eugene Fama from the University of Chicago was officially credited with developing the Efficient Market Thesis after publishing his Ph.D thesis.  His paper was titled "The Behavior of Stock Market Prices."  The core tenet of his paper and the Efficient Market Thesis is that an investor "cannot consistently achieve returns in excess of average of market returns on a risk-adjusted basis, given the information that is publicly available at the time the investment is made."

Is it not somewhat ironic that the determination of who founded the Efficient Market Thesis was not efficient?

Despite not having a Ph.D on staff at Hedgeye Risk Management, we have been performing our own experiment to test the Efficient Market Thesis over the past two years.  We call this experiment the
Hedgeye Virtual Portfolio, and it is a culmination of our stock picks since inception.

In that time, we have closed 510 long positions and closed 490 short positions. 85.9% of the closed long positions have been winners and 83.5% of the closed short positions have been winners.  Obviously, these results are far from a "random walk".  So, either we are good at our jobs, or the market is not quite as efficient as Efficient Market Theorists believe.  I would submit that it is a combination of both. 

Clearly, though, many stock market participants work hard, have processes, and are intelligent.  So, why do many stock market operators underperform even the basic broad market returns? Simply put, because of this little critter called Behavioral Economics that leads many market participants to act against their best interests. 

By way of example, let's consider the St. Petersburg Paradox, which is as follows:

"Consider the following game of chance: you pay a fixed fee to enter and then a fair coin is tossed repeatedly until a tail appears, ending the game. The pot starts at 1 dollar and is doubled every time a head appears. You win whatever is in the pot after the game ends. Thus you win 1 dollar if a tail appears on the first toss, 2 dollars if a head appears on the first toss and a tail on the second, 4 dollars if a head appears on the first two tosses and a tail on the third, 8 dollars if a head appears on the first three tosses and a tail on the fourth, etc. In short, you win 2^k−1 dollars if the coin is tossed k times until the first tail appears."

So, what would be a fair price to pay for entering the game?

I posed this question to our Research Team at Hedgeye yesterday and they came back with myriad of answers, which ranged from $1 to infinity.  This simple mathematical answer is that you should be willing to pay infinity (or your entire net worth) to play this game as your expected value is infinity.

 As one of our astute Analysts responded to me yesterday:

"Well, the series doesn't converge ...EV = (1/2)*($1) + (1/4)*($2) + (1/8)*($4) + ...EV = ½ + ½ + ½ + ...... the sum of which is infinite.  So, is the fair entering price infinite? Strictly speaking, I think the answer is yes - but no one on earth would take that deal (even if we cap the number of rounds such that EV = all your money, since no one has infinite money)."

Therein is another paradox, the paradox of the Efficient Market Thesis.  Specifically, most market operators do not make rational decision based on math.  They make emotional decisions based on arbitrary evaluations of risk. This, of course, leaves opportunities for the sneaky mathematicians to make profit.

So then, how do we account for valuation when considering an investment?  Surely, valuation is rational?

In my view, valuation is an indicator of sentiment around a security.  For instance, when a stock trades with a single digit P/E, its business is either declining, or the collection of market operators believe it is.  There are many studies that support the idea that value based strategies (i.e. buying cheap stocks) outperform over time, but I would submit that this is not because of the valuation, but rather because of the behavioral finance indicator embedded therein.

As we consider the stock market today, the first question many strategists try to answer is whether the stock market is "cheap".  The simple way to make this determination is to pull up a long term price / earnings chart and look at it going back fifty years.  Today, at 15x current earnings and 13.7x forward earnings, the SP500 looks cheap versus history. 

The more important task though is determining what expectations are embedded in that valuation.  What is the correct earnings multiple for an economy that has crossed the
Rubicon of Debt at 90% debt / GDP and has budget deficits projected for the next thirty plus years (I would say infinity, but that's probably not fair)? Additionally, if growth rates are mired in the 1 - 2% range as a result of this fiscal situation, is the stock market "cheap"?

In the shorter term, setting those sneaky valuation metrics to the side for a second, what do you think is priced into the S&P500 up 8.8% in September?  Given the cover of Barron's this weekend and the rapid rise in the S&P in the last few weeks, the catalyst of the Republicans winning more seats than expected in the midterms is likely priced in. (We called this out on our conference call with Karl Rove in early September - Could the Midterm Election Be A Major Stock Market Catalyst?)  So, what is priced in now?

Well, perhaps our friend George Soros said it best:

"The financial markets generally are unpredictable. So that one has to have different scenarios. The idea that you can actually predict what's going to happen contradicts my way of looking at the market."

Or as we say at Hedgeye, the plan is that the plan will change.

Yours in risk management,

Daryl G. Jones
Managing Director