Sunday, February 28, 2010

S&P 500 composite regression to trend chart

Real Prices with Official CPI | Real Prices with ShadowStats CPI

Dow adjusted for inflation since 1925

Taking the long-term perspective, you just have to wonder if the market isn’t in the same process it was in the mid-70’s when the sideways to down churn ultimately resulted in a downside overshoot that ended in the early 80’s.

For some long-term perspective, today’s chart illustrates the Dow adjusted for inflation since 1925. There are several points of interest. For one, when adjusted for inflation, the bear market that concluded in the early 1980s was almost as severe as the one that concluded in the early 1930s. Also, the inflation-adjusted Dow is a little more than double where it was at its 1929 peak and trades 54% above its 1966 peak – not that spectacular of a performance considering the time frames involved. It is also interesting to note that the Dow is up 57% from its March 9, 2009 low which is actually slightly more than what the inflation-adjusted Dow gained from its 1966 peak to today.

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Saturday, February 27, 2010

Grantham is usually right and well ahead of market realization

Jeremy Grantham warned in January 2000 that U.S. equities were “more overpriced than at any time in the last 70 years due to the massive overpricing of technology and especially dot-com stocks.”

By the end of 2002, the Standard & Poor’s 500 Index had fallen 40 percent and technology shares were down 73 percent. The forecast didn’t help his firm, Grantham Mayo Van Otterloo Co., because he’d been bearish since 1997. Assets declined 45 percent in the late 1990s as customers sought out better- performing mutual funds that liked the technology stocks Grantham disdained.

Grantham said in an interview that his negative calls are often so early that investors who acted on them gave up gains before prices peaked. He recommended avoiding Japanese stocks more than two years before they started falling at the end of 1989. While his timing doesn’t deter fans like former Harvard University endowment manager Jack Meyer, it requires a delicate balancing act by GMO, which oversees $107 billion.

“We lost business like it was going out of style,” the 71-year-old Grantham said of his dot-com prediction at a Jan. 28 speech to investment advisers in Boston, where GMO is based. The firm, which he co-founded in 1977, had net mutual-fund inflows of $12.9 billion in 2003 and 2004, according to data compiled by Morningstar Inc.

GMO’s funds usually don’t fully adopt his recommendations, or hedge their bets, underscoring the difference between being a star strategist and successful money manager. That’s true for the fund Grantham works most closely with, GMO Global Balanced Asset Allocation, which oversees $3.1 billion.

The tension between acting on a long-term vision and keeping clients happy in the short run is a fact of life for all money managers, said Charles Lieberman, chief investment officer at Advisors Capital Management LLC in Hasbrouck Heights, New Jersey, which oversees about $190 million. “The issue is: Are you willing to stick your neck out and how far?” he said in a telephone interview.

The tension is heightened at GMO, where Grantham’s warnings of investment bubbles have at times sent customers packing for firms with a more upbeat view of the markets.

“If we are too aggressive, and we don’t get it right, we run the risk of being fired,” Ben Inker, GMO’s head of asset allocation, said in a telephone interview.

Two of Grantham’s most recent forecasts were right -- and timely.

In 2007, he wrote in his newsletter that all asset classes were overvalued and it was time to sell high-risk securities. GMO’s $2 billion Emerging Country Debt Fund, which held high- yielding securities from countries such as Venezuela and Argentina, decided to stick with those investments in 2008.

“Every bet we made turned out to be wrong,” Thomas Cooper, the fund’s co-manager, recalled in an August interview, pointing out that investors sought out safer securities during the financial crisis. The fund lost 33 percent in 2008, and the following April GMO was fired by the Massachusetts state pension system as manager of $230 million in emerging-market debt.

The fund bounced back, returning 50 percent in 2009. Its 14 percent annual return over the past 10 years made it the best performing bond fund, according to Chicago-based Morningstar.

“Jeremy has been a great long-term investor,” said Meyer, who ran Harvard’s endowment for 15 years until 2006, when he left the Cambridge, Massachusetts, university, to start Convexity Capital Management LP, a Boston-based fund manager. Grantham was ahead of the pack in the 1990s identifying the value of emerging-market stocks, inflation-adjusted securities and timber, Meyer said in a telephone interview.

In March 2009, when the S&P 500 index bottomed out at 676, Grantham wrote that fair value for the benchmark of the largest U.S. stocks was 900, or 33 percent higher. By July, with the index above that mark, Grantham concluded U.S. stocks had become too expensive again.

“After 20 years of more or less permanent overpricing, we get five months of underpricing,” he told newsletter readers. “There is no justice in life.”

The fair value of the S&P 500 is 850, 23 percent below today’s 1105, said Grantham. He arrives at that valuation by assuming a long-term average price-to-earnings ratio of about 15 for U.S. stocks and applying it to a long-term average for profit margins.

Grantham is chief investment strategist at GMO, whose assets have risen almost fivefold since 2000. Its more than 40 mutual funds usually require a minimum investment of $10 million and are aimed mainly at institutions such as pension funds and endowments, according to the firm’s Web site. The firm also acts as a sub-adviser on several retail mutual funds.

In his appearance in Boston, Grantham, who is whippet-thin with a full head of gray hair, wore a dark suit and a pink tie with giraffes. Until the past few years, he played in a weekly soccer game to stay in shape.

Over the course of 45 minutes, he poked fun at the investment business and himself. Recalling the five-month period in which he considered U.S. stocks inexpensive, Grantham said, “I refer to it as my very short life as a bull.”

After the speech, more than a dozen advisers gathered around Grantham, peppering him with questions about everything from China to the U.S. budget deficit.

“He’s got the perspective of someone who has been in the battle for a long time,” said Robert Henkel, an adviser from Portsmouth, New Hampshire, explaining why he sought out Grantham for a private conversation.

Grantham’s favorite asset class today is high-quality U.S. stocks, companies defined by high, stable returns and low debt. The allocation fund had 31 percent of its money in that category at year-end, sometimes called blue chips, according to the GMO Web site. In the interview, he said he expects such stocks to return an average of 6.8 percent a year over the next seven years, compared with 1.3 percent for all large-cap U.S. stocks.

Emerging-market stocks may rise about 4 percent annually in the next seven years, as investor enthusiasm for economic growth in developing countries carries the stocks to unsustainable levels, Grantham said.

“Why not go along for the ride?” he said. The MSCI Emerging Markets Index returned an average of 22 percent in the past seven years, compared with a gain of 5.5 percent by the S&P 500 index.

U.S. government bonds will return 1.1 percent a year over the seven-year period, according to the latest GMO forecast. The Bank of America Merrill Lynch U.S. Treasury Master Index rose 4.3 percent from 2003 through 2009.

Grantham said he expects a difficult, not disastrous, period for the economy and investments.

“It will feel like the 1970s,” he said. “One step forward, one step back.”

Grantham was raised in Yorkshire, England, and has a bachelor’s degree from Sheffield University. His father was a civil engineer who died in World War II.

“Yorkshiremen have a well-deserved reputation for a highly developed sense of value,” he wrote in a follow-up e-mail. “In other words, they’re cheap.”

Grantham came to the United States to go to Harvard Business School in Boston. Following graduation in 1966, he spent several years as a self-described speculator, borrowing money to invest in “flaky little companies I hardly knew,” he said in the interview.

After he suffered large losses in 1969, “it brought out my deeper instincts to be a contrarian,” he said.

That year Grantham co-founded Batterymarch Financial Management Inc., a Boston firm that is now owned by Baltimore- based Legg Mason Inc. At Batterymarch, Grantham and co-founder Dean LeBaron were among the first to offer clients the chance to invest in indexes, according to the book “Common Sense on Mutual Funds” by John Bogle, who started Vanguard Group Inc., the Valley Forge, Pennsylvania-based mutual-fund firm.

In 1997, Grantham and his wife created a foundation to protect the global environment. In 2007, the couple donated $23.6 million to Imperial College London to establish an institute on climate change.

“This is the most important economic and social issue of the 21st century,” Grantham wrote in the e-mail.

Grantham, as a member of GMO’s asset-allocation team, makes recommendations to the firm’s 114 investment professionals. They are free to accept or reject the advice.

GMO Global Balanced Asset Allocation fund returned 6.8 percent annually in the past decade, a performance topped by 4 out of 50 rival funds, according to data from Chicago-based Morningstar Inc.

The GMO fund attempts to beat its benchmark, a blend of 65 percent global stocks and 35 percent U.S. bonds, by 2 percent to 3 percent a year, according to the firm’s Web site. The benchmark returned less than 1 percent a year in the past decade, according to the GMO Web site.

The fund will make “significant” bets, within limits, on asset classes such as emerging-market stocks or real estate, said Inker, who is a co-manager. The fund generally keeps at least 45 percent to 50 percent of its money in stocks, he said.

“We are as aggressive as we can get away with, but not more aggressive,” said Inker.

Grantham is best known for his quarterly newsletters, which have appeared since 1999. The publications, which run as many as 18 pages, represent his personal views on the stock market, sprinkled with acerbic comments on subjects such as private equity and Federal Reserve policy. Last October, he compared giving Ben Bernanke a second term as Fed chairman to reappointing the captain of the Titantic.

The newsletters have a following among investors large and small.

Chuck Levin, a financial planner in Wayland, Massachusetts, admires them for their “salient and clear thoughts on investment.” Levin doesn’t necessarily follow Grantham’s advice, particularly when the strategist is bearish on stocks.

“I am not going to tell my clients to put all their money into cash,” he said in a telephone interview. “Who has the courage to do that?”

Jack Ablin, who helps manage $55 billion as chief investment officer at Chicago-based Harris Bank, regularly reads Grantham.

“When he gets bullish, that’s when you have to sit up and take notice,” Ablin said in a telephone interview.

Jeremy Siegel, who has squared off with Grantham in a series of bull-bear debates over the past decade, said Grantham can cost investors money by being so early with his calls.

“There have been periods when he would have kept people out of the market while it was still rising,” said Siegel, a finance professor at the Wharton School at the University of Pennsylvania in Philadelphia and author of the book “Stocks for The Long Run.”

Grantham dismisses his “permabear” label, saying that in 2000 he was bullish on emerging-market stocks, real estate investment trusts and inflation-adjusted bonds. GMO data show that the three asset classes returned between 4.9 percent and 8.1 percent a year in the 10 years ended Dec. 31. The S&P 500 lost 1 percent a year over the same stretch.

Looking back on more than 40 years in the investment business, Grantham summed up his career this way: “We win all the bets but we are horrifically early,” he said.

(from Bloomberg, February 26, 2010)

Jeremy Grantham: Stop the Presses!

Jeremy Grantham, co-founder of GMO, which manages $102 billion, is out with his January 2010 quarterly letterJGLetter_ALL_4Q09.pdf

Credit Conditions Still Tight, Mishkin, Hatzius, Hooper Say

Financial conditions in the U.S. may be tighter than many indicators suggest, former Federal Reserve Governor Frederic Mishkin and four other economists said in a paper.

The economists reviewed the performance of seven financial conditions indexes, including those produced by Bloomberg LP, Goldman Sachs Group Inc., Deutsche Bank AG and Citigroup Inc., and then constructed their own index.

While many indexes “show the current level of financial conditions to be back at or slightly better than normal levels, our index has deteriorated substantially over the past two quarters,” Mishkin and his co-authors write. “This setback suggests that financial conditions are somewhat less supportive of growth in real activity.”

Mishkin and his co-authors said that deterioration in their own index was concentrated in non-mortgage asset-backed securities issuance, commercial mortgage debt and repo loans.

“The continued woes of the shadow banking system could continue to weigh on the pace of the recovery, despite the recovery in more traditional measures of financial conditions,” the authors say.

Mishkin said in an interview today that the central bank needs to keep interest rates low because there is “a tremendous amount” of idle capacity in the economy.

“We’re not going to get through that slack in the near term,” Mishkin said in an interview on Bloomberg Radio. “Monetary policy needs to be accommodative.”

Fed Chairman Ben S. Bernanke this week said the world’s largest economy is in a “nascent” recovery that requires low interest rates to encourage demand.

Fed Funds Rate

Policy makers have kept the benchmark federal funds rate for overnight loans among banks close to zero since December 2008 and said at their meeting in January that borrowing costs will stay low for an “extended period.”

Mishkin, 59, served as a Fed governor from September 2006 to August 2008. He is currently a professor of economics at Columbia University in New York.

The Bloomberg Financial Conditions Index stands in positive territory at 0.183, up from negative 12.6 on Oct. 10, 2008, in the days following the collapse of Lehman Brothers Holdings Inc. Among the Bloomberg index’s components are yield differences between commercial paper and Treasury bills and stock prices.

Co-authors on the paper include Jan Hatzius, chief economist at Goldman Sachs Group Inc.; Peter Hooper, chief economist at Deutsche Bank Securities Inc.; Kermit Schoenholtz, managing director at Citigroup Global Markets Inc., and Princeton University professor Mark Watson.

The paper entitled, “Financial Conditions Indexes: A Fresh Look after the Financial Crisis,” was submitted to the annual U.S. Monetary Policy Forum sponsored by the University of Chicago Booth School of Business.

(By Craig Torres, Bloomberg, February 26, 2010)

Gundlach Answers TCW, Files Own Case

Star bond-fund manager Jeffrey Gundlach fired another round at his former employer, claiming in a complaint filed Wednesday that TCW Group Inc. sought to deprive him of his share of fees generated by funds he managed.

TCW, a Los Angeles-based money manager, in December dismissed Mr. Gundlach, its chief investment officer, saying that he had threatened to leave and take key personnel with him. The firm later claimed in a lawsuit that Mr. Gundlach and his group had stolen proprietary information from the firm in laying the groundwork to launch a rival money-management firm, DoubleLine Capital.


Jeffrey Gundlach

Mr. Gundlach, who launched DoubleLine in the weeks after his dismissal, also filed an answer Wednesday to TCW's January complaint, saying the allegations were false and designed to interfere with his firm's business. He said in an interview that the TCW litigation had affected DoubleLine, adding that the dispute "extends the timeline of ramping the business."

The dispute has had fallout for both sides. Investors have yanked roughly $6 billion from TCW's flagship Total Return Bond Fund, which Mr. Gundlach managed, in the wake of his departure. That fund now has less than $5.9 billion in assets, down from roughly $12 billion. And since TCW claimed in its lawsuit that Mr. Gundlach not only stole its property but also kept drugs and pornography in his TCW offices, the bond-fund manager finds himself defending his character while trying to persuade investors to entrust their money to his new firm.

The bond-fund manager's complaint against his former employer claims that TCW agreed in early 2007 that Mr. Gundlach and his group would receive a chunk of the management and performance fees generated by funds they managed. Over time, these funds performed so well that the money owed under this fee-sharing agreement reached at least $600 million "and easily approaching $1.25 billion and beyond," the complaint said.

Mr. Gundlach's complaint charged that TCW schemed to deprive him and his group of this compensation, alienating the investment chief by marginalizing him and refusing to address his concerns about the future of the firm. After dismissing Mr. Gundlach, the complaint claims, TCW repudiated any obligation to pay the fees it had promised Mr. Gundlach and his group.

"We will address Mr. Gundlach's counterclaims in the appropriate venue, which is the court," TCW said in a statement. The firm added that "Mr. Gundlach's spin regarding the reasons for his termination are completely erroneous," noting that Mr. Gundlach earned $40 million last year and $135 million over the past five years.

In denying the allegations in TCW's complaint, Mr. Gundlach addressed the charge that he and his group had stolen proprietary TCW information. DoubleLine retained an outside firm to collect and return any computers or devices belonging to TCW, the court filing said, and took other steps to avoid using TCW's proprietary information.

In an interview last month, Mr. Gundlach said that he had no knowledge of anyone intentionally downloading information that was intended to be used at DoubleLine. In launching the new firm, Mr. Gundlach said, he and his group contacted clients by looking them up on Google.

In the January interview, Mr. Gundlach acknowledged he had made "very preliminary" inquiries into starting his own business while still employed at TCW. Able Grape LLC, the company that would ultimately become DoubleLine, was registered in Delaware on Oct. 23.

(By ELEANOR LAISE, from WSJ, February 27,2010)

Friday, February 26, 2010

Reflection Series: Goldman, J.P. Morgan Economists Debate Shape of Recovery

The recession might be over, but how goes the recovery?

Wall Street Journal posed that question to two prominent Wall Street economists with two very different views of 2010. Bruce Kasman, chief economist at J.P. Morgan, sees the U.S. growing at about a 3.5% pace for most of next year. That appears optimistic compared to Jan Hatzius, chief economist at Goldman Sachs, who sees gross domestic product growth of 2% or so at the start of the year tapering off to just 1.5% by year-end.

The following is an edited transcript of their remarks during a recent conference call with The Wall Street Journal.

Looking ahead to 2010, what kind of recovery do you see?

Kasman: We’re going to get more growth than people expect, but a lot less than we need. The power of a business cycle, once policymakers are committed to supporting growth and once activity levels get down so low that even modest changes in behavior start to give us a lift, should not be underestimated. Deep recessions have been followed by strong growth [because] those dynamics start to gather some steam. At the same time, even if we’re talking 3.5% to 4% growth, that’s not going to put us in a position 18 or 36 months from now to feel as if we have a labor market that will look anything like it used to over the last 20 years – I think that would take sustained growth in the 5-6% range for three or four years, which we did deliver coming out of the mid-70s and early-80s recessions, so it has been done.

Hatzius: I think we’re going to lose a lot of short-term stimuli and the headwinds to a stronger pickup in underlying demand are, I think, pretty formidable and much more formidable than what you saw, for example, in the mid-1970s or early ‘80s when you had a lot more pent-up demand. I think it’s just a very different business cycle and extrapolating from the history of the ‘70s and early ‘80s I don’t find that promising on the forecasting front.

Kasman: What is similar, I think, in this cycle that has been consistent across cycles is that we get to a point in which the adjustments in housing, in manufacturing, in the retail sector become very sharp and with a little bit of help from policy and an improvement in financial market conditions that provides an opportunity for a lift – and I think now that’s what we’re starting to see take place.

Hatzius: We do have some improvement [in our forecast] and I do think there will be some healing on the surface but I don’t think it’s enough to offset the loss of the stimulus that’s been behind a large part of the improvement we’ve seen over the last six or nine months.

How does your forecast play out for the labor market? Any chance job creation could be stronger than expected?

Kasman: I think the labor market will improve – we’re looking to see jobs begin to be created [on net] sometime early next year – but even with our upbeat view on growth, at the end of next year we’re still sitting with over a 9% unemployment rate so this lift doesn’t really do a lot to dig us out of the hole of the jobs that have been lost in this recession.

Hatzius: I also think we’ll probably start to see some job growth in the course of 2010, starting in the second quarter, but we’ve got the unemployment rate rising through 2010 and that’s a direct reflection of the fact that GDP growth just isn’t strong enough [to bring the rate down]. In our forecast the unemployment rate grinds higher to about 10.5% by the end of the year.

So even if we get the kind of growth Mr. Kasman is forecasting, it seems like high unemployment and other slack in the economy could keep the Federal Reserve from raising interest rates next year.

Hatzius: I don’t have any [rate] hikes in my forecast and if my view on the economy is right then I think the probability of rate hikes is extremely low. I think I’d have to be wrong by a reasonably sizeable margin to get hikes from the Fed next year.

Kasman: We also don’t have the Fed tightening next year although I do think they will be using some levers on the balance-sheet side, particularly with the “reverse repo” plan which we very well think could happen before the middle of next year. The Fed will be seeing growth but will still be watching very high unemployment and core inflation, which could slip below 1% next year. The Fed’s job here is to reflate the economy and I think when they see success on that front they’ll start to act potentially aggressively, but we don’t have the Fed tightening until sometime in early 2011.

Hatzius: I think the risks are tilted towards deflation. We have core inflation falling through next year to close to zero, and if we were to get another downturn in the economy over the next few years then I think the risk of deflation – a painful deflation – is something you cannot dismiss. The Fed has essentially an unlimited ability to tighten policy in response to upside surprises on inflation and output but their ability to provide more stimulus to avoid deflation is much, much more limited.

It sounds like despite your diverging views of growth next year, you both think more needs to be done to stimulate the U.S. economy. Even the “optimistic” outlook here isn’t really expecting a strong recovery.

Hatzius: There’s a good chance that [more stimulus] is going to be the conclusion, at least on the fiscal side, in 2010 and I think it’s appropriate to think about that because you’ve got an economy that is very, very badly underutilized. On the monetary side, I think there’s a case for doing more as well.

Kasman: Where I think we differ is that we [at J.P. Morgan] have some more confidence that in a world of very depressed levels of activity, in which you get more lift from modest changes on the part of businesses and households, I do think we have a business cycle that’s got some power behind it and we should respect what that’s likely to deliver at least for the next three to four quarters. But I would agree with Jan that if his forecast is tracking there’s a need and I think an important need for more stimulus.

Hatzius: The one thing that would be desirable ultimately would be a weaker currency. The boost that the U.S. is getting via the export side at current exchange rates is still pretty limited, and helping that case along through the currency side would certainly be welcome. I wouldn’t say dollar depreciation is at all worrisome – I think it would actually be quite welcome. What we’ve seen over the past few months [with the dollar’s decline] to me looks like a good thing rather than a bad thing.

Kasman: I agree with the importance of helping trade from our demand markets globally. We basically lifted emerging Asia out of its crisis in the 1990s – at least, we smoothed the pain there – and I think there’s an opportunity for the reverse to happen now. Domestically, I think it would be quite dangerous to remove stimulus too early, so I think the idea that there should be early adjustments on the part of the Fed in a world of low inflation and high unemployment is a mistake here – we just have to stay the course and let the private economy make its adjustments, and provide support for those adjustments to take place.

(from Real Time Economics, October 29, 2009)

Thursday, February 25, 2010

The future of public debt: prospects and implications

by Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli

This paper was prepared for the Reserve Bank of India's International Research Conference "Challenges to Central Banking in the context of Financial Crisis", Mumbai, India, 12-13 February 2010.


The financial crisis that erupted in mid-2008 led to an explosion of public debt in many advanced economies. Governments were forced to recapitalise banks, take over a large part of the debts of failing financial institutions, and introduce large stimulus programmes to revive demand. According to the OECD, total industrialised country public sector debt is now expected to exceed 100% of GDP in 2010 - something that has never happened before in peacetime. As bad as these fiscal problems may appear, relying solely on these official figures is almost certainly very misleading. Rapidly ageing populations present a number of countries with the prospect of enormous future costs that are not wholly recognised in current budget projections. The size of these future obligations is anybody's guess. As far as we know, there is no definite and comprehensive account of the unfunded, contingent liabilities that governments currently have accumulated.

Should we be concerned about high and sharply rising public debts? Several advanced economies have experienced higher levels of public debt than we see today. In the aftermath of World War II, for example, government debts in excess of 100% of GDP were common. And none of these led to default. In more recent times, Japan has been living with a public debt ratio of over 150% without any adverse effect on its cost. So it is possible that investors will continue to put strong faith in industrial countries' ability to repay, and that worries about excessive public debts are exaggerated. Indeed, with only a few exceptions, during the crisis, nominal government bond yields have fallen and remained low. So far, at least, investors have continued to view government bonds as relatively safe.

But bond traders are notoriously short-sighted, assuming they can get out before the storm hits: their time horizons are days or weeks, not years or decades. We take a longer and less benign view of current developments, arguing that the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point. In the face of rapidly ageing populations, for many countries the path of pre-crisis future revenues was insufficient to finance promised expenditure.

The politics of public debt vary by country. In some, seared by unpleasant experience, there is a culture of frugality. In others, however, profligate official spending is commonplace. In recent years, consolidation has been successful on a number of occasions. But fiscal restraint tends to deliver stable debt; rarely does it produce substantial reductions. And, most critically, swings from deficits to surpluses have tended to come along with either falling nominal interest rates, rising real growth, or both. Today, interest rates are exceptionally low and the growth outlook for advanced economies is modest at best. This leads us to conclude that the question is when markets will start putting pressure on governments, not if. When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways? In some countries, unstable debt dynamics, in which higher debt levels lead to higher interest rates, which then lead to even higher debt levels, are already clearly on the horizon.

It follows that the fiscal problems currently faced by industrial countries need to be tackled relatively soon and resolutely. Failure to do so will complicate the task of central banks in controlling inflation in the immediate future and might ultimately threaten the credibility of present monetary policy arrangements.

While fiscal problems need to be tackled soon, how to do that without seriously jeopardising the incipient economic recovery is the current key challenge for fiscal authorities. We believe an important part of any fiscal consolidation programmes are measures to reduce future liabilities such as an increase in the retirement age. Announcements of changes in future programmes would allow authorities to wait until the recovery from the crisis is assured before reducing discretionary spending and improving the short-term fiscal position.

The remainder of this paper is organised into four sections. In section 2 we present an examination of the recent build-up of public debt. Following the facts, we turn to a forward-looking examination of the public debt trajectories in industrial countries. In section 4 we discuss the challenges these possible future debt levels pose to both fiscal and monetary authorities. The last section concludes.

Full publication (PDF 21 pages, 187 kb)


Monday, February 22, 2010

Hedge Fund Holdings Update from Goldman

First, Goldman's summary of the the results:

Hedge Fund re-risking slowed following large increases over 2009

Hedge fund long equity assets appreciated by 3% in 4Q compared with a 6% return for the market suggesting levered funds were net sellers. Funds now own 3.8% of the Russell 3000 index compared with 2.9% in 4Q 2008.

Little change in net long exposure and net weighting in cyclicals

Hedge fund net long exposure increased only modestly to 42% in 4Q from 40% in 3Q. Net weighting in cyclical sectors rose to 73% from 72% last quarter. Funds rotated within the cyclicals, moving out of Information Technology and into Industrials and Consumer Discretionary.

Hedge funds rotate into Industrials and out of Info Tech

Hedge funds are underweight Information Technology for the first time since 2005 when comparing their net weighting with the Russell 3000. Hedge funds lifted their net weighting in Industrials to 9% from 6% during 4Q, the largest increase of any sector, but they remain net underweight.

And with that preamble out of the way, here are the relevant charts.

In Q4, hedge funds started to rotate out of IT and defensive sectors, and rotate into cyclicals, mostly industrials. Additionally, after surging from Q2 to Q3, net long exposure, at 42%, has commenced to plateau. Most notable, HF ownership of US equities has hit an inflection point and is now declining.

A more detailed look into IT and industrial exposure, as well as specific stocks in these industries. IT stocks getting thrown out with the bathwater include NSM, FIS, EBAY, FFIV, and ONNN. On the other end, Industrials which have gotten the valueinvestorclub stamp of approval are SWK, AONE, FDX, ITT and BUCY.

Next up, is the Goldman Sachs VIP list, or the names that "most frequently appear among the largest 10 holdings of hedge funds." No surprises here: this is groupthink central. The contrarians among you will be shorting the following names with reckless abandon: AAPL, PFE, BAC, GOOG, JPM, MSFT, MA, DTV, WFC, CVS (after all, the pre-marginal buyers are in. At this point it is just the retail investors left to provide marginal buying).

Next, Goldman looks at the most concentrated Hedge Fund holdings: i.e., the stocks whose holders are primarily represented by hedge funds.

And, inversely, here are the stocks most hated the most by hedge funds:

Next up, let's not forget the short side. Here is how Goldman estimates hedge fund short exposure:

Short positions shed light on the “other side” of fund portfolios

We combined $621 billion of single-stock and ETF long holdingin 13-F filings of 627 hedge funds with our estimate of hedge fund short positions (based on $425 billion in single-stock, ETF and market index short interest positions filed with exchanges). We estimate hedge funds accounted for 85% of total short interest positions, or $361 billion as of December 31, 2009. Our analysis suggests the typical hedge fund operates 42% net long, up from 40% in 3Q 2009 and up from 21% at year-end 2008. Part of the short positioning is conducted at the market level via ETFs.

Short positions offer more comprehensive insight to hedge fund sector tilts. Our analysis of short interest data suggests that hedge fund sector net exposure may differ from what 13-F filings indicate. For example, Energy represents 9% of hedge fund long holdings, underweight relative to the Russell 3000. However, hedge funds hold a relatively small amount of shorts in the sector, suggesting that funds are actually neutral Energy on a net basis.

Hedge Funds appear net underweight Info Tech for the first time since 2005. Hedge funds appear to hold a 16% net weighting in Info Tech versus 20% weighting in the Russell 3000. Hedge funds reduced exposure to Info Tech on the long side (17% vs. 19% in 3Q) and increased allocation to the sector on the short side (18% vs. 17% in 3Q). Hedge funds were last underweight Info Tech in 2005 although funds were neutral in 2007.

Financials appears neutral on the long side of hedge fund portfolios (16% vs. 16% Russell 3000 weighting). However, short interest data indicates that Financials also accounts for 19% of all short positions, the highest weighting of any sector. This suggests that funds indeed “hedge” their Financials exposure. Combining long and short data, hedge funds appear to hold a 12% net weighting in Financials.

Industrials net long exposure rose to 37% from 26% last quarter. Although Materials and Telecom Services represent just 9% of gross assets, Hedge Fund have the highest net long exposure to these two sectors, consistent with the previous two quarters.

We believe hedge funds account for the vast majority of short positions. The steady growth of shorts in the US equity market during the past eight years has accompanied the rise in hedge fund assets (see Exhibits 15 & 16). We estimate that hedge funds account for 85% of all short positions. In the future, mutual funds may become a larger share of the short market, given initiatives such as 130/30 programs. Short interest for the S&P 500 declined over the second half of 2009. Currently, 2.1% of equity cap is held short while the short interest ratio remains at a 10-year low.

We construct a “typical” long/short hedge fund portfolio. Combining our hedge fund long and short data, we constructed two 50-stock equal-weighted portfolios (one long and one short) in an attempt to replicate a “typical” hedge fund (see Exhibits 17 and 18).

We acknowledge certain limitations to our hedge fund short position analysis. There is time delay, as short interest is filed bi-weekly with the exchanges and released with a 10-day delay. The short interest information we have represents positions reported by U.S. broker/dealers. Broker/dealers incorporated outside the US do not have to report their positions. Swaps and other derivatives are also not captured in this analysis.

For all you "alphaclone" fans, or whatever it's called, who think there is some incredible complexity to recreating a hedge fund portfolio, here is the typical hedge fund long portfolio.

And yes, there is short exposure too.

Some interesting observations from Goldman on ETFs. We will have substantially more to say on this topic tomorro, not so much for hedge funds, as for firms like Goldman itself.

Hedge funds appear to use ETFs more as a hedging tool than as a directional investment vehicle, based on our analysis of 13-F and short interest filings. We estimate that hedge funds hold $84 billion in gross exposure to ETFs, compared with $982 billion of gross exposure to single-stocks.

The $65 billion of short ETF positions accounts for 77% of the hedge fund gross ETF exposure. In contrast, single-stock short positions ($310 billion) represent 34% of hedge fund gross single-stock positions. The most shorted ETFs tend to be index hedges (representing $32 billion of the $65 short positions). Commodity-related ETFs appear to be the only ETFs that hedge funds utilize on the long side.

ETFs now represent 3% of long assets, down from 6% in 1Q 2009. This is consistent with a falling correlation environment, in which stock-picking comes into focus.

And here are some summary tables.

First - the 50 stocks with the largest number of hedge fund investors.

The stocks with the greatest hedge fund rotation in and out of their holdings.

Listing out the small cap (under $1 billion mkt cap) stocks with the largest hedge fund concentration.

And large cap...

The top 50 stock seeing the greatest hedge fund inflow:

And outflow:

This chart may be the most relevant to many of you, who are focused on capturing the short squeeze in the small caps, where violent moves to the upside on a concerted effort to trap shorts, have worked so well on so many occasions.

And here are the big cap stocks with the biggest short interest:

Lastly, here are the top 100 hedge funds listed by Equity assets (not AUM, and excluding credit and other holdings). Note that of the top 10 HFs, there are 4 quant names, 5 if in the top 11. Of the top 11 hedge funds, which control $160 billion in Equity assets, 5 of the names are quants and these have $102 billion in equity assets. Roughly 63% of equity assets in the top 10, well 11, are controlled by quants.

(from ZeroHedge, February 22, 2010)

Saturday, February 20, 2010

Business Insider Interview: China – Speed 3?

Vitaliy Katsenelson, Director of Research / Portfolio Manager at Investment Management Associates, Inc (IMA) a value investment firm based in Denver, Colorado, was interviewed on BusinessInsider about China.

Gold as a Global Real Store of Wealth

1. Alan Greenspan, 'Gold and Economic Freedom' (1966)
"In the absence of a gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good and thereafter decline to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as claims on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to be able to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."

2. A Note on Government Gold Policies

"Governments can achieve a welfare gain roughly equal to that from an immediate sale through alternative policies. One such policy is specified in the bottom panel of Chart 5. Under this alternative policy, governments loan out all their remaining gold in each period. In the future when all gold now owned by private agents, whether above or below ground, has been used up, governments sell in every period whatever gold is necessary to make the price be what it would have been if they had sold all their gold immediately. The quantities of gold available for private uses are the same under the alternative policy as with an immediate sale. However, there is an important difference: under the alternative policy, governments relinquish title to their gold in the future and then only gradually. Therefore, to the extent that government uses can be satisfied by owning gold but not physically possessing it, most if not all of the gains associated with maximizing welfare from private uses can be obtained with little or no reduction in welfare from government uses until sometime in the future."

Please read the entire PDF for far more information. This is but one of quite a few government and Fed papers that may be quite revealing.3. More from the United States Federal Reserve:

4. Greenspan's admission is still posted at the Fed's Internet site:

5. Barrick's confession posted at GATA's Internet site:

6. Maybe the most brazen admission of the Western central bank scheme to suppress the gold price was made by the head of the monetary and economic department of the Bank for International Settlements, William S. White, in a speech to a BIS conference in Basel, Switzerland, in June 2005.

There are five main purposes of central bank cooperation, White announced, and one of them is "the provision of international credits and joint efforts to influence asset prices (especially gold and foreign exchange) in circumstances where this might be thought useful." White's speech is posted at GATA's Internet site:

more at

7. The paper from University of Albany professors Faugère and Van Erlach "The price of gold: a global required yield theory" . The authors observe that gold is priced to yield a constant after-tax real return related to long-term productivity as defined by real long-term GDP/capita growth.

We construct a gold valuation theory based on viewing gold as a global real store of wealth. We show that the real price of gold varies inversely to the stock market P/E and thus is a direct function of a global yield required to achieve a constant real after-tax return equal to long-term global real GDP per-capita growth. We introduce a new exchange rate parity rule based on the equalization of inverse stock market P/Es (required yields) across nations. Foreign exchange affects the price of gold to the extent that required yields and Purchasing Power Parity equalizations do not take place across nations in the short run. A quarterly valuation model is constructed using concurrent economic data that is within 12% mean percentage tracking error from real U.S. gold prices from 1979– 2002. Several major world events have had a large but fleeting impact on gold prices.

In the long run, the gold mining industry’s real profit margin is constant and equals the real per capita productivity. The price of gold, on average, must be the average production cost plus a constant mark-up. Furthermore, in order for the real value of gold to be maintained on a per investor basis, the stock of gold has to grow at a rate that can be no greater than population growth in the long-term. If the supply of gold grew at a lesser rate than population growth for reasons other than depletion of the exhaustible ore, gold price would grow faster than inflation and the quantity demanded for gold would drop. Eventually the supply of mined gold will dwindle, which will drive prices up unless world population experiences zero growth in the foreseeable future. In that circumstance, far off in the future, a substitute medium of storing value may be discovered and used.

Another prediction of our theory of gold pricing is that the decrease in proportion of gold total value as compared to world wealth is explained by RYT in the fact that relative to financial assets, the long-term nominal value of gold must increase at the inflation rate, whereas the value of other assets rise with inflation plus real productivity
. Thus, the proportion of investable wealth declines at an annual rate equal to real per share earnings growth or GDP/capita growth.

Full paper by Faugère

Friday, February 19, 2010

Where Will the Growth Come From?

Roubini: Dollar Will Not Weaken Much From Now On, Where Will the Growth Come From? It Won't

* The question is whether China will have a soft landing or a hard landing. There were two episodes of China tighteninglatelty, in 2004, when there was a soft landing, and in 2007, when there was a hard landing. He thinks this time it will be like 2007.
* The reported 5% GDP growth was due to inventories
* US growth will slow down in 2nd half of the year as stimulus dies down
* Dollar will not weaken much, where is the growth coming from?

Tuesday, February 16, 2010

Bruce Krasting is commenting on revaluation of Yuan

In my yearend projections for 2010 I said (among other things) the following:

-China will surprise us all and revalue the Yuan by 10%. The currency will still be undervalued.

On Monday morning Bloomberg has a story out quoting Goldman’s Chief European Economist as saying:

Feb. 15 (Bloomberg) -- Goldman Sachs Group Inc. Chief Economist Jim O’Neill said China may be poised to let its currency strengthen as much as 5 percent to slow the world’s fastest growing major economy.

I doubt that Mr. O’Neill is making a guess here. I think he may have some real insight on this. When he says this, I listen:

“I have a strong opinion that they’re close to moving the exchange rate,”

Say this story is true and in the not too distant future China will adjust its currency against the dollar by a reasonably significant amount. Assume that they move by 5%. What might this mean in the scheme of things? What are the market implications, if any? Just some thoughts.

-If China does do something significant, it is another sign that should not be avoided. Something is up with China. They are changing direction. A currency move this week followed by the monetary moves last week is a clear indication that things have heated up, and they don’t like it. The two steps (assumes currency reval.) would prove that Chanos etal. were right all along. There is a bubble.

-If you were China Inc. and you owned the IOU’s behind a monster amount of empty buildings (and cities) the last thing you would do is to strengthen your currency and tighten monetary policy. But if the arguments in favor of reversing stimulus outweigh the consequences of extending fast money policies then it is not hard to predict that those empty buildings will remain so for a while to come. There would appear to be some urgency to the Chinese steps, should they occur.

-Should this happen it would come at a very inconvenient time. China’s currency is tied to the dollar. The dollar his risen against the Euro by 10% in the last two months. Therefore China’s currency has risen by the same amount against the Euro Zone. That is a big market for China’s exports. If they revalue against the dollar by 5% and the dollar stays where it is they will have taken a 15% hit on the terms of trade in just 60 days. If I were China I would be putting out the story, “Our currency is up 10% versus half the world. Stop yapping at us to make it higher still”. So that makes the timing of this (should GS be correct) very suspicious in my mind.

-All else being equal I would rate this a win-win for the Euro Zone and Brazil (again), a win-lose for the USA and a lose-lose for China. For the US it might be of some benefit to the big exporters, but I doubt it. Any improvement on pricing will be offset by a reduction in demand. For all of those Wal-Mart and Home Depot shoppers beware. Prices are going up.

The market outlook on this is murky for me. There are some checks and balances to this that could in theory bring some stability. Everyone has been leaning on the Chinese to hike their currency. So if they were to do it the spin would be, “Hey! Here’s some Good News!” I don’t see it that way.

-Last week the market tanked on the news that China was moving on reserves. This is no different. So if it was bad last week. It will be bad this week too.

-Should this happen it raises a big question about the HK dollar. Logically that would have to be re-pegged as well. Should that not take place I would expect a mega move into the HK$. I can’t imagine that the Central Bank will accommodate that.

The money flow to Hong Kong has been big and steady for some time. The reserves were $206B as of 12/31/2009. Should there be an adjustment in the HK$ rate there would be some very big overnight profits. At some point thereafter the reserve flow would reverse to more normal levels. Say 50% or $100b. That just means there is one less buyer of US Treasury bills at the next auction. Most of the hot money that went to HK was borrowed, so when the short-term flows are reversed the margin debt is paid down. There is no new or alternate buyer of those Tbills.

-China was supposed be a global engine for growth. Whatever your expectations were on that score a week ago you must revise them down today. A year ago there was all the talk of green shoots. There were many of them. China tightening its belt at this time and at this pace is a brown patch. In Europe there are dead tumbleweeds blowing around. These things do not make for an improving growth story.

-Using the wisdom of purchasing power parity an argument could be made that the Euro would be a tad undervalued should the Chinese move. I don’t see that happening either. Much to the chagrin of the Chinese the dollar could go right on rising. To hell with purchasing power parity.

-If you read the Chinese steps as deflationary, it has to be bearish for the commodities. They have all been backing up. This could cause that to continue.

-Gold could be interesting. Say the thoughts on the dollar were right and we move toward 1.30. Say the commodity markets followed that lead. That would imply that gold should move lower in sympathy. I would watch that one. These things that may be coming are on the side of the shelf that is marked: DESTABILIZING. I am not sure if this will come into the gold equation at this time. It will soon enough.

-In this environment the TLT is not the place to be. Not yet.

-On paper this could mean that China has less exports and more imports. Should that be the case their reserves will stop growing. Who is it that is going to be buying all of the paper that is being created by all of the debtors in 2010? At the moment I am having trouble of thinking of any ‘size’ buyers. Possibly Ben B will have to add some more demand to meet the supply. That would be very big tumbleweed.

The GS report got me to write these thoughts. This is all just blue-sky thinking. Probably nothing will come of it. I hope not.

(from Bruce Krasting's blog, February 25, 2010)

Monday, February 15, 2010

David Weidner's Writing on the Wall: Citigroup's new plan: profit from the next crisis

Citigroup Inc. , our taxpayer-funded national bank, is readying a new credit derivative, the CLX. Basically, the CLX is systemic risk insurance that will pay out in the event of a financial crisis. The basic premise is to allow investors to hedge against a spike in funding costs.

Citi's Vikram Pandit

According to Risk Magazine "the CLX is constructed as a sum of the Sharpe ratio -- deviations from the mean divided by volatility -- of various market factors, such as equity volatilities, Treasury rates, swap spreads, corporate bond swaption-implied volatilities, and structured credit spreads. Citi will make the CLX tradable by using fixed historical values for the mean and volatility parameters, eliminating the need for costly recomputation from lengthy time series." Read Risk Magazine story on the CLX.

If you understood the last paragraph, please take two bailouts, a bonus and call your Treasury Secretary in the morning.

Citigroup says CLX is based on six indexes. It's still in the planning stages, but it won't put the firm at risk. Citi's considering building it at the request of customers it considers sophisticated enough to use CLX wisely. Citi just wants to make a market in CLX. It will buy when there are no buyers, sell when there are no sellers. Citi says its role will be neutral. They may even bring other brokerages in to spread the risk.

Sorry, but the CLX sounds a lot like what got Wall Street into trouble in the first place. Complicated derivatives, including collateralized debt obligations, synthetic CDOs and credit default swaps, ripped apart balance sheets and drove financial institutions such as Citigroup into the arms of taxpayers.

Investors, swayed by Wall Street sales pitches touting the safety of these securities, had little understanding of the risks these securities held. And who can blame them? When you look at the CLX, it's not exactly clear on what it's based and who's really carrying the risk.

But the complexity is only part of the problem.

Barry Ritholtz, the well known blogger and investor, points out on his Big Picture blog that "Any insurance product, CDS, any contract is only as a good as the financial condition of the contraparties. Any insurance product designed to pay off in the event of a financial crisis becomes increasingly unlikely to do just that...We already have systemic risk insurance. Only, it's not from Citi, it's from Uncle Sam." See blog post by Ritholtz.

The point is, when push comes to shove, will there be a market for the CLX? Won't most of the institutions buying them be in trouble if they need to cash out? And who cashes them out, Citi? How much is Citi going to set aside to cover potential losses?

Citigroup, denies that it's putting taxpayers at risk. Rather, it might have the opposite effect: for example strengthening an insurer when borrowing costs soar.

But a lot of finance pros have looked at this and they say the way CLX is laid out, there doesn't seem to be any specific party responsible for paying on the contracts. If it's Citi, what happens if Citi can't pay? Under proposed reforms, Citi would be too big to fail and get a bailout if it ran into CLX trouble.

You, dear taxpayer, may be the ultimate counterparty to this "innovation."

CLX raises a lot of questions, but let's add one more. Where are the regulators?

For months, we've been hearing how there's been a regulatory crackdown on Wall Street. Agents from the Securities and Exchange Commission, the Commodities Futures Trading Commission and Federal Reserve allegedly are swarming institutions such as Citigroup. They're pushing banks to build up capital, reduce leverage and cut the risk-taking.

Federal Deposit Insurance Corporation (FDIC) Chairman Sheila Bair

Testifying before the Financial Inquiry Commission, Lloyd Blankfein, chief executive of Goldman Sachs Group Inc., told lawmakers that his firm was under more scrutiny than ever, especially from the Fed.

More regulation was the tradeoff made in the fall of 2008 when the Fed offered cheap money and protection to institutions such as Goldman and Morgan Stanley by giving them a banking charter.

Citigroup CEO Vikram Pandit reportedly nearly lost his job because of one dissatisfied regulator, Sheila Bair, the chairman of the Federal Deposit Insurance Corp. She might want to revisit the subject, given how CLX could impact the bank's $303 billion in U.S. deposits. Read WSJ report on Bair and Citigroup.

Citi says regulators have been given CLX for consideration. So far, they haven't passed judgment.

(from, February 16, 2010)

Thursday, February 11, 2010

Sergey Aleynikov was indicted

Sergey Aleynikov was indicted today on charges that he stole the secrets to the bank's closely guarded high-frequency trading platform.

The platform, according to the indictment, gave Goldman Sachs a "competitive advantage" by executing high volumes of trades at breakneck speeds. Aleynikov, who could face 25 years in jail, was in charge of a group of computer programmers who maintained the bank's trading platform. The platform reportedly generated "many millions" in profits each year.

According to the indictment, Aleynikov went to work for Teza, a newly-formed firm in Chicago, in April of 2009, and was tasked with developing a high-frequency trading platform for the company. With a pay package totaling $400,000 at Goldman Sachs, Aleynikov was certainly already well-compensated. Teza, however, offered him a guaranteed salary of $300,000, a guaranteed bonus of $700,000 and a profit-sharing agreement that was worth about $150,000.

Prosecutors from the U.S. Attorney's office in Manhattan allege that Aleynikov, after 5 p.m. on his last day at Goldman Sachs, "executed the transfer of thousands of lines of source code for Goldman's high-frequency trading system." And, the indictment alleges, he skirted Goldman's security apparatus by uploading the source code files to a server in Germany.

Aleynikov then encrypted the files and, several days later, logged onto a computer from his home in New Jersey and downloaded Goldman's proprietary data. He then carried that data into a meeting with Teza workers, according to the indictment.

In November, the government indicated that it was discussing a plea deal with Aleynikov that might have resulted in little or no jail time, reported Reuters.

Zero Hedge wonders whether or not a trial will reveal some crucial details of Goldman Sachs's secret sauce:

"The indictment comes at a time when most observers had expected this case would be settled quietly, as the prevailing sense was the Goldman had no actionable case, especially after numerous months of court delays.

The question now is how much information will be made available for discovery, and how much will be filed under Seal so that no additional Goldman HFT secrets enter the public domain."

READ the indictment:

Aleynikov_ Sergey Indictment -
full screen

Secular Trends Diverge: US - Bear, Emerging Markets - Bull

Puru Saxena, CEO of PuruSaxena Wealth Management expressed his view on the secular trends of US and Emerging Markets.

Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action. Puru Saxena is the founder of Puru Saxena Limited, his Hong Kong based firm which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.

Wednesday, February 10, 2010

Controlled Emotions

In some situations, brain images of drug addicts are indistinguishable from those of traders, a researcher has found.

It is easy to dismiss Jérôme Kerviel, the rogue trader at Société Générale, as a fluke.

So here is a sobering thought for Wall Street: There may be a bit of Mr. Kerviel in all of us.

A small group of scientists, including some psychologists, say they are starting to discover what many Wall Street professionals have long suspected — that people are hard-wired for money. The human brain, these researchers say, responds to high-stakes trading just as it does to the lure of sex. And the riskier the trades get, the more the brain craves them.

French prosecutors have likened Mr. Kerviel’s trades to a drug habit. That is no surprise to Brian Knutson, a professor of psychology and neuroscience at Stanford University and a pioneer in neurofinance, an emerging field that combines psychology, neuroscience and economics, to examine how the brain makes decisions.

Mr. Knutson has sent volunteers through high-power imaging machines to map their brains as they trade. He concludes that sometimes, people get high on making money.

“The more you think you can gain from the risk, the more you take the risk and the more activation in the circuitry,” Mr. Knutson said.

Neuroeconomics has not won many converts on Wall Street. Researchers like Mr. Knutson have yet to show how their work can be applied effectively in the markets. And some academics question whether the field is of any use in economics.

“Economics is about equilibrium, and supply and demand, and forces that come to some stabilized system,” says Stephen A. Ross, the Franco Modigliani Professor of Finance and Economics at the Massachusetts Institute of Technology. “It’s not about atoms or how little people behave.”

Even so, the field seems to be gaining some traction. Last year Jason Zweig, who edited the 2003 edition of “The Intelligent Investor” by Benjamin Graham, wrote a 352-page book entitled “Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make Your Rich.”

One of his findings was that brain images of drug addicts who are about to take another hit are indistinguishable from those of traders who are making money and about to place another trade. “That tells us pretty confidently that if you make money and make money again,” Mr. Zweig said, “it is very similar to a chemical addiction and it becomes very hard to let go.”

Mr. Kerviel, 31, told prosecutors that he was thrilled when his surreptitious trades in European stock index futures began to pay off. By late December, he had made a profit of about $2 billion. “That produced a desire to continue,” Mr. Kerviel said. “There was a snowball effect.”

But when the markets turned against him, Mr. Kerviel made an all-too-common mistake: He refused to cut his losses, which would balloon to more than $7 billion as the bank frantically unwound his positions on Jan. 21-22.

Daniel Kahneman, a Nobel Prize-winning psychologist, showed that individuals do not always act rationally when faced with uncertainty in decision making. When faced with losses, individuals may seek to take more risk rather than less, contrary to what traditional economic thought might suggest.

“When you are threatened with extinction, you act like nothing matters,” said Andrew Lo, a professor at M.I.T. who has studied the role of emotions in trading. Mr. Kerviel, he said, is a case study in loss aversion.

Mr. Lo and Dmitry V. Repin of Boston University have studied traders to determine how stress and emotions affect investment returns. They monitored traders’ vital signs like heart rate, body temperature and respiration as their subjects darted in and out of trades.

The findings, while preliminary, suggest — perhaps unsurprisingly — that traders who let their emotions get the best of them tend to fare poorly in the markets. But traders who rely on logic alone don’t do that well either. The most successful ones use their emotions to their advantage without letting the feelings overwhelm them.

“The best traders are the ones who have controlled emotional responses,” Mr. Lo said. “Professional athletes have the same reaction — they use emotion to psych them up, but they don’t let those emotions take them over.”

Or, as Warren E. Buffett once put it, “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

Of course most traders do not breach ethical boundaries like Mr. Kerviel, who doctored e-mail messages to hide his unauthorized trades. But unbridled ambition and the hit from the money high are a dangerous combination.

People like to think that logic prevails in the financial markets, that traders and investors always act rationally. “Clearly, institutional investors want to believe it’s all scientific,” said Mark W. Yusko, president of Morgan Creek Capital Management.

But Wall Street can get carried away. The Internet boom and bust were followed by an even bigger boom and bust in mortgage lending. Wall Street is now saddled with more than $100 billion in losses stemming from mortgage investments, and the economy may be sliding into recession.

Alpesh Patel, principal at the Praefinium Group, an asset management company, said that when traders get too emotional, they start making bigger, more frequent trades.

“You know you are damaging yourself, and there’s no gain in a financial sense, but the highs from the winning lead you to take bigger risks,” said Mr. Patel, who has written 11 books on trading psychology and risk management.

Legendary Wall Street traders like Steven A. Cohen and Julian H. Robertson Jr. are students of human emotion. Mr. Cohen, who runs a $15 billion hedge fund called SAC Capital Advisors, keeps Ari Kiev, a psychiatrist, on hand to work with his legions of traders, people from SAC say. (Dr. Kiev declined to say whether he worked for Mr. Cohen’s firm.)

Mr. Robertson, the founder of Tiger Management, which at its peak in 1998 managed $22 billion, turned to a psychoanalyst, Dr. Aaron Stern, to test and evaluate Tiger’s traders.

Dr. Kiev, author of the forthcoming “Mastering Trading Stress: Strategies for Maximizing Performance,” said many traders, professionals and everyday investors alike, fail to manage their risks.

“It is more common for people to hold onto losers and see their investment go to zero, or shorts go to the sky, than it is for them to practice good risk management and get out,” Dr. Kiev said.

(from, February 7, 2010)

Reflection Series: Strong USD in 2010, but not for a good reason

Nouriel Roubini, and top fixed income manager, Jeff Gundlach, possess a contrarian view on the future of the U.S. dollar. While most analysts, economists, traders, investors, and speculators call for ongoing weakness in the greenback, Roubini and Gundlach believe the dollar will rebound and risk-based assets will retreat.

Jeff Gundlach of TCW is Calling for Deflation and Dollar Rally.

One of the few areas he’s bullish on is the U.S. dollar — but not for good reasons.

Gundlach sees such large debt defaults in coming years that he thinks the trend will cut the supply of dollars, pushing up the currency’s value.

“We’re standing on the edge of a major default wave,” he said. “Defaults are the elimination of dollars. You could eliminate so much actual wealth that this could be the source of a strong dollar rally.”

While Gundlach is clearly in the minority with this assessment, one individual who shares this outlook is Nouriel Roubini. What does Roubini see? Much of what Gundlach sees. Bloomberg provides interesting perspective in writing, Roubini Says Carry Trades Fueling ‘Huge’ Asset Bubble,

Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis. “We have the mother of all carry trades.”

“Everybody’s playing the same game and this game is becoming dangerous.”The dollar has dropped 13 percent in the past year against a basket of six major currencies as the Federal Reserve, led by Chairman Ben S. Bernanke, cut interest rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s.

Roubini said the dollar will eventually “bottom out” as the Fed raises borrowing costs and withdraws stimulus measures including purchases of government debt. That may force investors to reverse carry trades and “rush to the exit”.

“The risk is that we are planting the seeds of the next financial crisis,” “This asset bubble is totally inconsistent with a weaker recovery of
of economic and financial fundamentals.”

(, October 28, 2009)

EU will Help Greece in Risk Rollover

Rollover Risk, by David Kotok, Cumberland Advisors Market Commentary February 10, 2010
Tonight on Larry Kudlow’s show I listened to a gang of four first bash Greece, then the ECB and then the EU. They forecast the demise of the euro and the collapse of the EU. I couldn’t disagree more. Today I had to explain to a good friend and client why all $2.8 trillion of US state and local government debt wasn’t going to default. Today the FT said “Connecticut’s Lisbon, New York’s Rome, Georgia’s Athens and Iowa’s Madrid may lack the sense of budgetary crisis being felt lately in their European namesakes, but America’s states and municipalities could yet spark equally vexing problems for the United States. Like the eurozone’s members, America’s states have no currencies of their own to devalue and must tread cautiously between entrenched public sector unions and irate taxpaying voters.” We are witnessing much hyperbole about a crisis of confidence in sovereign debt. We’ve written about it for months. In our view, crises present opportunity. We will continue the dialogue about Greece below. In addition, we can report that our separately managed Muni accounts are full invested in tax-free bonds and in taxable municipal Build America Bonds. We expect that our clients will be fully paid and are amply rewarded for taking the risk of selected sovereign debt. More on Greece below.
Things are getting clearer regarding Greece. The unions are out in the street, as we expected. The Greek government has committed itself to advance the austerity measures in spite of the strikes. The European political organizations are holding much discussion but not committing hard money. So far, so good.
The next test will soon come for the European Central Bank (ECB) and here is where the rubber meets the road. Greece will have to roll over some large proportion of its debt within the next few months. Credit-rating agencies have said they need to see Greece adopt an austerity budget and implement it or they will cut the Greek sovereign rating. They mean it and Greek officials know it.
This brings us to the issue of “rollover risk.”
Rollover risk is the term that applies to governments when they have to refinance. Governments are going concerns. They do not liquidate in a bankruptcy. They perpetually refinance their debt. When governments issue debt over the longer term, like 10 or 30 years, they reduce their rollover risk. That is because only a small portion of the debt is coming due at any one time.
But longer-term debt is usually more expensive than shorter-term debt, because the interest rate that the government must pay is usually higher when the debt is longer term. So governments tend to choose shorter-term debt in an effort to lower cost, and then they “roll” the short term debt over and over. The United States is doing that as this is written, and the amounts involved are measured in the trillions. Greece did it and got away with it, for a while.
Some governments are forced to issue only short-term debt, because markets do not trust them. This is usually true of inflation-prone governments. Italy is a good example. Before the euro zone was created, the Italian government had a history of devaluation of its currency. It cheapened the lira whenever it got into economic trouble. It also had a history of high inflation. The bond markets did not trust the Italian governments and there were many of them in succession. Italy reached the point where it had to roll over nearly its entire issuance of government debt within a single year. And the debt burden was about 100% of the Italian GDP. That is an example of an extreme in rollover risk.
This was in the 1990s and during the formative period of the euro and before the euro actually became a currency, but after the Maastricht Treaty was signed in 1991. In that period the interest rate on Italian longer-term bonds was five full percentage points higher than that on the benchmark German bonds. 500 basis points was the spread between Italy and Germany on ten-year government bonds.
After the euro was fully launched, those rates converged and Italy at one point traded within a few basis points of Germany. Even today, with all the market turbulence, the Italian spread is still much, much lower than it was prior to the euro. Even Greece today is lower by several hundred basis points than its spread was prior to the euro.
What I have just written is well-known and understood in Europe; the memories of the inflation-prone period are fresh. Therefore those countries and governments are not about to go back to the former structure, which was very costly. Let’s assume that is the case.
The risk now ahead is the rollover. Will Greece be able to do it? Will they go to an auction and find that the bids received are not sufficient to cover the issue?
Here is where the ECB can step in and assist if, and only if, the Greek government has put the austerity budget in place. The ECB can finance the assistance needed to accomplish the rollover. Its method is to accept the Greek debt as collateral and to loan to the banks that are buying the debt. The banks will be at risk to a Greek default. The ECB will be at risk if the banks fail. The ECB will likely proceed as long as the credit rating on Greek debt is acceptable under the ECB rules. Thus the ECB can provide the financing so that the debt issue doesn’t experience a failed auction.
We expect this scenario to play out. That means Greece will reach a point where it can refinance, and the market will price in a premium for all the aggravation, but it will not experience a failed financing. The ECB will have held the high ground so that it will be able to maintain the strong and hard money characteristic of the euro as a reliable world reserve currency. We discussed this issue with Steve Liesman this morning on CNBC. See for the tape.
The weakness of the euro combined with the shock experience in European markets is setting things up for a good buying opportunity. It is too soon to do it now, but one must get prepared. Investors will be able to buy fine German companies and do so when the euro has been weakened by the events originating in Greece. European exporters are for sale cheap while their currency is weak. They will be strong competitors for US companies as they sell to Chinese and other emerging market buyers. That can be a real bargain for an investor.
Adversity is the source of opportunity in investing. Rollover risk is the issue for Greece. It will be resolved before the summer equinox ushers in the bright sunshine that warms the Adriatic. Cruise in the Greek Isles anyone?