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Economic/Market Highlights 11/21/08: V-O-L-A-T-I-L-I-T-Y !!

Posted by Larry Doyle on November 22, 2008 4:10 PM |

The fact that the equity markets totally reversed yesterday’s 5-6% selloff is not the biggest story of the day. In short, 400-500 point swings either way have become so normal as to not be a big deal. But they are a big deal and I will explain why shortly.

At 2:30pm the equity markets were basically unchanged. By 3:45pm the equity markets had rallied by 5-6% primarily on the announcement of Tim Geithner, NY Fed chair, as the nominee to be Treasury Secretary, while the other candidate for that role, Harvard professor and former Tsy Secretary for Bill Clinton, Larry Summers will be a senior White House economic advisor. Well done by Barack to get both on the team.

The markets respect Geithner and he will be easily approved. Summers would have faced some grilling for sexist comments he made while President of Harvard as well as the fact that he has already been Tsy Secy and it would have been viewed as “the more things change the more they stay the same”. Geithner obviously knows where all the bones are buried on Wall St. having worked very closely with Paulson over the entirety of this financial fiasco. The transition should be seamless. Geithner and Paulson have different styles but both are respected by Wall St. even if Paulson is not fully liked by Main St. The markets respect Geithner and this is obviously very important.

Read more here as to “Obama Likely to Pick Fed’s Geithner for Treasury.”

While Geithner and Summers are obviously highly respected they are not Houdini and they will not be able to singlehandedly turn our economy or markets around based on their name alone. If they can influence Barack that a cut in the capital gains tax rate along with a freeze in the overall tax rates is in the best interests of our markets, our economy, and our citizens, well maybe I’ll start calling them Harry!!

In the midst of the Geithner news and the rally in equities, I personally think that there was a much bigger trade that occurred today and I will watch closely to see if this trade becomes a trend. When equities were unchanged on the day, 10yr government bonds had sold off by 20bps (a huge move and a reversal of 2/3rds of yesterday’s up move) while gold and silver rallied by 5% and oil had rallied by 2-3%. Gold is now back to $800/oz which means it is virtually unchanged in price over the last 12 months while oil is down almost 50% in the same time period and equities are down 40-50%. While many market participants are highlighting the risk of deflation, I still believe inflation is the greater long term risk. We will watch the price action of these commodities closely.

Let’s get back to where and why the markets are generating all of this volatility. There is no doubt in my mind that the preponderance of hedge funds in the markets is creating most of the volatility. Hedge funds typically have a variety of strategies: one strategy may be a “long/short” (going long one security vs shorting another), another strategy is trading volatility as an asset in and of itself, another strategy would employ “momentum” trading, another strategy would employ using different types of derivatives vs other cash products within the same sector or across sectors. In all these strategies there is some form of leverage employed (using borrowed funds to trade assets) typically anywhere from 2 times leverage to perhaps 10 times leverage. However in virtually all of the strategies employed volatility is created and promoted as a means of garnering profits. Hedge funds make money not only based on assets under management (typically a 2% fee of total assets…a $100million hedge fund earns $2mm in fees) but the bigger vig is in the 20% of profits that accrue to the fund. Thus the funds are VERY ACTIVE traders which on top of the variety of strategies and the leverage = INCREASED VOLATILITY. In addition to those factors, hedge funds only earn the 20% of fee if they clear what is known as a high water mark. That means that if a fund is down 5% one year, they need to make that 5% back the next year before they can start to earn the 20% performance fee. That structure is utilized to protect the investors but what it promotes is the fact that hedge fund managers swing for the fences.

While the equity markets are down 40-45% for the year and bond funds are down 0-20% more or less depending on the asset class, hedge funds in general are “supposedly” down 20-25%. I personally do not believe those numbers. I do not believe them because if even using hedges to offset market risk, the fact that most hedge funds are levered 5-10 times would exaggerate losses. I am not the only “doubting Thomas” when it comes to hedge funds activities and returns. Their compensation system promotes aggressive trading, doubling down, swinging for the fences as opposed to cutting losses. IMO this is an industry that is going to see a number of blowups in 2009 which will lead to badly needed oversight.

Read more here how an investor Sandra Manzke is “Disgusted by Hedge Funds”. I think you will find it enlightening. When you read that funds are setting up side pocket accounts, that to me is code for “hiding losses”.

Company News

1. Citigroup
The biggest company news continuing to roil through the markets is the fate of Citigroup. The stock was down app another 20% today and now 87% for the year and closed at a 3.87.

The board of Citigroup met and announced that they will not look to sell divisions in an attempt to raise capital. A merger with a domestic partner would be difficult given the turmoil in the markets. A merger with a foreign entity may be possible (HSBC perhaps) but that would be politically difficult if one of our largest national banks sells to a foreign entity. It may actually make the most economic sense, though.

Any other options? Oh yeah, our good old Uncle Sam has more than set the precedent as to injecting himself where need be. By every measure and analyst’s take, Citigroup is definitely in the “too big to fail” camp.

The government rescues of Freddie/Fannie, Washington Mutual, and AIG have come at the expense of existing shareholders. However given that F/F are now penny stocks with one line of biz, Wamu is now part of JP Morgan, and AIG is merely trying to buy time to sell assets and divisions which will result in a company that it is a shadow of itself, what is the future for Citi? Having let the genie known as Uncle Sam out of that bottle, just how and when if ever do we get him back in? Rest assured there will be volumes and volumes written about this period in our economic and national history.

For my money, I think the government will inject another $25bln into Citi in the form of preferred stock, guarantee their debts, and proceed to effectively dilute common shareholder equity. They will then declare that it is business as usual but for all intents and purposes they will have nationalized the institution. Ahhh, those enormous embedded losses will kill you every time. … “Where have you gone Joe Dimaggio, our nation turns its lonely eyes to you” !!

2. Berkshire Hathaway
Legendary investor Warren Buffett’s prized jewel Berkshire Hathaway has gotten hit quite hard in this downturn in the market. While Berkshire had been handsomely outperforming the overall market up to the last few weeks it has gotten hit hard and is now down in line with the rest of the biggest blue chip stocks. What happened?

Well, Warren sold puts on the high yield market and our equity market in SIZE. Selling puts allows Warren to collect the premium paid by the buyers of the puts but gives those buyers the option to “put” (meaning “to sell”) the underlying asset or index to him.

Thus Warren collected a lot of premiums (like supposedly on 13bln face value) but effectively got “long” both sectors about 15% higher than where the market is currently trading. That is a big loss and it is reflected in the price of Berkshire over the last two weeks. Warren has staying power but he is not perfect.

3. General Motors
When you are the CEO of a major corporation and you make a blanket statement along the lines of “bankruptcy is not an option” and within 24 hours the board of your company releases a statement that says that they are willing to explore every option, including bankruptcy, “you’re toast”. We’ll never know but I am willing to guess that members of the GM board have already been in discussions with members of the Obama economic transition team who floated the concept of a prepackaged bankruptcy today.

Read more here as to how “Bankruptcy is Option to GM Board”

4.  New York Times
The dividend paid on NY Times stock represents the bulk of the income for the Sulzberger family. Well given everything that is going on in the print media (not good) the NY Times announced that it cut it’s dividend by 75%. Oh well, … perhaps a number of their friends can pay them back for all the favors bestowed the other way over the years. … In all honesty, a number of advertisers that had traditionally used the NYT are now shifting to the WSJ.

Economic News

Goldman Sachs announced revised forecasts for GDP and unemployment.
4th qtr GDP -5%
1st qtr ’09 -3%
2nd qtr ’09 -1%

Unemployment by end of ’09 9%

I think we can wait before buying the market anytime soon…

Don’t be surprised to see news about Citi this weekend, perhaps Sunday evening…

Go Holy Cross beat Colgate for the Patriot League football championship tomorrow!!

Have a nice weekend!!


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