Via Pension Pulse.

I spent the day in Toronto on Thursday visiting pension fund managers with the commodities relative value manager
I met a couple of weeks ago. Went down there by train on Wednesday
afternoon and he gave me a lift back to Montreal after our afternoon
meeting. I was too exhausted to blog late last night so I decided to
write my comment this morning.

Below are my bullet points on this trip (please take the time to read them all):

• I
  took the train down to Toronto. Booked Via Rail business class one way
  and left Wednesday afternoon. Cost me $246.36. If I planned it in
  advance, I could have flown there for less with Air Canada or Porter,
  but it was last minute and I like the train (business class was a perk I
  treated myself to but it wasn't worth it).
• Brought a copy of Dan Ariely's book, The Upside of Irrationality: The Unexpected Benefits of Defying Logic,
  which I highly recommend. The first chapter, Paying More For Less, Why
  Big Bonuses Don't Always Work, is brilliant. Big bonuses are often not
  doled out to the most competent managers who are aligning their
  interests with shareholders (or pension fund beneficiaries).
• Stayed
  with a buddy of mine in Toronto who trades currencies for a living. He
  lives out in Oakville, Ontario, about 30 minutes outside Toronto when there is no traffic. I typically stay at the Fairmont Royal York
  which is downtown and right across the train station, but he insisted I
  stay with him and his family. His wife spoiled me with a nice meal and
  had everything ready for me, including a laptop to write my blog and my vitamin D drops which I forgot back in Montreal (thank you Nancy, you're a sweetheart!).
• On Thursday morning, I had an eight o'clock meeting with Jim Keohane, Senior VP and CIO at Healthcare of Ontario Pension Plan (HOOPP).
  My buddy warned me that we have to leave the house at 6:15 or else we'd
  get stuck in traffic. Woke up at 5:30 naturally but didn't feel great
  and by the time we left it was 7:00 a.m.
• Disaster! The traffic
  in Toronto is horrendous! It took us over an hour and a half to come
  downtown. I emailed Jim to reschedule for a little later in the morning.
  I also emailed Andy Moysiuk, Managing Partner at HOOPP Capital Partners to see if he was available to grab a coffee before my meeting with Jim. Luckily, he was.
• Driving
  in from Oakville and being stuck on the highway, I noticed a lot of
  nice cars on the road: BMWs, Mercs, Porsches, etc. Told my buddy "there
  is a lot of money in this city. He replied: " Yup, no thanks to the
  Parti Quebecois. There are lots of showoffs too. Torontonians are more
  like Americans; they want to display their wealth. Montreal's rich are
  more European, they are a lot more low key" ( a point that Andy Moysiuk
  reiterated during our meeting).
• As we were stuck in traffic, we talked about seeding hedge funds,
  business opportunities in Greece (imports to Canada), and listened to
  some talk show on why women prefer "bad boys" (LOL!). The radio
  commentator read an email from one lady who wrote in "I prefer to have
  great sex for one year with a jerk than make love to a nice romantic man
  for 10 years." My buddy and I looked at each other thinking how some
  women can be so stupid (not that men are any better as many like chasing
  skirts with attitude!).
• Anyways,
  grabbed a coffee with Andy Moysiuk at Mercato, a nice little coffee
  shop right next to HOOPP's offices. Andy is a smart private equity
  investor. I don't agree with all his views on pension investments but he
  knows his stuff, especially in private equity and venture capital.
• We
  didn't have much time. Our discussion was on seeding funds, not just
  hedge funds but funds in general. Andy sees this as a strategic
  partnership. "You're nurturing a business, not just a fund. You want to
  make sure this will be a success, and you want to make sure the manager
  will not pack up and leave at the first sign of trouble leaving you, the
  seeder, holding the bag."
• This is an excellent point. When you
  are seeding a fund, any fund, you are nurturing a business. You want to
  make sure the manager is committed to the business (it's not just about
  managing money). The pension fund is there for the long-term and wants
  to realize gains on their seeding activity. The last thing any pension
  fund manager who seeds a fund wants is to pull the plug fast. They want
  to realize gains on the business as it grows and eventually IPOs.
• I
  also talked to Andy about board governance at pension plans. Told him I
  know he sits on a board of a fairly large church pension fund along
  with Diane Urquhart an several other experts. He told me: "It's a good
  board and well managed fund but every board member brings their baggage.
  The actuaries tend to be overly-sophisticated, sometimes to the
  detriment of the investment process." I can relate. Often, it's best to
  keep things simple.
• My meeting with Jim Keohane, SVP and CIO
  at HOOPP was brief but excellent. Jim is incredibly smart, he really
  knows his stuff across all public and private asset classes. Told him
  that Andy warned me not to trash derivatives but I added: "I have
  nothing against derivatives, only pension fund managers who take stupid
  risks using derivatives".
• HOOPP is a derivatives powerhouse.
  They know exactly how to use derivatives wisely to match assets with
  liabilities, do enhanced indexing, overlay and absolute return
  strategies which they do exclusively internally (no allocations to
  outside funds in public markets and limited ones in private markets).
• I
  asked Jim why not allocate more to outside funds. He replied: "It's all
  about cost of delivery. When I got here 15% was allocated to outside
  managers but they were underperforming the market. By indexing using
  swaps, we got our beta, lowered the volatility and reduced costs
  substantially."
• I told Jim that Leo de Bever did the same thing at AIMCo,
  substantially lowering the costs, but the media in Edmonton harped on
  bonuses he doled out to internal managers (some reporters are so
  stupid!). However, Leo de Bever kept managers in public and private
  markets that earned their fees, delivering alpha that cannot be
  replicated internally. Again, I asked Jim why doesn't HOOPP do the same
  thing? If they're worried about risks, they can use managed accounts and
  have full transparency and control over the investment portfolios.
• Jim
  replied: "We are doing a good job creating alpha internally. Maybe that
  will change in the future, but right now there is no point of
  outsourcing we can can do the job internally at a lower cost of
  delivery." This is a bit of a sticking point with me because I believe
  true alpha exists in long-only and absolute return strategies and the
  best managers are not working at pension funds, they're running their
  own fund, charging fees for this expertise. As one pension fund manager
  told me later in the day: "If they're that good, they'd be charging
  2&20 managing their own fund."
• Importantly,
  it's in the best interest of pension fund beneficiaries to discover
  these fund managers and allocate to them. No doubt about this in my
  mind. It's just that most pension funds are not approaching their
  allocations to outside managers in an intelligent way, using managed
  accounts in public markets or co-investing in private markets,
  negotiating hard on fees and extracting maximum knowledge leverage off
  their external partnerships using solid investment management agreements
  with clauses that list exactly what they expect from the partnership.
• Something Jim said about the big private equity funds did make perfect
  sense.: "Pension funds investing in these large PE funds are going to
  underperfom large cap stocks. Because of their size, these mega buyout
  funds are taking out large public companies at substantial premiums. It just doesn't make sense to pay fees and take on illiquidity risk for these large deals. "
• Thanked Jim, told him I wish HOOPP was managing the pensions of all
  healthcare professionals across Canada, and went off to my next meeting
  where I hooked up with the commodities fund manager and the External
  Portfolio Management team at a large pension fund. It was an excellent
  meeting, I mostly listened and observed the manager and the team that
  was evaluating his presentation. The manager covered a lot of ground and
  the team asked good questions.
• At the end of that meeting, I asked the head
  of External Portfolio Management team whether they plan on seeding
  funds. He told me that they're looking into it and if "they think it
  makes sense, they'll recommend it. Maybe even partner up with other
  funds on such a venture." Maybe I was a bit bitchy yesterday morning but
  I answered back: "I've sat in your shoes and done many board
  presentations. If I'm sitting on your board, I don't want to hear 'I
  think it makes sense', I want to hear 'IT MAKES SENSE' and here is the
  research from PAAMCO on emerging funds to prove it."
• Afterwards,
  the relative value commodities fund manager told me "nothing personal,
  but it shows you haven't done a lot of marketing, interjecting at times
  and telling the guy how to do his job." I replied: "Let's get something
  straight, I am here as an independent, not to market your fund. We have
  not signed any legal agreement. I believe in you and this fund which is
  why I opened the doors using my senior pension contacts and got you meetings in record time. My comment to the head of this team was not
  intended in a malicious way but more to make the forceful case for
  seeding funds and why it's in the best interest of pension fund
  beneficiaries. No offense taken and will take your constructive
  criticism and recommend that you speak more slowly during our afternoon
  meeting."
• We parted ways at lunch as he had to meet someone. I
  ate outside, enjoying the sun and exchanged some emails with Colin
  Carlton, former Vice President, Investment Research at CPPIB, telling
  him I was in the vicinity. Colin was recently replaced by Jean-François L’Her, formerly of the Caisse, but he has consulting mandates to complete at CPPIB.
  
• Colin told me that he was busy writing large parts on CPPIB's 2011 Annual Report.
  I appreciate the time and effort it takes to complete these annual
  reports and told him one of my former employers, the Business
  Development Bank of Canada (BDC), has a whole team dedicated to corporate planning and drafting the annual report. It's a lot of work!
• I
  praised him for the annual report but did mention that the whole
  discussion on benchmarks and value added needs more clarification as
  it's overly complicated. Colin said they have simplified it and will do
  more.
• I also asked him about his future plans and told him I see a huge gap in
  pension consulting. He agreed and is looking into some options but told
  me he's not interested in expanding a new business and having a crazy
  work schedule. "My wife is my boss now." Colin is an intelligent and
  nice man and I wish him success in his new projects, wherever they lead
  him.
• Hooked up again with the commodities relative value
  manager and headed to our afternoon appointment with another large
  pension fund. In the lobby, I ran into the president, greeted him and introduced the manager. We then proceeded to meet with the VP
  of Alternative Investments and his portfolio and assistant portfolio
  managers.
• In my opinion, this meeting was even better than the
  first. The VP of Alternatives couldn't stay long but let his portfolio
  manager ask the questions. Before the VP rushed off to his next meeting,
  I asked whether their investment policy precludes them from seeding
  funds. He replied: "Not at all. If it makes sense and fits in our
  portfolio, we will seed a fund."
• I asked him if he can let the
  CIO know I am in their offices but he was in a rush so I emailed the CIO
  myself to let him know I was in a meeting at their offices and would
  like to say hello after. To my surprise, the CIO came into our meeting
  wearing a golf shirt, holding a cup of Starbucks coffee, introducing
  himself and asking if he can sit in. I loved it!!!
• The portfolio manager was asking amazing questions. This guy is simply
  the best at analyzing hedge funds and strategies (told him to write a
  book). The manager answered all the questions and even gave numerous
  examples on his strategy and how he mitigates risk (excellent exchange).
  The CIO listened carefully and then asked the important business
  questions on fees and why they should consider seeding his fund. He got
  the answers to his questions and walked out of the meeting after 30
  minutes. Before walking out, he told me he liked my last comment on reducing risk
  and told me that Roger Martin, dean of the Rotman School of Management
  sounds like a "frustrated professor" in his op-ed (totally agree).
• We
  wrapped things up with the portfolio manager who explained the next
  steps. He also stated he likes the relative value commodities strategy,
  the liquidity, the fact that it fits on their managed account platform,
  but needs to do more background checks. The manager provided him with a
  list of references and urged him to call them.
• We then proceeded to drive back to Montreal. It was a long drive, we
  stopped off at Chalet Suisse for dinner, but I really enjoyed my
  conversation with this relative value commodities manager. He's
  exceptionally bright, driven, has the entrepreneurial mindset, right
  work ethic and values which he and his wife instill in their three
  children. We got into a lot of personal discussions during this car
  trip and I admire the depth of his character given the personal
  challenges he's faced growing up as an orphan at an early age. I
  honestly marvel this individual and know the pension fund that seeds him
  and his team will not regret their decision just like I have no regrets
  whatsoever introducing him to these two large pension funds.

That's the end of my long comment on my trip to Toronto.
I wish you all a great weekend. Enjoy the sun as summer has finally
arrived!

Via Pension Pulse.

Following my last comment on Japan's pensions betting on hedge funds, Jonathan Jacob of Forethought Risk sent me an Institutional Investor article by Imogen Rose Smith, Public Pension Plans Bet Their Future On Hedge Funds:

It didn’t sound like much, even at the time. In April 2002 the California Public Employees’ Retirement System invested a total of $50 million with five hedge fund firms. For the then-$235.7 billion CalPERS, the largest state pension plan in the U.S., writing $50 million in checks was hardly a noticeable occurrence. But as the first step in an initial $1 billion allocation, the investment was a monumental moment for the hedge fund industry. It marked one of the first significant commitments by a public pension fund to a program of investing with hedge fund managers, a group that the pension community and its advisers had previously shunned as too risky and secretive. And in ways that are only now starting to become completely clear, it would dramatically change how public pensions invest.

CalPERS had good reasons for wanting to get into hedge funds. By 2002 the U.S. stock market, which had overheated during the late 1990s as the mania for technology and telecommunications stocks generated trillions of dollars in paper wealth for individuals and institutions, was plunging in a bear market rout. Like most U.S. public pensions, CalPERS had heavily invested in such securities as part of an outsize allocation to large-cap equities that had made the plan rich during the boom years but hurt on the way down. The fund lost $12.3 billion in the fiscal year ended June 30, 2001, and $9.7 billion the next year. CalPERS had gone from having 110 percent of the assets it needed to meet its future pension liabilities in fiscal 2000 to being underfunded, with a 95.2 percent — and falling — funding ratio.

One person who saw the writing on the whiteboard was Mark Anson. A lawyer with a Ph.D. in finance, Anson had been recruited to CalPERS from OppenheimerFunds in New York in 1999 to head up its alternative investments. By the time he became CIO in December 2001, he was seriously worried.

“I could see the dot-com bubble popping and the impact it would have,” Anson tells Institutional Investor. “I was concerned that our asset growth would not be faster than what I could see on the liabilities side.”

Anson believed that hedge fund investing would help protect CalPERS during times of market stress. For Anson, hedge funds are their own asset class and a valuable tool for diversifying a portfolio beyond traditional bonds and equities. In The Handbook of Alternative Assets, which Anson wrote while at CalPERS and published in 2002, he devoted more than 150 pages to hedge funds, including sections on how to set up an investment program and handle risk management. Unfortunately, by the time CalPERS began seriously investing in hedge funds, it was too late to prevent the carnage from the 2000–’02 bear market, but Anson remained convinced that the asset class would help the retirement plan in the future.

He was not alone. In New Jersey newly elected governor Jim McGreevey in 2002 appointed hedge fund manager Orin Kramer to the board of the New Jersey State Investment Council, which oversaw management of the Garden State’s then-$62 billion retirement system. Like CalPERS, the New Jersey fund had been badly scarred by the bear market; it was also laboring under a debt burden in the form of $2.75 billion in pension obligation bonds. Kramer started pushing for the system to invest in alternatives, stressing the diversification and risk management benefits. But the politically charged environment made change difficult.

In Pennsylvania, Peter Gilbert was having more luck. As CIO of the Pennsylvania State Employees’ Retirement System, Gilbert had gotten permission from his board in 1998 to start investing in hedge funds. After a failed attempt at “going direct” by investing in four long-short equity managers, he says, the then-$23 billion in assets PennSERS in 2002 hired Blackstone Alternative Asset Management (BAAM), the hedge fund arm of New York–based private equity firm Blackstone Group. Gilbert was one of the early public fund adopters of “portable alpha,” the strategy of taking the alpha, or above-market returns, of an active manager — often a hedge fund — and transporting it to the more traditional parts of the portfolio (large-cap U.S. equities, in the case of the Pennsylvania retirement system).

Between 2002 and 2006 other large state pension funds began investing in hedge funds, with varying levels of sophistication. They included New York, Missouri, Massachusetts, Texas, Utah and finally New Jersey. By May 2006, Marina del Rey, California–based investment consulting firm Cliffwater, itself a product of the growing interest by institutional investors, found that 21 U.S. state retirement systems were using hedge funds, with a total investment commitment of $28 billion. But there were also funds that held back, like the Public Employee Retirement System of Idaho and the Washington State Investment Board. Some were legally prohibited from making investments; others were not convinced hedge funds were right for public plans. Hedge fund investing remained controversial.

The hedge fund experiment was put to the test in 2008, when, under the pressure of too much bad debt, the U.S. housing and mortgage markets collapsed. That was soon followed by the near-failure of the banking system, the credit markets and the entire global financial system. State pension plans lost, on average, 25 percent in 2008, according to Santa Monica, California–based Wilshire Associates’ Trust Universe Comparison Service. That was better than the broad U.S. stock market — the Standard & Poor’s 500 index plummeted 38.5 percent in 2008, its third-worst year ever — but it lagged the performance of the typical hedge fund, which was down 19 percent, according to Chicago-based Hedge Fund Research.

Hedge fund managers often like to tell investors they’ll be able to deliver positive absolute returns regardless of what happens to the market, but in 2008 most managers didn’t live up to those expectations. Hedge funds did, however, cushion their investors against the near-record drop in the stock market and proved their value as portfolio diversifiers. Now, a decade after the first generation of public pension plans started to invest in hedge funds, more and more are looking to do so. In fact, today some of the biggest holdouts from the past decade are beginning to embrace hedge funds, including the $153 billion California State Teachers’ Retirement System, the $152.5 billion Florida State Board of Administration and the $74.5 billion State of Wisconsin Investment Board.

If things looked bad for defined benefit pension plans in 2002, they look a whole lot worse today. The 126 public pension systems tracked by Wilshire Associates had, on average, a funding ratio for the 2009 fiscal year of 65 percent — meaning they had only 65 percent of the assets needed to pay for the current and future retirement benefits of the firefighters, police officers, schoolteachers and other public workers covered by their plans. The situation has been exacerbated in states like Connecticut and Illinois, which in the intervening decade decided to increase benefits without increasing their contributions to pay for them.

“The pension benefit promises that have been made to unions by politicians have been in many respects unrealizable,” says Alan Dorsey, head of investment strategy and risk at New York–based asset management firm Neuberger Berman.

To make up for the shortfall, public pension plans have few places to turn. In the current economic environment, it is political suicide to even broach the topic of raising taxes. And despite calls from some high-ranking officials, like New Jersey Governor Chris Christie, to reduce health care and retirement benefits for public workers, getting state legislators to approve such cuts won’t be easy. For beleaguered public pension officers, the best and perhaps only solution is to try to figure out a way to generate better investment returns.

“Hedge funds start looking attractive because of their superior liquidity relative to private equity and real estate, and superior risk-adjusted returns relative to the overall market,” says Daniel Celeghin, a partner with investment management consulting firm Casey, Quirk & Associates, who wrote a seminal paper on the future of hedge fund investing in the aftermath of the 2008 crisis.

That is, of course, assuming that hedge funds continue to put up superior risk-adjusted returns. Capturing alpha — skill-based, non-market-driven investment returns — is, at the end of the day, the whole point of putting money in hedge funds. Although hedge funds as a group didn’t produce the same amount of alpha in the past few years as they did early last decade, it appears that they added some.

The ability to generate alpha enables hedge funds to justify their high fees. Managers typically charge “2 and 20”: a management fee of 2 percent of assets and a performance fee of 20 percent of profits. It’s been harder for funds of hedge funds to make the case for their management and performance fees — typically 1 and 10 — which investors must pay on top of the fees of the underlying managers. As a result, many fee-conscious pension plans that initially invested through funds of funds are now electing to go direct. That approach, however, can make hedge fund investing much more challenging, especially for pension plans with small investment staffs.

Hedge funds are not like traditional money managers, says former PennSERS investment chief Gilbert, now CIO of Lehigh University, responsible for managing the Pennsylvania school’s $1 billion endowment. Hedge fund managers require more due diligence and constant monitoring because in their search for alpha they operate with few if any constraints. “You really have to know what to expect from each particular hedge fund manager and how you are going to use them,” Gilbert says. Most investment consultants, the group that public plans typically rely on to help with manager selection — which can step in to take over the role of a fund of funds at a lower cost — are still grappling with advising on hedge funds.

Public pension plans, for their part, with their billions of dollars and stringent investment requirements, are changing the parameters of the hedge fund experiment. In a January 2011 report, consulting firm Cliffwater found that 52 of the 96 state pension plans it surveyed had a total of $63 billion invested in hedge funds as of the end of fiscal 2010, more than double the amount from four years earlier. “Public pension funds are the investment group that is going to shape the hedge fund industry,” says Scott Carter, head of global prime finance sales and capital introduction in the U.S. for Deutsche Bank, as well as co-head of hedge fund consulting.

Christopher Kojima, global head of the alternative investments and manager selection group at Goldman Sachs Asset Management in New York, would agree with Carter’s assessment. “The debate we are seeing at public plans today is much less about whether hedge funds are a sensible contributor to their objectives,” Kojima says. “The question we encounter much more is how to invest with hedge funds.” Pension funds are looking at how to identify and monitor top managers, think about risk management and connect hedge funds to their broader portfolios. “Are hedge funds even a separate asset class?” Kojima asks. More and more, the answer is no.

Public pension plans were not the first institutional investors to experiment with hedge funds. During the late 1980s and early ’90s, a group of influential endowment and foundation investors steeped in Modern Portfolio Theory started exploring the notion that these managers, freed from the constraints of more-traditional funds, could enhance their returns. The hedge-fund-investing hothouses of those early years were located on the campuses of a handful of universities, including Duke, Harvard, North Carolina, Notre Dame, Virginia and Yale.

As head of the Yale University Investments Office in New Haven, Connecticut, David Swensen pioneered an approach to endowment investing that put a heavy emphasis on alternatives, including hedge funds. Swensen’s acolytes at Yale would go on to run a network of school endowments, taking his ideas with them. Duke, North Carolina and Virginia were close to Julian Robertson Jr., founder of New York–based Tiger Management Corp. and one of the top hedge fund managers of that era. They embraced the Tiger investment ethos — fundamentally focused long-short strategies, sometimes with a tilt toward macro — as a source of returns.

For those early adopters, hedge funds proved their worth. In 1993 the HFRI fund-weighted composite index was up 30.88 percent, more than three times the total return of the S&P 500 composite index, which was up 10.1 percent. As the bull market started to roar, hedge fund results, on a relative basis, didn’t look so impressive. In 1997 the HFRI index rose 16.79 percent, roughly half the total return of the S&P 500, which was up 33.34 percent.

The first public plan to start looking seriously at hedge funds was the Virginia Retirement System. In the early 1990s the fund had made a controversial investment in a railroad company, leading to a legislative review, published in December 1993, that found the system had too many active managers and was paying too much in fees while not seeing much in the way of results. The review recommended that state law be amended to allow the retirement system broad discretion in the types of investments it could make. The change was enacted the following year, opening the door to hedge fund investing. By 1998, Virginia had invested $1.8 billion of its then-$23 billion in assets in market-neutral, long-short managers while at the same time indexing a significant portion of its equity portfolio.

In 2001, Virginia started talking to D.E. Shaw & Co. about having the New York–based hedge fund firm run a benchmarked long-only strategy for the retirement system. D.E. Shaw, a quant shop founded in 1988 by computer scientist David Shaw, was the classic hedge fund firm: supersecretive, using leverage, charging high fees and focused on finding returns. The firm didn’t have any close relationships with public pension plans before Virginia, but it quickly realized their potential value. “For years and years we had an absolute-return focus,” says Trey Beck, head of product development and investor relations at D.E. Shaw in New York. “This gave us an opportunity to go into the benchmarked business.”

The decision to build an institutional business meant that D.E. Shaw would need to produce funds that could perform on a relative basis. It would also need to become more transparent, which the firm had already started to do (in 1999 it had registered with the Securities and Exchange Commission as an investment adviser). D.E. Shaw began to expand its investor relations and reporting. “We had to get up the curve very quickly,” Beck says. “Because ten years ago the demands placed on managers by hedge fund investors were very different from the demands placed on investors in more-traditional products.”

The CalPERS hedge fund story begins with Bob Boldt, who was brought in from money manager Scudder, Stevens & Clark as senior investment officer for public markets in December 1996. Boldt was a big advocate for hedge funds, and by September 1999 it looked like he had gotten his way. CalPERS hired its first hedge fund manager, investing $300 million with San Francisco–based, technology-focused Pivotal Asset Management, and Boldt’s plan for CalPERS to invest $11.25 billion in hedge funds surfaced in the press. Then, Boldt left in April 2000. Seven months later he landed at Pivotal.

Paying talent has always been an issue for public pension plans. But the added challenge of running the more-sophisticated portfolios that typically accompany hedge fund investments makes it an even bigger issue, especially given the wide gulf in compensation scales between the hedge fund industry and the public pension world. Boldt was not alone in making the switch, though his stint at Pivotal would be short. (The firm folded after the dot-com bubble burst.)

In the absence of Boldt, CalPERS continued to take steps toward building a hedge fund program. In November 2000 the board approved a plan to invest $1 billion in hedge funds. (By that time, Anson had been promoted to senior investment officer for public markets.)

The following May, CalPERS hired fund-of-funds firm BAAM as a strategic adviser to its hedge fund portfolio, to help identify and interview potential managers, perform due diligence and provide risk management and reporting. This was a major change in the way an institution worked with a fund-of-funds firm. CalPERS paid less in fees than it would have if BAAM had been managing the money, and it had more control over the portfolio and transparency into the underlying managers. It also got to educate itself about hedge fund investing and grow its in-house expertise.

“We had not yet built up the staff within CalPERS, and we did not have feet on the ground,” says Anson, who became CIO in December 2001. “There were only so many due diligence trips I could take myself as CIO. We needed to really outsource some human capital.”

For all its pioneering work, CalPERS was actually slow to invest its first $1 billion in hedge funds. By December 2002, PennSERS had overtaken it as the largest public pension investor in hedge funds, with $2.5 billion allocated to four absolute-return fund-of-funds managers: BAAM, Mesirow Advanced Strategies, Morgan Stanley Alternative Investment Partners and Pacific Alternative Asset Management Co. (Public pension funds like PennSERS preferred the moniker “absolute-return funds” over “hedge funds” because it was more politically palatable when discussing their investments.)

But rather than carve out a separate allocation, PennSERS housed its hedge fund investments in its equity portfolio as part of its portable-alpha strategy. That made it much easier for then-CIO Gilbert to build a hedge fund portfolio that rivaled many endowments’ in size and scope. By June 2006, PennSERS had invested $9 billion of its $30 billion in assets in hedge funds.

New Jersey’s Kramer is also a big believer in the benefits of investing in hedge funds. But when he became chairman of the board of the New Jersey State Investment Council in September 2002, he couldn’t act on that belief because the state’s antiquated pension system was prohibited from using any outside managers — alternative or traditional. By November 2004, Kramer had gotten the Investment Council to agree to allocate 13 percent of its assets to alternatives (private equity, real estate and hedge funds), overcoming the objections of state unions, which accused Kramer and his fellow board members of wanting to give fees to their Wall Street fat-cat friends. New Jersey made its first hedge fund investments in the summer of 2006.

“There is no avoiding politics at public plans, in the same way that you would have it at a school district or at an investment board,” says Neuberger Berman’s Dorsey. “What winds up happening is that you end up handcuffing the investment performance.”

With their high fees, wealthy founders and reputation for risk-­taking, hedge funds became an attractive political target. Hedge fund managers, for their part, were not used to dealing with the scrutiny that invariably comes with running public money. Some decided it wasn’t worth the hassle. For those managers that did take public money and suffered major losses, the headlines were especially unforgiving. Just ask Nicholas Maounis, the founder of Amaranth Advisors, a Greenwich, Connecticut–based multistrategy manager that at one time was among the 30 largest hedge fund firms in the world. In the summer of 2006, the press skewered Amaranth after the firm’s supposedly diversified flagship fund lost more than $6 billion betting on natural-gas futures and had little choice but to shut down.

Amaranth’s investors included some of the U.S.’s biggest public funds, including the New Jersey system, PennSERS and Massachusetts’ Pension Reserves Investment Management Board, though most of their exposure was through funds of hedge funds. New Jersey’s CIO at the time, William Clark, pointed out in a January 2007 memo to the Investment Council on Amaranth and the lessons learned that the fund had taken greater hits from individual stock positions that same month. (New Jersey’s total exposure to Amaranth was $21.8 million, or 3 basis points of its total investment portfolio.)

Before Amaranth, the largest hedge fund disaster had been another Greenwich-based firm, Long-Term Capital Management, which famously lost 44 percent of its capital in August 1998, after Russia defaulted on its debt, and had to be bailed out by a consortium of 14 banks assembled by the Federal Reserve Bank of New York. The group put up $3.6 billion for 90 percent of the fund. But LTCM had little or no institutional money.

Public pension plans did not get off so easy during the recent financial crisis, which began with problems in the subprime mortgage market in 2007 and spiraled out of control in September 2008 when Lehman Brothers Holdings filed for bankruptcy. That month the HFRI index dropped 6.13 percent. In October 2008 the index lost a further 6.84 percent, and hedge funds started putting up gates to prevent investor redemptions. Firms liquidated struggling funds or moved troubled illiquid assets into so-called side pockets, trapping the invested capital until the walled-off assets were unwound. A record 1,470 hedge funds liquidated in 2008, according to HFR. It was an exceedingly tough time to be a hedge fund investor.

Between 2002 and the start of 2008, the hedge fund industry tripled in size, skyrocketing from $625.5 billion in assets to nearly $1.9 trillion, according to HFR. The bulk of the new money — approximately $610 billion — came from institutions, including public funds. These large investors wrote bigger checks than most managers were used to receiving; direct commitments of $50 million to $150 million were not unusual. In much the same way that scientists can change the results of an experiment simply by observing it, the influx of institutional investors, though they were more than mere observers, was bound to impact the return profiles of hedge funds.

As the last decade progressed, some experts began to suspect that much of hedge funds’ returns was not in fact alpha but market-driven returns, or beta, that had been leveraged using borrowed money to produce seemingly superior results. The events of 2008, when the markets collapsed and suddenly it became very expensive to borrow, bore this out. Neuberger Berman’s Dorsey and former CalPERS CIO Anson are among the money managers looking into beta creep, the notion that over time hedge fund performance has become increasingly market-driven. “Or, as I like to call it, ‘creepy beta,’?” quips Anson, who is now a managing partner with Oak Hill Investment Management in Menlo Park, California. It’s not that beta itself is bad, just that investors do not want to pay hedge funds 2-and-20 for market returns.

After Anson left CalPERS in 2005, the hedge fund program picked up speed under the guidance of senior portfolio manager for global equities Kurt Silberstein. Two years earlier, CalPERS had replaced BAAM with Paamco and UBS and embarked on a program of direct hedge fund investments as well as fund-of-funds commitments. Silberstein is proud of what the U.S.’s biggest public pension plan has achieved. “We run a very conservative portfolio, and for each unit of risk we take, we have been rewarded with a unit of return,” he says.

Going into 2008, however, CalPERS had too much beta in its hedge fund portfolio, which fell 19 percent that year. Silberstein freely admits that 2008 was “a really black eye” and that the pension system would probably not still be investing in hedge funds “if 2008 had happened two years into us building out the program.” Since the crisis, Silberstein has almost completely redone the direct hedge fund portfolio, terminating relationships with many of the long-short equity and multistrategy managers that underperformed in 2008. Today he prefers to invest with smaller managers he believes are more likely to add alpha.

CalPERS has also taken much closer control of its hedge fund investments. It now demands what it perceives as a better alignment of fees from its hedge funds, enabling the California plan to reclaim some of the 20 percent performance fee it pays during a good year if a manager loses money the next. Cal­PERS invests whenever possible using separate or managed accounts instead of commingled funds; this means it, not the manager, holds the underlying securities.

“You can mitigate business risk by having control of your assets,” says Silberstein. “Once you have control you don’t have to be so adamant on the terms of the contract, because if I don’t like what a manager is doing, I can just take my money and walk.”

CalPERS is not alone in making such demands. Its crosstown Sacramento counterpart, CalSTRS, is making its first move into hedge funds with a global macro program that will be handled exclusively using managed accounts. At the $19.8 billion Utah Retirement Systems, deputy chief investment officer Lawrence Powell also has been playing hardball with hedge fund managers over fees.

Fees continue to be a big issue for funds of hedge funds, as more and more public funds opt to use less expensive investment consultants to help them construct and monitor hedge fund portfolios. Still, Neuberger Berman’s Dorsey, who worked at Darien, Connecticut–based consulting firm RogersCasey from 2002 through 2006, thinks funds of funds can play an important informational role for public plans. “Most funds of hedge funds have a large staff, and these people are engaging in continuous contact, monthly conversations and conference calls with hedge fund managers,” he says.

Although some public pension officials were disappointed with the 2008 performance of hedge funds, they are increasingly starting to look at hedge funds not as a distinct asset class but as a way of managing money. The Virginia Retirement System, for example, doesn’t separate hedge fund managers into their own group but categorizes them according to the types of securities in which they invest. Scott Pittman, CIO of the New York–based Mount Sinai Medical Center Foundation, which has more than 70 percent of its $1 billion endowment invested in hedge funds across different asset classes, thinks this approach makes a lot more sense.

“When you take hedge funds that have lots of different securities and strategies and group them together and call it an asset class, you are ignoring the consequences of those exposures on the overall portfolio, both unintended and intended,” Pittman says. “Hedge funds are just a vehicle by which we invest.”

One of the effects of 2008 was to increase discussions about risk management. Institutional investors realized they had not been doing a good enough job of paying attention to risk. The result is that some institutional investors — including Alaska Permanent Fund Corp., CalSTRS and the Wisconsin Investment Board — have been working with hedge funds or money managers that offer hedge-fund-like strategies to put together portfolios that, through tactical asset allocation and hedging, can offer overall risk protection.

“We are trying to develop a system that does not seek to time the market but does try to identify those extreme left-tail events,” CalSTRS CIO Christopher Ailman recently told Institutional Investor, referring to statistically rare events, like those experienced in 2008, that can have a seismic impact on markets and returns. Funds designed to hedge against tail risk often rely on derivatives-trading strategies and as a result have their own built-in leverage. Such funds can act as a drag on a portfolio when markets are rising, but they are expected to provide a valuable hedge in times of significant market stress and volatility.

The real key to pension fund investing has always been asset allocation — long the purview of investment consultants. As hedge funds, which roam all over the capital structure looking for returns, become a more integrated part of what pension plans do, investment officers and their boards are leaning on their managers to answer more of their general asset allocation and investment concerns.

Hedge funds have had to learn to become more receptive to such inquiries from their largest clients. “The industry mind-set has changed,” says D.E. Shaw’s Beck. Hedge fund managers realize that public funds want to be able to call up investment professionals at their firms for insights into what is happening in the markets and for their views on macroeconomic events.

The Washington State Investment Board is looking forward to just such a relationship with D.E. Shaw. In April the board voted to approve the firm for a global non-U.S. active equity mandate. “Part of the reason we chose the manager was not just for the product but because of the depth of resources and talent at the investment manager that we will have access to,” says CIO Gary Bruebaker. “I call it noninvestment alpha.”

Bruebaker was a member of the President’s Working Group on Financial Markets’ investors’ committee when it released its report on hedge fund investing in April 2008. Although he appreciates the merits of D.E. Shaw, he has no plans to invest in the firm’s hedge fund strategies or, indeed, with any hedge funds at all.

“I take my responsibilities very personally; I manage the financial future of over 400,000 public employees, many of whom work a lot harder than I do,” says Bruebaker, whose mother was a public employee. “If there was a way I could make more money on a risk-adjusted basis, I would find a way to do it.” But he just does not believe the $82.2 billion Investment Board has any competitive edge when it comes to investing in hedge funds.

Public funds, he says, should be cautious investing in hedge funds: “Many of them don’t have the flexible budgets or the dollar amounts to hire the kind of skill sets they need to help them do the due diligence that would be necessary to do it correctly.”

New Jersey lost a highly skilled investor when Kramer resigned from the Investment Council in February. In his last year on the board, he successfully pushed to raise the limits on how much New Jersey could invest in alternatives. But even Kramer was finally exhausted by the years of battling to move the $74.7 billion retirement system into the modern investment era. Though public scrutiny serves an important role as a guard against corruption, the political nature of the public pension system can alienate the very best investment talent. And yet it is the resource-constrained, funding-challenged public funds that need the most help, especially as their investment portfolios become more and more complex.

Bruebaker is right that
public pensions should be cautious about hedge funds. But I am very
surprised that he invested with D.E. Shaw to leverage off their
knowledge investment managers because D.E. Shaw is the quintessential
epitome of a ultra-secretive "black-box" hedge fund which is why after
2008, some of the public pension fund managers I know, pulled their
money out of D.E. Shaw and other black-box shops.

Via Pension Pulse.

On
Sundays, I like to write and reflect on various topics. Take the time
to read this comment carefully as it covers everything from
relationships (personal to professional), to markets to politics. The
theme today is going to be the Ugly Truth.

1) Ugly truth on yours truly: I'm going to begin and end this post on a personal level. I've been going through a lot of introspection ever since turning 40. First, I'm glad I got off my ass and joined a gym. I don't know what is going on in my body but ever since I underwent the CCSVI procedure
in late March and then joined the gym to work out with a trainer, I've
seen a major transformation and feel stronger than I have in years. I'm
walking further, my upper back pain is almost gone, and my posture is
better as I stand up straight and push my shoulder blades back. I'm
honestly not scared of my MS and know I will beat this bloody disease
through diet, exercise and positive energy. And let me assure other MS sufferers, scientists will cure MS sooner than we think.

The only thing I've
been doing at the gym is legs and back, focusing on developing muscles
that have atrophied over the years. If you have MS, no matter how
severe, get cracking and head to the gym and do whatever you can! I'm
now completely and utterly obsessed about working out first thing in the
morning and simply love pumping iron as I listen to music. To pump
myself up, I listen to Tiesto's Elements of Life and a song by Lil Wayne and Eminem, Drop the World. Don't ask, it helps me channel my inner rage!

That's
the second thing you should know about me, I have anger issues. I'm not
angry that I have MS -- it's actually made me stronger in ways very few
people can possibly relate to -- but angry at the weasels I've
had to deal with in my life and how they used and abused me.
Unfortunately, I'm very naive when it comes to personal and professional
relationships. In finance, there are two types of people: those who are
primarily focused managing money and those who are primarily focused on
managing their careers. I would say the bulk lie in the latter camp
(over 95% of the CFAs in Montreal have never managed money!!), and these
people tend to be extremely dangerous narcissistic egomaniacs who only
care about their public image. Makes me sick to my stomach!

But I
need to explore some of my other anger issues that have been festering
inside me for years because it's affecting my ability to develop more
meaningful relationships, focus on more productive goals and just be my
old happy self again. My brother, a psychiatrist, recommended a
psychologist and I decided to go see her this week. I've seen someone in
the past but got bored after three sessions, never listened to him, and
didn't take it seriously. This time, I will put in a lot more effort
and be completely honest with her. I'm doing this mostly for me, but
also for the two people I love the most in this world, my mother and
father. I could be a stubborn, intense, obsessive ass but sometimes you
have to listen to the people who love you the most and trust their
judgment. Importantly, there is no shame in seeking professional help.
If you need it, just do it! Who cares what others think! And remember
Einstein's definition of insanity: "Doing the same thing over and over
again and expecting different results."

2) Ugly truth on Quebec's Absolute Return Fund: My inner rage was definitely expressed in my last comment on Quebec's absolute return flop.
I simply cannot understand how poorly managed this whole endeavor was.
If it was done properly, Mario Therrien's team at the Caisse would have
invested directly into these funds, doing the due diligence, informing
the FTQ and Fondaction CSN every step of the way, and they would have
used Innocap's managed account platform, one of the best managed account platforms in the world.
Everything would have been open, public, transparent, including the
investment management agreement which would stipulate how managers are
selected, what percentage is going into directional and market neutral
strategies, what percentage goes into established versus emerging
managers, what are the terms governing these investments, including the
fees being paid out to everyone. I don't blame Mario Therrien or his
team for the sloppiness of this whole project. In fact, I have a strong
feeling something else is going on in the background and it likely goes over Michael Sabia (ie. political nonsense!).

3) Ugly truth on Quebec's absolute return funds and my capital introduction services:
Having met a lot of hedge funds here in Montreal, I'm impressed with
the alpha talent we have in this city. And there are other talented
individuals I know of, getting screwed working at some bank which
extracts the blood from their veins. All these people deserve a fair
shot. There is exceptional talent in this city that is grossly
underutilized and I also know of other experienced money managers from
Quebec outside this province who would come back to manage money if the
terms were right. Not everyone is up to snuff, some managers are a lot
more experienced than others, but they all deserve a fair shot and a
helping hand.

I have done more than my fair share to promote these funds on my blog.
I will continue meeting new managers and updating my list. I have even
done some capital introduction without having signed any legal
agreement. All I'm asking for my capital introduction is 25 basis points
for the initial investment, and 12.5 basis points for all subsequent
investments. To my great disappointment, none of the Quebec hedge funds I
approached and met have signed the legal agreement I provided them and
none of them have contributed a dime to my blog (except for my former boss at PSP Investments, Pierre Malo, who is now
working at Jean Turmel's global macro fund, Perseus Capital and someone
else who shall remain anonymous).

Worse still, I
provided the legal agreement to the limited partners (LPs) so they can
see the terms and see that they are part of the prospective qualified
investors, and a couple of them came back to me to ask me to be removed
from the list even though they're open to meeting new managers. I
reminded these people that their job is to meet the best managers from
around the world, including those in Canada, and that they can't be open
to meeting managers and not accept that they be listed on my legal
agreement. Moreover, unlike the US, none of the LPs in Canada have open
policies governing capital introduction -- a major governance gap!

In this world, I trust two people unconditionally: my mother and my father. The rest can screw me over at any time and verbal agreements are absolutely worthless in a court of law.

So if you want me to help you, get to it and sign the legal agreement.
At a minimum, all of the hedge funds I've helped in my career should
have contributed to my blog by clicking on the PayPal account button
under the pig at the top of my blog.
Importantly, to all GPs and LPs, if you're going to talk the talk with
me, make sure you walk the walk. I mean it, no more double-speak or
blowing smoke in my face, when I talk, I deliver, and I expect the same
from all of you. You're all aware of my current situation and while
you don't owe me anything, I expect you to be honorable and fair with
me.

4) Ugly truth on Greece: A senior pension fund manager sent me an interesting blog comment on Greece, Democracy vs Mythology: The Battle in Syntagma Square.
I enjoyed reading it and passed it along to family and friends in
Greece and Canada. My uncle Takis in Athens read it, found it too
leftist for his taste and wrote back: "Our politicians are responsible
for the enormous debt they created by overborrowing (the debt never was
never enforced on us) and we are now paying the consequences of the
big mistakes they have done."

It's true. With the help of US,
French and German banks, Greece borrowed more than it was able to pay
off and global financial system will likely experience yet another crisis due to contagion risk.
What angers me and most hard working Greeks is that the common workers
are bearing the brunt of the austerity measures while the rich get off
scot free.

Let me share with you the ugly reality on Greece's
woeful tax collection system. Everyone in Greece knows this, but let me
give it to you straight. A close buddy of mine, a radiologist, is now
vacationing in Greece with his family. His aunt recently had to replace a
heart valve and she slipped an envelope of 12,000 euros to the
cardiovascular surgeon so he would do it. In Greece, this envelope is
called "fakelaki" and if you don't have the money, you're dead.
Specialist surgeons working at public hospitals are typically the worst
offenders, but there are others notorious for accepting huge sums and
they declare nothing. And most of them pay off Greek tax collectors who
are equally corrupt and greedy.

In Greece, if you want to strike
it rich, become a specialist dealing with critical life and death
decisions, tax collector or a high profile minister in the government.
The scandalous stories that are coming out now of doctors, tax
collectors, and ministers with millions of euros in their bank accounts
and villas in Santorini and Mykonos are no surprise to regular
hard-working Greeks. They know the system is corrupt at its core. It's
disgusting. I'd make a public display of all these criminals by throwing
them in jail for treason for the rest of their living years.

5) Ugly truth on US economy: This morning I listened to a roundtable discussion on ABC's This Week with Christianne Amanpour on the state of the economy. Click here to watch this discussion. I've already written on how the US and developed world jobs crisis is here to stay.
Given the current political environment, I doubt any new spending will
pass in Congress. There is an irrational fear that the US will default
on its debt, but this is all nonsense. Robert Reich is right: the issue
now is jobs, jobs, jobs! Not the stupid debt ceiling, the deficit or the
debt. The sooner American policymakers get to tackling this jobs
crisis, the sooner they will be able to increase their government
revenues and pay down the debt in the long-run.

6) Ugly truth on the Canadian economy: This one is easy. Just go back to read my comment on the Canada bubble and Canada's mortgage monster. In case you haven't been paying attention, Canada's benchmark index, the S&P/ TSX has been taking a beating over the last three months. The Canadian dollar remains strong, but it too is losing its luster and it can head much, much lower from here. The problem is so can the US dollar, especially if the Fed moves ahead with QE3.

7) Ugly truth on the 'solarcoaster':
I'll tell you what else has lost its luster in the last three months,
solar stocks. Along with other risk assets, they've been slaughtered. According to Bloomberg, short sellers are flocking to solar power, dumping record levels of stock in First Solar Inc. (FSLR)
and competing equipment makers in a bet that profit will be hurt by a
glut of Chinese panels and shrinking demand in Europe. The shorts have
hammered solars but they're creating opportunities for long-term
investors.

I recommend investors keep an eye on solars and start scooping them up
at these levels. The companies I'm watching carefully are: Amtech
Systems (ASYS), Daqo New Energy Corp. (DQ), Emcore Corp (EMKR), First Solar (FSLR), JASO Solar (JASO), LDK Solar (LDK), Power-One (PWER), Satcon Technology Corp. (SATC), Suntech (STP), Trina Solar (TSL), MEMC Electronic Materials (WFR), Yingli Green (YGE) and speculative plays in Canada are Timminco (TIM.TO) and Opel Solar International (OPL.V).

8) Ugly truth on unrequited love:
It's agonizing. Trust me, I know because I just lived through it and
it's not her fault. Like any relationship, if you're not getting what
you expect or putting into it, have the courage to walk away. Just like a
good traders know when to cut their losses, you got to know when to
stop doubling, tripling or quadrupling down, hoping things will change.
They don't and you have to accept that reality and start expending your
emotional capital on people who will reciprocate your love. Always be
true to yourself.

And on that highly personal note, I'm going to
wrap this comment up with some humor. I got the idea on the title of
this post from a movie I saw in the middle of the night on Friday when I
woke up and couldn't fall back to sleep. The movie is called The Ugly Truth,
starring Katherine Heigl and Gerard Butler, and it left me in stitches.
Below is one of the scenes that made me laugh out loud (Only found one
with subtitles. Try not to be offended and watch the movie, it's
hilarious!).

***Feedback***

A senior pension fund manager was kind enough to share this advice with me:

A piece of advice.

Be careful how much you tell about yourself in public.

Most people who know you will not pose a problem.

But I have learned that a small minority will turn the kind of personal information you just wrote about against you and to their advantage when they see an opportunity.

Homo homini lupus

And that may be unkind to wolves.

Indeed, he's right. I thank him and remind these wolves that I can see them coming from a mile away. I may be naive but not stupid and realize in this industry, I've got very few friends and lots of enemies who would love to see me crumble. Won't give them that satisfaction.

Via Pension Pulse.

On Thursday, I met three sharp hedge fund managers based in Montreal: Jacques Lacroix and Paul Beattie of BT Global Growth and Brian Ostroff of Winderemere Capital.
Their offices are all next to each other. I first met with Jacques and
Paul and chatted a little with Brian before heading off to lunch with
Paul.

My meeting with Jacques and Paul was extremely interesting.
I've met many managers in my career and you can always tell which ones
have substance and brains as opposed to the ones that are slick
marketing types. The two met at Telesystem International Wireless (TIW),
a company founded by Quebec entrepreneur Charles Sirois. Jacques was
among the first hires there and Paul followed soon after.

Both
men made more money on TIW stock towards the end when it was trading for
pennies and they scooped it up than while working at TIW (Paul told me
he dumped some shares at $55 and bought back a boatload at 33 cents when
institutions dumped and the company's enterprise value was $4). Paul
worked in private equity briefly after TIW before teaming up with
Jacques to form BT Global Growth. They manage roughly $25 million, have
their liquid assets in the fund, and their clients are mostly former
senior managers they worked with at TIW. Paul told me flat out: "we want
smart clients who we can interact with and learn from."

Both
managers have extensive global finance experience and it shows in the
way they invest. Paul told me straight out: "We're finance guys and
invest based on cash flows. We don't like highly levered companies."
Indeed, they can look at any balance sheet and understand the potential
of any company as well as the pitfalls. Their global finance experience
serves them well. Paul has traveled to India and China countless times
as well as other parts of Asia, and he's a big believer in the secular
shift towards that part of the world. "We're going to have huge problems
in the future competing with Asia."

Importantly, he doesn't buy the "China is imploding" scenario that Jim Chanos is warning of.
"If you think the price of oil is high now, just wait, it's going
much, much higher. 30% of our portfolio is in oil and oil services
companies. Don't like natural gas as there are storage problems, but oil
is definitely heading higher and anyone who doesn't see it is going to
get blindsided."

I stopped him there and asked him "if China
continues to do well, then that's bullish for Canada?" He responded:
"It's good for Vancouver real estate prices and generally good for the
Canadian economy." However, Paul sees inflation rising and told me rates
are heading higher: "You saw the latest Canadian CPI numbers?
Consumer prices rose 3.7% over the past year." I told him if rates go
higher, a lot of Canadians are in big trouble as they're carrying way
too much debt, especially on their houses. He replied: "That's why the Bank of Canada has been talking up rates so that people are prepared for the inevitable."

On their investment process, Jacques told me that they actively trade
their short book, mostly have core holdings in their long book and every
year since they started managing money they have hit home runs with
many of their stock picks. Their latest audited financial statements are available on their site,
and I saw the performance figures. Since inception (Oct. 2006), the
Fund has returned 17%. They got hit in 2008, down 26% but came back
strongly in 2009, rising 64% (using no leverage!).

The
2008 crisis was a wake-up call for both managers. Paul and Jacques told
me the Fund was down 11% in September 2008 and that's when they sat
together and said they have to manage their short book better to limit
downside risk and minimize volatility. Again, keep in mind, they use no leverage whatsoever in their fund.
But because some of their core holdings are tied with the China theme
(they invest almost exclusively in Canadian stocks), they have suffered
some bad months (Paul told me the Fund had a bad June as one of their
core holdings was accused of being a Chinese fraud; he doesn't see it).
Some of their holdings are illiquid and volatile (they didn't provide me
with standard deviation figures, but saw vol has come down considerably
in last 18 months).

However, Paul told me that liquidity is not a problem as he can "convert
the entire portfolio into cash in less than a week." They showed me
their top 7 holdings: Domtar, International Paper, Gammon Gold, Garda
World HY Bonds, Megabrand HY Bonds, Pacific Rubiales and Ressources
d'Arianne. I found their two top holdings very interesting because some
top funds bought paper companies over the last year, including the
Caisse , Dodge & Cox, and Paulson & Co (go back to read my last comment on spying on elite funds). Just look at the top institutional holders of Domtar, which has soared over the past two years (click on image to enlarge):

I
wouldn't touch Domtar or International Paper now, but guys like Paul
and Jacques who got in early, and other money managers who also got in
after the crisis, made a killing off these paper stocks.

On the
short side, Paul told me he's short Canadian money managers. "A lot of
them are managing way too much money and their performance is lagging.
Their business model requires more and more assets, which they gather
through paying brokers fees, but this approach has run its course. Look
at some of the largest funds in Canada (I'll be kind and omit their
names), managing billions and some of the larger players have performed
terribly over the last five years but their assets keep growing because
institutions find refuge in brand names and brokers get nice fees. Even
guys like Eric Sprott who I admire a lot are now managing $10 billion
and given his approach, he is the market in many illiquid names. His
performance has suffered lately and it will be hard for him to recover
given his size." (must admit, I was floored when I heard Sprott is now
managing $10 billion. 2% management fees on $10 billion pays a lot of
hefty salaries and an army of salespeople focusing on gathering ever more
assets and doesn't incentivize him or his managers to collect
performance fees. At one point, you're just an asset gatherer).

Paul
has strong views on raising assets. "I think we'll cap the Fund at
roughly $200 million. We're not in the asset gathering business and
prefer focusing exclusively on performance." I told him the terms of his
Fund, publicly available on their site,
are quite impressive with a high water mark, a 5% hurdle rate, but also
asked him about the $150,000 CAD minimum investment. I told him "it
looks like you're desperate raising assets." He told me "not at all,
we're just not willing to give any equity stake away to anyone. We got
some of the smartest investors in the country but the truth is it's hard
to raise institutional money even if you have an exceptional audited
track record that goes back several years."

Paul gave me examples of top Canadian funds that have not raised a dime
of institutional money even though they have the best long-term track
record. Both Paul and Jacques are very open to local money from high net
worth individuals and institutions. "We treat all our investors with
respect and work hard to deliver on our objectives." I did get the
sense, however, that Paul was a little frustrated with the Quebec absolute return fund.
"Look, we remain hopeful, met the guys from HR Strategies, they're
smart, but the truth is what you wrote, namely that the bulk of money
has been funneled to the largest funds, and most of them don't really
need it." I told him flat out: "That's Quebec's finance community, one
big club where they scratch each other's back" (not that it's any
different elsewhere).

Anyways, towards the end of our meeting, we started talking about their
core mining holdings. They like phosphate and zinc and told me they have
big stakes in Ressources d'Arianne (DAN.V),
a small Quebec mining company that holds interest in the Lac à Paul
project, a phosphorus and titanium deposit, and Focus Metal (FMS.V),
which explores for flake graphite, rare earth elements, and precious
and base metals. In terms of a pure zinc play, Jacques wrote me that
Full Metal Minerals (FMM.V) announced the spinout of Full Metal Zinc which should start trading in the next few weeks.

I wanted to know more on phosphate. Paul introduced me to Brian Ostroff of Windermere Capital,
another extremely sharp manager with years of experience. Brian knows
his stuff on mining stocks. He told me that his fund is a an excellent
diversifier in an overall portfolio but too volatile when looked at on a
standalone basis. He and his investors own almost 20% of Ressources
d'Arianne and firmly believes in their Canada Phosphate potential.
"My only concern is that management is going to find growth challenges
ahead that they're not prepared to deal with right now which is why I'm
actively involved on finding competent board of directors."

My
entire discussion with Brian was just as fascinating as my previous one
with Jacques and Paul. He told me to read an article on phosphate
independence which was published in The Energy Report (click here to download article) and inform myself on the importance of phosphate for fertilizer. He told me the two biggest producers are Agrium (AGU) and Mosaic (MOS).
He told me that Mosaic is currently in court fighting to keep a plant
in Florida open -- one that produces close to 18% of Mosaic's total
phosphate production. "If that plant shuts down, fertilizer prices will
shoot through the roof." As far as which countries have huge phosphate
deposits, he told me that Morocco has the biggest deposits in the world
but given its political climate, companies are looking elsewhere. That's
where Canada comes into the picture.

Brian also told me that
resource stocks will be the next big thing. He agrees with Paul on China
and emerging markets, and told me that gold shares bottomed six months
before the market bottomed in March 2009. "Precious metals and
commodities were in vogue in the 70s and 80s, then came tech in the 90s,
then financial paper in the last ten years. Now we are coming back to
fundamentals."

I found the discussion on phosphate fascinating and the fact that we
have deposits here in Quebec bodes well for our economy. Paul told me a
lot of Quebec resource companies are small, have small capitalization,
but once "institutions wake up see the potential, these companies are
potential 10-baggers." I did some research on the phosphate fertilizer industry
and the environmental concerns, and came away a little mixed.
Nonetheless, I think that phosphate could be Canada's next Potash and
bought a speculative position in Ressources d'Arianne (nothing big, 3000
shares, and this is money I'm prepared to lose).

I grabbed
lunch with Paul downstairs from their offices at Sho-Dan restaurant (amazing sushi and sashimi). What struck me is his work ethic, his
integrity and his brains. All three men are extremely sharp and work
like dogs. Paul told me "in this biz, if you're not putting 80 hour
weeks, you're not going to be successful. I've met many CEOs and CFOs
right here at Shodan, and believe me, we are one one up on Toronto being here in Montreal. They don't cover Quebec's mining industry anywhere near as
well as they should. That leaves plenty of opportunities for us."

Another
thing struck me at lunch. Paul praised his partner Jacques calling him
"a true genius," told me Brian is equally bright and "they're lucky to
have him there " and he told me that he put his father's nest egg in the
Fund at the age of 72 and "it's been his top-performing asset over the
last five years" (all of Paul and Jacques' liquid net worth are in the
Fund). He also told me his dad's brokers were trying to "dissuade him
from investing in a hedge fund" and they ran all sorts of "bullshit
stress tests with faulty assumptions to make their case." We both agreed
that many brokers are full of it and only look after their interests.
Finally, Paul told me that in his opinion, the two smartest guys in
Canada's financial industry are Tom Higgins, President and CEO of Maple Financial Group, and Ed Clark, President and CEO of TD Financial Group.

I'm glad I met Paul, Jacques and Brian. If you want to invest with BT Global Growth,
go to their website and contact them. The minimum investment is $150,000
CAD and they accept money from individuals and are looking for
institutional backing. If you want to know about a couple of more
interesting resource plays they mentioned to me, then donate $100 to my blog (under the pig at the top of my page) and I'll be glad to forward you the information.

Have a great long weekend. Happy Canada Day!

Via Pension Pulse.

John Cassidy wrote an excellent article in the New Yorker magazine, Mastering the Machine, on how Ray Dalio built the world's biggest and strangest hedge fund:

Ray
Dalio, the sixty-one-year-old founder of Bridgewater Associates, the
world’s biggest hedge fund, is tall and somewhat gaunt, with an
expressive, lined face, gray-blue eyes, and longish gray hair that he
parts on the left side. When I met him earlier this year at his office,
on the outskirts of Westport, Connecticut, he was wearing an
open-necked blue shirt, gray corduroy pants, and black leather boots.
He looked a bit like an aging member of a British progressive-rock
group. After a few pleasantries, he grabbed a thick briefing book and
shepherded me into a large conference room, where his firm was holding
what he described as its weekly “What’s going on in the world?”
meeting.

Of the fifty or so people present, most were clean-cut men
in their twenties or thirties. Dalio sat down near the front of the
room. A colleague began describing how the European Central Bank had
just bought some Greek bonds from investors at a discount to their face
value—a move that the speaker described as a possible precursor to an
over-all restructuring of Greece’s vast debts. Dalio interrupted him.
He said, “Here’s where you are being imprecise,” and then explained at
length what a proper debt restructuring would entail, dismissing the
E.C.B.’s move as an exercise in “kicking it down the road.”

 

Dalio
is a “macro” investor, which means that he bets mainly on economic
trends, such as changes in exchange rates, inflation, and G.D.P.
growth. In search of profitable opportunities, Bridgewater buys and
sells more than a hundred different financial instruments around the
world—from Japanese bonds to copper futures traded in London to
Brazilian currency contracts—which explains why it keeps a close eye on
Greece. In 2007, Dalio predicted that the housing-and-lending boom
would end badly. Later that year, he warned the Bush Administration that
many of the world’s largest banks were on the verge of insolvency. In
2008, a disastrous year for many of Bridgewater’s rivals, the firm’s
flagship Pure Alpha fund rose in value by nine and a half per cent after
accounting for fees. Last year, the Pure Alpha fund rose forty-five
per cent, the highest return of any big hedge fund. This year, it is
again doing very well.

 

The discussion in the conference room
moved on to Spain, the United Kingdom, and China, where, during the
previous week, the central bank had raised interest rates in an attempt
to slow inflation. Dalio said that the Chinese economy was in danger
of overheating, and somebody asked how a Chinese slowdown would affect
the price of oil and other commodities. Greg Jensen, Bridgewater’s
co-chief executive and co-chief investment officer, who is thirty-six,
said he thought that even a stuttering China would still grow fast
enough to push world commodity prices upward.

 

Dalio asked for
another opinion. From the back of the room, a young man dressed in a
black sweatshirt started saying that a Chinese slowdown could have a
big effect on global supply and demand. Dalio cut him off: “Are you
going to answer me knowledgeably or are you going to give me a guess?”
The young man, whom I will call Jack, said he would hazard an educated
guess. “Don’t do that,” Dalio said. He went on, “You have a tendency to
do this. . . . We’ve talked about this before.” After an awkward
silence, Jack tried to defend himself, saying that he thought he had
been asked to give his views. Dalio didn’t let up. Eventually, the
young employee said that he would go away and do some careful
calculations.

 

After the meeting,
Dalio told me that the exchange had been typical for Bridgewater, where
he encourages people to challenge one another’s views, regardless of
rank, in what he calls a culture of “radical transparency.”
Dalio had no qualms about upbraiding a junior employee in front of me
and dozens of his colleagues. When confusions arise, he said, it is
important to discuss them openly, even if that involves publicly
pointing out people’s mistakes—a process he referred to as “getting in
synch.” He added, “I believe that the biggest problem that humanity
faces is an ego sensitivity to finding out whether one is right or
wrong and identifying what one’s strengths and weaknesses are.”

 

Dalio
is rich—preposterously rich. Last year alone, he earned between two
and three billion dollars, and reached No. 55 on the Forbes 400 list.
But what distinguishes him more from other hedge-fund managers is the
depth of his economic analysis and the pretensions of his intellectual
ambition. He is very keen to be seen as something more than a
billionaire trader. Indeed, like his sometime rival George Soros, he
appears to aspire to the role of worldly philosopher. In October, 2008,
at the height of the financial crisis, he circulated a twenty-page
essay immodestly titled “A Template for Understanding What’s Going On,”
which said the economy faced not just a common recession but a
“deleveraging”—a period in which people cut back on borrowing and
rebuild their savings—the impact of which would be felt for a
generation. This line of analysis wasn’t unique to Dalio, but almost
three years later, with economic growth stagnating again, it does not
seem off the mark.

 

Many hedge-fund managers stay pinned to their
computer screens day and night monitoring movements in the markets.
Dalio is different. He spends most of his time trying to figure out how
economic and financial events fit together in a coherent framework.
“Almost everything is like a machine,” he told me one day when he was
rambling on, as he often does. “Nature is a machine. The family is a
machine. The life cycle is like a machine.” His constant goal, he said,
was to understand how the economic machine works. “And then everything
else I basically view as just a case at hand. So how does the machine
work that you have a financial crisis? How does deleveraging work—what
is the nature of that machine? And what is human nature, and how do you
raise a community of people to run a business?”

The
entire article is too long to post here. I recommend readers buy a copy
of the New Yorker magazine and read it. It's also available online by
clicking here (9 pages in all).

I've already shared with you the time I met Ray Dalio back in 2004 when I discussed his principle #11, which is my motto in life: "Never say anything about a person you wouldn't say to him directly. If you do, you're a slimy weasel."
Unfortunately, the slimy weasel who accompanied me on that trip screwed
me over, but that's alright, he offered me tremendous opportunities too,
and in the end he did me a favor. I hate working with weasels who are
more concerned about managing their careers than managing money.

I also remember in that meeting when I told Ray I was much more
concerned bout deflation than inflation (still am but the banksters will
fight it tooth and nail), and he responded: "Son, what's your track
record?," a polite way of saying "what the fuck do you know about
managing money, kid?" That's what I like about Ray Dalio, his
confrontational style. No bullshit, no sitting on the fence, tell me
what you think and why I should listen to you. If I worked at
Bridgewater, we'd either end up as best friends or as mortal enemies. I
back down from nobody -- not Ray Dalio, not George Soros -- nobody
intimidates me! I couldn't care less if you have more money than God, if
I think you're full of shit, I'll tell it to you in your face!

Maybe
that's why I'm blogging, doing my own thing and happier than ever. I
like being the odd guy out, working on the fringes. And that's why I
like Ray Dalio and Bridgewater. But I also fear that they too will
ultimately be victims of their success. Hope I am wrong because lots of
pension plans are relying on Bridgewater, but the bigger you are, the
harder you fall.

And Ray, extend and pretend will continue. The debt boogeyman is overdone and once this week passes and they sign some deals in Brussels and Washington, the world will wake up to another beautiful day.
As big and as smart as Bridgewater is, the world's financial oligarchs
are bigger, stronger, more corrupt and more devious, always scheming on
how to fuck the system to make ever more profits and record bonuses. Yup, at the end of
the day, the slimy weasels will win and the rottenness of the world will prevail.

When it comes to reading the world's "tea leaves", few are as capable as Ray Dalio, head of the world's biggest (macro) hedge fund, Bridgewater Associates. So when none other than Ray tells PBS' Charlie Rose that "there are no more tools in the tool kit" of fiscal and monetary policy to help America kick the can down the road, perhaps it would behoove the respective authorities to sit down and listen. Or not... and just to buy S&P futures in hopes that record career risk is big enough to force every other asset manager in the market to do the dumb thing and follow the crowd of lemmings right over the edge. Luckily, there are those who have the luxury of having both the capital and the time to not be drawn into the latest sucker's rally. More importantly, Dalio shares some unique perspectives on what it means to run the world's largest hedge fund, his perspective on social anxiety, and Occupy Wall Street and thus the demonization of wealth and success (in a way that does not imply crony capitalism: see Omaha), his views on taxation, on China, on the markets, on Europe and its insolvent banks, and most imporantly on the economy and why the much pained 2% growth (if that) will not be nowhere near enough to alleviate social tensions, such as those that have appeared over the past two months. Dalio's conclusion, in responding to whether he is optimsitic or pessimistic, to the current environment of broad delevaraging of the private sector, coupled with record releveraging of the public, is that he is "concerned." And that's why, unlike the recently unemployed David Biancos of the world, who never exhibit an ounce of skepticism, Dalio is among the wealthiest men in the world (and hence a prime target of the #OWS movement). Well, that and also being smarter than most.

Full video interview after the jump

And complete transcript:

CHARLIE ROSE: Ray Dalio is here. He is the founder of Bridgewater Associates. He created the investment firm in 1975 out of a two-bedroom apartment in New York City. Today the company managed roughly $125 billion in global investments. Its clients include foreign governments, sovereign banks, central banks and institutional pension funds.

Over the last two years, Bridgewater ranked as the largest and best- performing hedge fund in the world. In 2010, his returns were greater than the profits of Google, Amazon and eBay combined.

I`m very pleased to have Ray Dalio at this table for the first time to talk about a perspective on the global economic scene and a whole range of issues having to do with where we see ourselves and also a look at his own philosophy and what has informed his own opinions and the way he looks at the world. Having said that -- welcome.

RAY DALIO: Thank you.

CHARLIE ROSE: It`s great to have you here.

RAY DALIO: It`s great to be here.

CHARLIE ROSE: What is Bridgewater Associates?

RAY DALIO: It`s a global macro firm. We assess what the world economy is like and what -- how asset classes will change and we are managing money for pension funds and endowments like you described; the Pennsylvania teachers, those types of pension funds. We`re trying to keep them safe.

CHARLIE ROSE: When you look at the world today, the global economic picture, I read today Goldman Sachs had a disappointing performance. JP Morgan did not do as well as some had hoped it might be. What`s happening with financial firms?

RAY DALIO: I think it`s important to understand that we`re going through a deleveraging. So we have to understand the big picture is -- there`s a deleveraging. Three big themes: first there`s a deleveraging; secondly we have a problem with monetary and fiscal policies are running out of ammunition; and thirdly we have an issue in terms of people most importantly who are at each other`s throats politically and globally in terms of having a problem resolving those.

Imagine you earned $100,000 a year and you didn`t have any debt. You can go to a bank and borrow $10,000 a year. You can spend, therefore, $110 a year. When you spend $110,000 a year, somebody else earns $110,000 and they can go to a bank and there`s a self-reinforcing process in which your debt rises in relationship to your income.

And that goes on for a long time and that goes on for 50 or 75 years through history. We`ve had 50, 75-year cycles and then you reach a point where you can`t anymore get more debt and the process starts to change. And you can`t leverage up. Traditionally the private sector leverages up, we leveraged up then we got to a point in 2007 where we had a bubble and that same sort of bubble that happened in Japan, same sort of bubble that happened in the Great Depression, meaning we reached our debt limits. Europe`s reached its debt limits.

So then we begin the process in reverse as you can`t spend as much you -- somebody else`s income falls. And that process works in reverse. So we`re in a deleveraging. So I think that this is important globally. That`s what Europe`s in.

So when we deal with Goldman Sachs or when we deal with banks and when we deal with Europe I think you can break the world into two parts, there`s the debtor-developed world which has reached its debt limits and is going through a deleveraging. Then there`s the creditor-emerging world, the countries like China which are competitive and are beginning to have those big surpluses and they`re lending us money. So we have this big imbalance in the world.

You can break the world into two parts. Debtor-developed countries and emerging-creditor countries and they have a big imbalance which is a debt problem. That`s the nature of the beast of what`s going on.

CHARLIE ROSE: And how long would the deleveraging take place? Ten years?

RAY DALIO: These take place over ten years. The key is to spread it out as much as you can. Make sure that it`s not disorderly.

CHARLIE ROSE: let me talk about the dysfunction issue. We can`t solve our problems domestically in the United States, our economic problems, unless there`s some sense of respect for other people`s views and some sense of it being able to come together and find solutions that are in the interest of the country, not necessarily always in the interest of the ideology or the party.

RAY DALIO: Yes. And I think that`s the problem so pervasively when we`re talking about culture. It is -- when people disagree and you can take thoughtful people disagree, you have then the potential of learning a lot. If people who were disagreeing can say why do we disagree and work through that conversation in an intelligent way to try to find out what`s true, you can learn, you can make progress, it can be a fabulous thing.

When you instead have people who were talking behind each other`s backs and all criticizing and all looking for blame, this is a problem. I think the real question is how we approach those -- can we approach that in a thoughtful way in which we work that through?

Let`s say for example the government budget balance.

CHARLIE ROSE: Right.

RAY DALIO: The government budget balance if you raise taxes -- if everybody just sucked it in a little bit, you raise taxes by three percent, you cut spending by three percent -- I`m using three percent as an example to say not much. Everybody should be able to pay three percent more or you should be able to cut your expenditures by three percent.

CHARLIE ROSE: If the government did that --

RAY DALIO: If the government did that, they would eliminate half the budget deficit -- it`s estimated about $8.5 trillion over the next ten years is what we`re going to have as a deficit, they will eliminate half of that. Now --

CHARLIE ROSE: Over how long a period?

RAY DALIO: The next ten years.

CHARLIE ROSE: The next ten years, all right.

RAY DALIO: Now, I`m asking you if we could have every American -- can everybody pay three percent more? Can everybody just spend three percent less? You can make a heck of a contribution to that.

Instead we have a division that`s going on in which we -- the basic division is Republicans will say that we shouldn`t raise taxes.

CHARLIE ROSE: Or even reduce deductions.

RAY DALIO: Yes -- in that way of raising taxes. So we -- and Democrats say that we must raise taxes because we can`t cut the spending. So the delineation that as we came into that was the debt limit issue, that remains the debt limit issue.

And there`s vested interests involved; 70 percent of the taxes are paid by the top 10 percent of income earners, income taxes. And so -- so what we have is a division here in which there`s not a coming together, I believe, and that means that in a deleveraging at a difficult time we`re not dealing with it in the best possible way. But it`s human nature.

CHARLIE ROSE: We are doing as they say, kicking the can down the road and not dealing with it. Suppose the super committee does not reach an agreement in terms of its requirement and therefore the mechanism -- the trigger mechanism kicks in? What does your team think about that and what impact will that be?

RAY DALIO: Charlie, I`m meant to be a realistic person and sometimes when there`s concerns it`s difficult to talk about difficult situation. So I want to try and answer your question as honestly as I possibly can but I want to say that I`m very concerned not just of that. I do not believe that we will find a political solution. I think that that would not be -- I`m pessimistic about that.

CHARLIE ROSE: So you have the same opinion that Standard & Poor`s had when they reduced --

RAY DALIO: Essentially.

CHARLIE ROSE: -- America`s credit rating.

RAY DALIO: Essentially. So I think -- and by the way I think it`s very important to understand that the government debt is the terrible challenging issue that we should talk about maybe but also more important is the private sector debt. So that resolving the public sector debt does not resolve the problem.

That individuals face the same problem meaning that they`re overly indebted and because they`re overly indebted and spend a lot of their consumption through borrowing and they had a -- it was like if you borrow you have a party and everything`s good and you have a prosperity and you -- you have your party, you hire the caterers, they`re employed and everybody`s happy.

So that there`s a private sector debt issue at the same time as the public sector debt. They`re both. So if you resolve the budget deficit, you do not resolve the private sector debt issue. Both of those things mean we`re both overly indebted. We cannot -- the amount that we owe and have promised in its various forms can`t be paid.

Now we can accept is that right or wrong but let`s -- and I think we need to talk about it forthrightly whether that`s right or wrong. And if it`s right -- and I believe it`s right -- then we have to talk calmly and logically about how we can approach that and deal with it in the best possible way without having this battle of one side or another.

Like the issue of is it better to have austerity or stimulus? The basic problem there is that there`s not a quality conversation on the subject. So if people who disagree could sit down and work on a television show or something, work through, how does the machine work, how does the economic machine work? What does it mean to each of those? How has it worked in the past so that they can understand what exists. Get past the ideology part of it and get on with trying to say we have is very difficult situation and how do we deal with it in our best possible way together?

We can`t solve the problem easily because we still have too much debt. But we can move forward in being able to make the best of it. We can spread it out, we can keep orderly we have a situation now in which we have a very severe situation, not only because we have a deleveraging going on, but we have a situation in which monetary policy cannot work the way it worked in the past, that fiscal policy will not be stimulative.

CHARLIE ROSE: Some people say that they describe that as there are no more tools in the tool kit.

RAY DALIO: There are no more tools in the tool kit.

CHARLIE ROSE: In terms of fiscal and monitory policy.

RAY DALIO: Yes, so number one is we have a deleveraging. Now that deleveraging means we`re going to have more debt problems. You`re going to see -- no matter what is solved in Europe you will have a deleveraging. Banks will lend less and lending less will mean a contraction. That`s -- that is what I believe is the case, we should talk about whether or not that is the case. Thoughtful people should discuss that.

If it is the case, we should then approach how do we deal with that? Now - - so I`m saying there`s a -- I believe there`s a deleveraging going on. There are no tools in the tool kit and everybody`s at each other`s throats.

So that there is not a quality conversation of what is true; how do we best handle it?

CHARLIE ROSE: We have had that debate about the need for growth -- which would be a stimulative impact on the economy and at the same time the need to reduce spending because of the debt and the deficit as well as the long- term debt. You need also to make investments for the future in terms of science and research and a whole range of issues so that that the country - - this country can be competitive around the world. Make sure it trained scientists and doctors and people who make a positive long-term contribution to the economy.

What is your own analysis as to how we find the right balance between austerity and growth? Or austerity and stimulus?

RAY DALIO: I think -- I think it just comes back to the fundamentals same for us. Individually, the economics for government work the same as the economics pretty much for the individual that whatever we expend money on, we have to make sure -- there`re certain things that are critical.

First you have to make sure that it will -- it produces an income to pay it back. Investment, in other words, in some fashion or another. What we have to do is make sure that we put that money out and we -- let`s say we build infrastructure, I believe that you can build infrastructure. I believe that you can hire people who unproductive people -- people now who are idle, I think the worst thing now is not only the economics of it but I think the social impact of individuals who are not working or are living beneath their potential is a -- is a dangerous thing.

It`s a social tragedy. It`s not good for them; it`s not good for the society. It`s a cancer that exists. They have to be made productive. But you can`t waste money doing it.

So those jobs -- whatever they may end up being -- or those investments have got to have a payback. And then --

(CROSSTALK)

CHARLIE ROSE: Did the stimulus program that was enacted by the Congress after the President -- this President -- assumed office, did it make a contribution to growth at all?

RAY DALIO: Oh, it made -- it certainly made a big contribution --

(CROSSTALK)

CHARLIE ROSE: It did create jobs? Because some people would like to believe that that stimulus program didn`t create jobs and you`re here to say with your own analysis it did create some jobs.

RAY DALIO: Oh, a lot.

CHARLIE ROSE: Yes.

RAY DALIO: Ok but we -- at the same time -- and it created growth and it created some jobs. At the same time we have this overriding factor that is depressing jobs. So it created jobs in an environment -- and let`s -- so let`s turn to what is depressing jobs.

CHARLIE ROSE: Right. What is?

RAY DALIO: Ok. What`s depressing -- what`s depressing jobs is that the world supply and demand for labor has changed. In other words, there`s a lot more people working as China came on and India came on and they are competitive. There`s a world supply of labor has change -- has increased and technology has had an effect.

So we`re in an interesting era because I think almost and if you think of a person as -- in a machine, an economic machine as being tool, a part of that economic machine the demand for labor has changed in a very profound way. It`s an interesting question. We might enter into a period in which we don`t need people as tools. So what does that mean?

CHARLIE ROSE: The two reasons that people are enormously curious about you: number one, is simply the objective success of what Bridgewater has done and become. And secondly there are interesting questions as to how you think about the world and how you think about investments.

You have mentioned a couple times the economic machine. Give us a sense of what that means to you. Because my understanding is that`s central to a philosophy you have about the way the economy works.

RAY DALIO: Reality works in a certain way. You have to understand how reality works. If interest rates go to zero and you can`t ease monetary policy, how does the economic machine work? Ok, a central bank can make a purchase and get money in the hands of somebody else or blah, blah, blah, blah, blah.

There is a certain machine. It is operated this -- you can raise your debt relative to your income to so far but you can`t raise it more than that. And then when you reach that, that changes.

So the private sector cannot -- there are such laws of economics, such realities of if -- let`s say Europe. I`ll give you another one. We have a debt problem in Europe. You can either transfer the money from one rich country to a poor country --

CHARLIE ROSE: Right, Germany to Greece.

RAY DALIO: You can print the money.

CHARLIE ROSE: You can`t do it.

RAY DALIO: Or ECB could say I`ll find a way to do it, whatever.

CHARLIE ROSE: Right.

RAY DALIO: Or you can write them down. Those are the choices.

CHARLIE ROSE: So-called hair cut?

RAY DALIO: Hair cut.

CHARLIE ROSE: Machine for you is a theory of the way things work?

RAY DALIO: And so -- yes, that`s right. It`s a description of reality. If I ski and I`m putting my weight on my downhill ski I will make a better turn than if I don`t.

CHARLIE ROSE: And you always make a point that you know what you don`t know and that`s equally valuable.

RAY DALIO: More valuable. I want to say that -- so this is the whole philosophy. I -- I so, know that I can be wrong; and look, we all should recognize that we can be wrong. And if we recognize that we`re wrong and we worry about being wrong than what we should do is have a thoughtful dialogue.

(CROSSTALK)

CHARLIE ROSE: Ok, but that --

(CROSSTALK)

RAY DALIO: So the way I get to success. The way -- it`s not what I know. I`ve acquired some things that I know along the way and they`re helpful.

(CROSSTALK)

CHARLIE ROSE: It is -- it is -- it`s not what you know but it is --

(CROSSTALK)

RAY DALIO: It`s knowing what I don`t know or worrying that I won`t -- that I`ll be wrong that makes me find --

CHARLIE ROSE: Yes.

RAY DALIO: Well, I want people to criticize my point of view -- I want to hold down.

CHARLIE ROSE: Right.

RAY DALIO: Say I have a -- I think this but I may be wrong. And if you can attack what I`m saying -- in other words stress test what I`m saying -- I`ll learn.

CHARLIE ROSE: So that everybody knows so therefore people will be free to tell you what they think.

RAY DALIO: Of course.

CHARLIE ROSE: Because you know that it will not be held against you and you can benefit from it.

RAY DALIO: That`s right.

CHARLIE ROSE: So anybody in a meeting at your company can stand up and say Ray --

(CROSSTALK)

RAY DALIO: Absolutely.

CHARLIE ROSE: -- you`re absolutely wrong.

RAY DALIO: Of course.

CHARLIE ROSE: And you have not been precise, and your assumptions are flawed.

RAY DALIO: Oh it`s so essential, right. There`s -- the -- the number one principle at our place is that if something doesn`t make sense to you, you have the right to explore it, to see if it makes sense.

I don`t want people around who do things that they don`t -- they don`t think makes sense because I`m going to have not-thinking people.

(CROSSTALK)

CHARLIE ROSE: Right.

RAY DALIO: So that they have not only the right, they have obligation. Don`t walk away thinking something`s wrong.

CHARLIE ROSE: Failure teaches you more than success?

RAY DALIO: Of course. One of my favorite books is "Einstein`s Mistakes."

CHARLIE ROSE: Right. And because it showed you that even Einstein, the most brilliant person of the century in common judgment made mistakes?

RAY DALIO: The great fallacy of all -- I think of all of mankind practically -- I mean that`s a big statement -- but the great fallacy is that people know more than what they do and there`s a discovery process and so when you look at -- that`s the process for learning.

The process for learning is to say "I don`t know." Like, I`m -- I`m totally comfortable being incompetent. If I -- if I -- I like being incompetent. I don`t mind being an incompetent. If I don`t -- how -- how much can you be competent about?

And so that whole notion of do you like learning? Do you like finding out what`s true and building on it without an ego? And that becomes the problem. How many statements do you listen to people that begin "I think this, I think that," where they should be asking "I wonder."

CHARLIE ROSE: What`s in here? And why did you write it; because you wanted people who come to work with you to understand what your own philosophy was about openness, about management about dialogue, about the machine.

RAY DALIO: Yes. So what -- I think every place has to have a culture.

CHARLIE ROSE: Right.

RAY DALIO: And culture is the values. What -- when values are leaving (ph) out and so for example the number one value is it has to make sense to you, we have to talk about it, we have to work it through in a none egotistical kind of way. And so it`s an unusual place and it`s an unusual culture.

CHARLIE ROSE: Are you offended when people sometimes label it a cult?

RAY DALIO: I think that -- I think a cult -- when I think of a cult it means believe this. And where -- it`s the opposite.

CHARLIE ROSE: Yes, you`re taken from on high.

RAY DALIO: In other words a cult mean -- yes. Somebody`s telling you believe this --

(CROSSTALK)

CHARLIE ROSE: Because I said so.

RAY DALIO: And follow it.

CHARLIE ROSE: Because I have a superior wisdom.

RAY DALIO: Ok, it`s exactly the opposite of that, right? The number one principle is "Don`t believe anything; think for yourself." And now let`s go through a process of what is true together. But we can`t stop that with ego. We can`t let that barriers stand in our way. So we`re going to live in a culture in which we can do that.

Ok, now that`s opposite of a -- ok, it`s a belief system, in other words I`ll ask you do you believe that we should operate this way with each other. Ok, if you want to call that a cult, I think it`s the opposite of a cult, it means "think," right? Speak up. Don`t hide it; don`t talk behind people`s backs. Its talking behind people`s --

(CROSSTALK)

CHARLIE ROSE: Did you have these ideas for a long time or these ideas that you came to through, came to through your own experience and your own living and your own sense of what you read and what you question and you came to this?

RAY DALIO: Of course, of course through my whole life. Now as I say when I started at the markets, the knowing I don`t know and the liking to have people challenge me. So when I was young I did like that -- to know. I did know that I`m -- I`m an independent thinker and I know that for an independent thinker and I like to innovate. We like to innovate.

And if you`re going to have an innovative thinker, they made --there`s a high chance they`ll be wrong and if you have to have an independent thinker they`re going to have a different point of view than the next person.

So if you`re going to have innovation and independent thinking you`re going to have to have the ability to disagree, to find out what`s wrong and I learned through my whole experience day after day that the cost of being wrong is a terrible thing.

So I worry about being wrong and because I worry about being wrong I want to know what`s true.

CHARLIE ROSE: Yes.

RAY DALIO: And we have a community here, I want to know what`s true including my strengths and weaknesses so that I know how to deal with them and I want to be in a community of other people who want to do that.

CHARLIE ROSE: Do you believe as --

(CROSSTALK)

RAY DALIO: And by the way that`s connected to our performance.

CHARLIE ROSE: You have this dialogue with members of the Tea Party on the Republican side and the members of the President`s administration on the other side. What would you tell them about the necessity for revenue in the next ten years?

RAY DALIO: Well, here`s what I would be telling them.

CHARLIE ROSE: You`ve got to tell them more than just talk.

(CROSSTALK)

RAY DALIO: Ok, no but here`s what I would say. Can I, Mr. President -- Mr. Alternative Republican --

(CROSSTALK)

CHARLIE ROSE: Mr. Cantor, let`s say.

RAY DALIO: Ok, can we first just together sit down in a room, together with whoever you want to bring in, and go through an exercise of finding -- now forget what we should do at the moment -- just find out a discussion of how does the economic machine work? How does the machine work? We`re not going to get to what we`re doing at the moment. And can we agree on how the machine works?

CHARLIE ROSE: Do you think they`ve done that or not?

RAY DALIO: I -- they don`t do that. They don`t -- this is the big thing. Everybody`s looking at what to do and there`s a debate --

(CROSSTALK)

CHARLIE ROSE: Well but no this is about can they do -- when I said do you think they have done that or not? Meaning have they set --

(CROSSTALK)

RAY DALIO: No, no, no.

CHARLIE ROSE: Let`s just test all of our assumptions about what`s necessary in the way the system works and the machine works?

(CROSSTALK)

RAY DALIO: No. No, so that`s the interesting thing. Everybody`s looking about what to do and each approaches it with a bias and we`ve not in a conversation that`s a quality conversation --

(CROSSTALK)

CHARLIE ROSE: And part of the argument comes -- has to do with how you read history too. Those people who were saying --

RAY DALIO: Well, we could do it together.

CHARLIE ROSE: Right, we read history together?

RAY DALIO: And you can at a very nuts and bolts level I can take any period of history and put it through my template. There`s a template I wrote that describes how I think machine works.

(CROSSTALK)

CHARLIE ROSE: Right, right. When you have signed "The Giving Pledge" with Warren Buffett and Bill Gates, have you not?

RAY DALIO: Yes.

CHARLIE ROSE: When you look at the Buffett rule about 00 as a man who has a huge income, how do you feel about the Buffett rule vis-a-vis the way you look at it in terms of whether there needs to be more sacrifice on the part of people who are at the highest level of the economic --

RAY DALIO: So I -- so -- I think the answer to that is probably true.

CHARLIE ROSE: Yes.

RAY DALIO: Ok. I think that -- but I want to be clear what -- I want to say more than this on the subject. I think that there`s not enough discussion on people being -- how do we get people to be self-sustaining?

So I want -- so the number one thing I want for my kids, the number one gift I can give my kids or the number one gift that I can give anybody is that you`re self-sufficient.

I don`t -- it`s not a matter of even living standards. It`s the notion of if you`re self-sufficient you have the freedom to make your own choices --

(CROSSTALK)

CHARLIE ROSE: It`s like a difficult parable about giving fish and teaching how to fish.

RAY DALIO: Yes and you can make whatever choices in life you want to make but you`re self-sufficient. And on an ethical standard it means that what I`m giving is equivalent to what I`m taking -- self-sufficiency, right?

So what I want to do, what I think that we need to do is say this large percentage of the population, how do we make them useful? How do we make them self-sufficient? Let`s all agree on a goal of how to achieve that. So like my kids I don`t want to just give money. Let`s -- I give -- I`m going to give away a lot more than half of my money.

CHARLIE ROSE: Right.

RAY DALIO: I`d be happy to give that to the government --

CHARLIE ROSE: If?

RAY DALIO: If the government put together programs that were like I`m giving away to charity to certain programs in which I believe the money is sufficiently used to help people.

Let`s say for example if the government created a series of programs that said there`s this education, teach for America. If I can read these things off, ok, of these types of things --

CHARLIE ROSE: All those you support.

RAY DALIO: Yes or it doesn`t have to be those.

CHARLIE ROSE: Yes.

RAY DALIO: It just has to be good.

CHARLIE ROSE: Right.

RAY DALIO: Ok? If the government --

(CROSSTALK)

CHARLIE ROSE: The result has to be self-sufficient?

RAY DALIO: Yes. So for example Arne Duncan --

CHARLIE ROSE: The Secretary of Education.

RAY DALIO: Secretary of Education is a fantastic person for dealing with improving the quality of education in the United States and he -- "Race for the Top" and such.

(CROSSTALK)

CHARLIE ROSE: So you say I`d be happy for my taxes to be raised if I knew that the money would go to be administered by someone like Arne Duncan.

RAY DALIO: Oh, man. Or even create a series of quality -- I will -- I will fund that opportunity. Give -- don`t waste it. Ok, don`t waste it. Put it to good use for education, for opportunity.

So I`m -- I think that what the country`s most important thing to give anybody is opportunity.

CHARLIE ROSE: Let me take this downtown to where there`s an economic protest on Wall Street.

RAY DALIO: Yes.

CHARLIE ROSE: In your sense -- you clearly have read about that and looked at it -- what do you think is at stake there and what do you think they`re saying to us?

RAY DALIO: I think the number one problem is that we`re not having a quality dialogue. So I wish that I could sit down --

(CROSSTALK)

CHARLIE ROSE: So somebody should be listening and --

RAY DALIO: No, no yes we get together, sit here in a room like you with those thoughts and understand how -- how -- what`s going on and what`s true. So for example on that particular case I don`t know that I adequately know the various points of views that are behind it.

CHARLIE ROSE: Right.

RAY DALIO: I certainly understand the frustration. I understand the dilemma. I understand that there`s discontent. Ok --

(CROSSTALK)

CHARLIE ROSE: Yes, discontent about there`s somehow a feeling that --

(CROSSTALK)

RAY DALIO: Right so it seems to me --

CHARLIE ROSE: -- that some people did better because of the way the rules were or some people did better because --

(CROSSTALK)

RAY DALIO: Right.

CHARLIE ROSE: -- they had power to influence Washington and they didn`t.

RAY DALIO: So I think we need to work ourselves through that. I -- I`m sorry --

CHARLIE ROSE: No, no go ahead.

RAY DALIO: Ok, so I think that not only do we have to work ourselves through that, I would say like the question really is also a question that should be dealt -- designated for our legislators, our government. Because if the government makes the rules, people will behind either -- did they break laws or did they not break laws? This is a -- this is a question of how should behavior be managed?

Like I think I -- I think I did everything right, you know I -- I did well for my customers. My customers are pension funds, teachers. I did well when others didn`t and I`m going to say that they are very grateful.

We have a wonderful relationship, 15-year wonderful relationship. That -- what happens is I happen to earn one-fifth of the profits.

CHARLIE ROSE: Right.

RAY DALIO: So then --

CHARLIE ROSE: You make 20 percent.

RAY DALIO: Ok, I earn 20 percent of the profits.

(CROSSTALK)

CHARLIE ROSE: And you take a two percent fee for doing it.

RAY DALIO: What -- yes that covers my overhead and a bit more.

CHARLIE ROSE: Right.

RAY DALIO: But anyway, I earn this money as a result. Very similar to I would say, any of those companies you mentioned, the eBay and so on and so forth.

CHARLIE ROSE: Right.

RAY DALIO: I pay about one-third in taxes. I pay about one -- I give away about one-third. And I`m -- and that`s what I do and I follow the law. And if I`m doing something that is incorrect, that they think is incorrect I`d like to know that and I would also like to say should those laws -- is that right or wrong.

CHARLIE ROSE: You want the people who work for you to tell you exactly what they believe and to be able to document the fact that it`s not just what they believe but it`s what they have discovered.

And you have to test those ideas in the marketplace of your own firm before you go off and act on those assumptions, correct?

RAY DALIO: Yes.

CHARLIE ROSE: So what is it telling you now if Greece defaults? And that has a contagion ability to leap across the Atlantic and have some influence on the U.S. economy. What is it telling you, you know, about whether China, for example can maintain the level of economic growth it`s had and avoid the kind of social conflicts that might exist in that society.

What does it tell you about emerging nations and what it is that -- what impact they will have on commodity prices and what does it tell you about the future of the dollar as a currency? All of those kinds of issues?

RAY DALIO: You`ve got a bunch of questions.

CHARLIE ROSE: No. I know I did.

(CROSSTALK)

RAY DALIO: And also I`ll do the best I can.

CHARLIE ROSE: In my remaining minute. Go ahead.

RAY DALIO: Ok, I would want to say that there is -- there are two worlds. There`s debtor-developed countries and there`s emerging creditor countries, classically the United States and China.

CHARLIE ROSE: Right.

RAY DALIO: One is a creditor, one a debtor. They are getting we`re still borrowing, we`re still in debt, we`re still -- they`re still earning. Then those two worlds can be broken into two -- those that can print money and those that can`t print money.

So now when I`m giving you the total answer in my remaining minutes, Europe is -- can`t, a lot of it, can`t print money. Therefore it will have to deal with whether there`s a transfer of wealth, there`s a limit to that transfer of wealth.

And so we are going to deal with the question of whether they would print money or get the haircuts. I think they`ll do both.

CHARLIE ROSE: Right.

RAY DALIO: When looking at China, China because they can`t raise interest rates because of their existing monetary policy, is that they can`t control credit growth in the normal ways that we control credit growth. So there`s a credit bubble emerging there and as -- in other words there`s a quality of lending and it`s bypassing the credit system.

And that`s something that the Chinese will need to get a control of because it`s a dangerous thing. And so that creates their risk. If I take then the United States we`re in a position in which there is this deleveraging. Deleveraging is risky so for example banks are leveraged about 12 to 15, 17 times.

CHARLIE ROSE: Right.

RAY DALIO: 15 times is a round number it depends on the bank. They`re leveraged 15-1 and if they go down by one-fifteenth, we have a capital problem and we`re in a deleveraging. Those problems -- bank crisis that have existed every ten years normally we are -- we can have a problem.

We don`t have the ability to have the same effect of monetary policy as we did before because a central bank -- it can buy a bond. It can -- therefore buy the bond. It gives that money to somebody who sold the bond and they were going to buy something like a bond. They`re -- the -- the getting it in the hands of somebody who spends it on cars and houses who really owes probably too much in debt is not an easy thing to do for monetary policy. So monetary policy is not as effective and then we have this social tension.

So we should be able to -- there`s this downward pressure of the deleveraging. We should be able to grow at a rate that`s comparable to our income growth if we are -- if we keep orderly and we -- and we work this through and everything is orderly. That means something between like 1.5 percent or 2 percent we should be growing at maybe about the 2 percent vicinity.

The problem with the 2 percent vicinity is that the employment rate remains the same or can trend higher. That produces social pressures, that produces tension which itself means that you can have a situation analogous to that which is existing in Greece and more social pressure you create the more tension that is existing and emerging in various ways, not just a Wall Street piece. But it`s existing in Spain.

CHARLIE ROSE: Right.

RAY DALIO: So if we can keep orderly and not argue with each other and not do disruptive things and we don`t go down ok and grow at that two percent you know maybe then it will be ok.

If we have disruption and we are not able to have a monetary policy and we can`t have fiscal stimulation and you have a problem of what do you do -- you can`t recapitalize the banks. I mean if you should happen to need to recapitalize the banks you can`t have a TARP program again.

CHARLIE ROSE: Politically not feasible.

RAY DALIO: Politically not feasible.

So you have to have a plan. You need to be thoughtful, I think, how do you create that plan and not only it`s a theoretical thing when I say how do you make a plan because you have to be able to have agreement to implement the plan. You can`t have people at odds.

As I say sometimes to policymakers my job is very -- is much easier than their job. My job is that I just have to pretty much anticipate what`s going to happen and be one step ahead. That`s not an easy job but it`s an easier job than policymakers who have to do that. They have to then find a solution for the bad stuff not happening. That`s not easy to find solutions and then even if they had solutions they have to get that solution through the political system. In which there`s -- there`s -- everybody`s saying that you can`t do that, whatever that is and everybody blaming each other.

CHARLIE ROSE: Are you optimistic or pessimistic?

RAY DALIO: I suppose I`m -- if I was -- I`m concerned. I think it`s a test of us. It`s a test of us in our society. It`s a test of us.

CHARLIE ROSE: On that note thank you for coming.

RAY DALIO: My pleasure, thank you for having me.

From Lance Roberts oF StreetTalkAdvisors

STA Risk Ratio Turns Up - We've Seen This Before

The market rallied this past week, albeit in a very volatile manner, to end the week on a positive note as the hopes of a final resolution to the Euro crisis has been reached.   In reality, today's announcement of the EU treaty is only the first step and there are many legal challenges that will still have to be resolved.  While the reality is that there is still a very long road ahead before anything will actually be accomplished the implication that the with the ECB willing to buy bonds, at least for the moment, and the coordination of two bailout funds the Eurozone can play "kick the can" for a while longer.  Those headlines, even without much substance were enough to drive return starved managers into the market for the year end rush. 

Even with the rally today the markets have made very little progress since the beginning of this year.   With that I thought it was time update our STA Risk Ratio indicator to see where we currently stand.   For reference the STA Risk Ratio indicator is a weekly composite indicator comprised of the Rate of Change of the S&P 500 Index, two different ratio of bullish and bearish sentiment, new highs versus new lows and volatility.  This indicator is weighted and then smoothed using an 8 week average.    The purpose of the indicator is not to provide trading signals for speculative stock trading but longer term asset allocation changes to adjust for market trend changes and risk management.  

As shown in the chart as the indicator rises above 50, and eventually above 100 on the index, the market is becoming overly bullish.  Therefore, as a contrarian investment indicator we begin to look for a turn down in the indicator as a sign to begin reducing portfolio risk by raising cash, increasing fixed income exposure, reducing portfolio beta or adding hedges.  Conversely, as the indicator falls below 0, and eventually -50 on the index, the market is becoming excessively bearish and we begin to reverse the allocation process.

For example, back in April, and early May, of this year we reduced our portfolio equity allocation levels to the market as the index peaked above the 100 level.  By raising fixed income and cash we avoided the majority of the summer decline.   As the indicator bottomed and turn up in October we began to add exposure back to the markets. 

My father told me long ago, and one of the best pieces of advice he ever gave me, that "when something doesn't 'feel' right - it probably isn't worth doing."  While my father was not in the investment game; his nuggets of "life" related wisdom have served me exceptionally well managing money.   With that begin said there is something that doesn't "feel" right about where we are. 

Besides the fact that our longer term "sell" signals are still in play; the STA Risk Ratio indicator is behaving very similarly to the 2008 market topping process.  First of all the current market top is still significantly below the previous 2008 top.  Furthermore, in 2008 pay particular attention to the topping action.  In mid-2008 the market peaked and made the initial decline, made a solid rally attempt that had the media alight with comments the worst was behind investors and then "BOOM".  During that process the indicator bottomed near -200, turned up signaling an increase to portfolio allocations and then you were promptly pummeled into the actual bottom in early 2009.  The difference is that in "bearish markets" turn ups in the indicator tend to denote bear market rallies rather than bull market advances.   With most of our market signals still in bearish territory and the markets remaining in a bearish trend since the peak  - market risk remains elevated. 

Today, we see the very same pattern emerging...and it doesn't "feel" right.   This is particularly concerning as we head into 2012 and potentially a very turbulent political election cycle, earnings compression due to the end of a profit cycle, a domestic economy that is currently in a "struggle to muddle" through phase, a slowing China, a recessionary Europe and plenty of potential for further crisis' from the Eurozone.  We have been here before.

Back on August 31st we wrote: "So far, none of this takes away from the larger fact that the economy is slowing down, corporate profits are weakening, and there is a lot of risk contained in Europe that could back-splash very rapidly into the U.S. This is clearly a bounce within a negative market trend at the current time and is not a new bull market to chase. With fundamentals of stocks deteriorating along with the economy, we see NO reason to take on excessive speculative risk at the current time. We are most likely witnessing end of the month portfolio rebalancing as the markets head into a long labor day weekend market. The light volume rally also does not invoke confidence in a continued push higher.

It is ALWAYS better to wait for the signal to change rather than trying to anticipate the change...many people have been hit by buses trying to jump the light. Therefore, we don't recommend chasing this rally until signals clearly provide a better opportunity.

Our primary buy/sell indicator is still firmly in SELL territory which automatically reduces equity exposure by 50% from normal allocations and increases fixed income holdings and cash. Until this indicator turns back to positive we will remain underweight in our models in equity and simply use the shorter term signals as noted above as trading opportunities to create additional alpha until such time as the risk/reward ratio is clearly aligned back in our favor."

We wrote that just before the bloodbath in September.  This is why we are currently positioned with higher than normal levels of cash and fixed income until our longer term "buy" signals come online. While "this time may be different" as long as we remain on a longer term market "sell" signal the cushion of cash gives us some flexibility to add beta if the market continues to rally.  However, and most importantly, cash provides us a "safety net" to rework portfolios should this rally fail and begin to push back toward market lows.

Paul Mylchreest, author of the Thunder Road, releases his much anticipated latest report, and it's a doozy: "2012: Dear Portfolio Manager, you are leaving the capitalist sector and heading into a full-spectrum crisis." He continues: "You were to hear a report on the world crisis. That is what you are going to hear. For twelve years you have been asking: Who is John Galt? This is John Galt speaking….Now it’s  getting serious. 2012 will be a year to remember as the globalist agenda comes into focus amidst economic and geo-political crises: The titles of the last two Thunder Road Reports were prefaced with “Helter Skelter” - “The Illusion of Market Stability” followed by “Gentlemen Start Your Engines”. Sadly, the Helter Skelter I was writing about – the second part of the Great Financial Crisis is in progress and I’m expecting it to come to a head next year (2013 if we’re very lucky). The only question is WHAT brings it to a head? We’re not short of possible causes – a bank failure, sovereign default, Eurozone tipping into recession or the Middle East. Despite all the evidence to the contrary, like overwhelming debt levels and insolvent banks/sovereigns, the consensus seems convinced that we can “muddle through”. Dow Theory veteran, Richard Russell, explained it best: “In the coming two or three years we will be going through unprecedented situations beyond the understanding of most analysts.”"

From the report:

• The turbocharged, debt-driven over-consumption of past decades must be undone. The strong medicine could and should have been taken years ago. As the primary architect, Greenspan shoulders much blame, but shrugs it off. The financial system is already past the point of no return (“In my mind and in my car, we can’t rewind we’ve gone too far”) – and we are on the brink of a TSUNAMI of new money/credit creation to delay its failure. This will be the final run to the summit of the Ponzi scheme. All Ponzi schemes end and there will have to be a system reboot. This is a “Crisis of the Ages”;
• To maintain credibility in the face of insane monetary/fiscal policies, a scapegoat for the coming surge in inflation would be helpful to TPTB, perhaps even necessary. The conflict in the Middle East and North Africa is almost certain to escalate, threatening to disrupt world oil supply. A surging oil price could be blamed as an “unexpected” external shock for the “unexpected” surge in inflation, which central bankers have repeatedly assured us (falsely) is not on the horizon. Since the creation of the Federal Reserve in 1913, the purchasing power of the US dollar has already declined by 98% (using the Fed’s own data). With a track record like that, the last 2% is not going to be difficult. Substantial declines in the purchasing power of the Euro, Yen and Sterling are likely to precede the dollar, especially if the oil price surges (importing nations will need to hold more dollars);
• BBWestern nations are at increased risk of false flag events as part of a “Strategy of tension” – be prepared then you won’t be surprised. Wikipedia: “The strategy of tension is a theory that describes how to divide, manipulate, and control public opinion using fear, propaganda,  disinformation, psychological warfare, agents provocateurs, and false flag t------st actions. The theory began with allegations that the United States government and the Greek military junta of 1967–1974 supported farright t------st groups in Italy and Turkey, where communism was growing in popularity, to spread panic among the population who would in turn demand stronger and more dictatorial governments.” TPTB might prefer a distracted, pliant and fearful public; and
• The majority of people probably won’t agree (yet) with much of this paragraph, but we are in a chain of events where the direction of travel is: INFLATIONISM - INTERVENTIONISM - SOCIALISM - REDUCED LIVING STANDARDS - TOTALITARIANISM. Elements of all of them are already present to a greater or lesser extent, as I’ll discuss. Of course, the earlier ones, inflationism and interventionism (which Ludwig Von Mises described as “socialism by installments”), are the most obvious. What we are experiencing was prophesied in fictional form by Ayn Rand in her masterpiece “Atlas Shrugged” when it was published in 1957. I’m reading it and it’s amazing.

This process raises interesting questions regarding asset allocation and while not all of them are very palatable, we are where we are. Let me outline my analytical framework for the big picture (rather than individual stocks) then highlight the key lessons from this report which, it turned out, fit into the framework:

Kondratieff Cycles: back to the dawn (almost) of the Industrial Revolution in 1788 - nominal GDP, real GDP growth, inflation, debt, interest rates and the performance of the key asset classes – stocks, bonds, commodities, gold and real estate. I only know of one other person (Ian Gordon) on the planet who has modelled this in detail, although there may be others. Joseph Schumpeter, who never did say which two of his three goals in life he achieved (to be the greatest economist in the world, the best horseman in Austria and the greatest lover in all of Vienna), had this to say:

“The Kondratieff Wave is the single most important tool in economic forecasting.”

Unfortunately my model of the Kondratieff Cycle is SCREAMING depression and reduction in living standards.

The mechanics of the four great price waves during the last millenium: Medieval, the “Price Revolution” of the 16th to the first half of the 17th centuries, 18th century-early 19th century and the (rather important) current one;

Geopolitics: Mackinder’s Heartland theory, Brzezinksi’s “The Grand Chessboard”, Paul Kennedy’s “The Rise and Fall of Great Powers”, Project for the New American Century, and numerous works on the decline of the Roman Empire due to the startling parallels with the US (as  documented in Thunder Road Report 23);

Demographics: like Harry S. Dent’s work on the predictable nature of consumer spending based on family formation pattern. The US birth rate peaked in 1961 (UK was similar) and peak earnings/spending of the average citizen is 48.5 years of age - as they say in America “you do the math”. The baby boomers’ kids will be coming out of college…!

Market interventions by the authorities: the Gold Cartel (the Gold Anti-Trust Action Committee - GATA - deserves immense recognition here), silver (Ted Butler likewise), equities via the President’s Working Group on Financial Markets and let’s not forget the Counterparty Risk Management Policy Group and the US Treasury Secretary’s gigantic slush fund, the Exchange Stabilization Fund. By the way, Bill Murphy’s Midas column on the Le Metropole Café website is the first thing I have read every day for six years and not just for gold.

Exter’s pyramid: a central banker who believed in sound money and his theory of capital flows in a major crisis is playing out right now. Speculative capital moves down through the credit instruments as, one by one, each credit instrument loses its “moneyness” – the last one being the US dollar/Treasury complex. The final destination is the only asset which doesn’t pay a yield – it doesn’t need to – it’s the ONLY one without counterparty risk in the biggest debt crisis in history.

The nature and history of money: I’m tempted to cite Francisco d’Anconia’s speech about money in Atlas Shrugged and Roy Jastram’s “The Golden Constant” - a key empirical study of how gold outperformed in both inflationary AND deflationary periods since the 16th century  (although it neglects today’s Gold Cartel and that alogorithm which only allows gold to rise on “risk on” days);

The globalist agenda: NWO, CFR, Rhodes, Trilateral Commission, Bilderberg, Club of Rome, etc. Few people in the markets incorporate its impact despite: i) it is heavily documented; and ii) it provides the context for so many world events - which suddenly lose their apparent “randomness”;

“Austrian” economic theory: especially Ludwig Von Mises’ work in relation to credit bubbles and free market capitalism; and

Studying financial history mixed with pattern recognition with the above.

Without a framework with which you can see beyond the short term, it’s getting more and more like being a spectator at a tennis match. Look at the equity market recently, or gold and silver, where the prices have fallen as the banking system disintegrates. Markets are all over the place, as more and more holes in the dyke burst open.

The main lessons I learnt from this report are about SOCIALISM and its impact on financial markets. For example:

• How far we’ve departed from the ideal of free-market capitalism and how far the Socialist takeover has advanced;
• How the style of the Socialist takeover has elements of both the extreme left and the extreme right (“national”) on the political spectrum – not only making it harder to categorise, but also harder to see; and
• What I think that this means for asset allocation.

Let’s take the last point and consider some of the key themes:

• Socialism from the Left: government taking a greater share of GDP, lower living standards and debasement of currencies;

Combined with:

• Socialism from the Right: government largesse and corruption with certain large corporate interests which serve the purposes of the state, military adventurism and a much more controlled society.

If it looks like a duck and quacks like a duck…

The source of this whole chain of events is inflationism and the debasement of currencies. As it unfolds, gold and silver increasingly become the critical assets to hold in order to safeguard capital. Currently, prices are being held down to hide the wreckage of the financial system and enable TPTB to load up. Market prices and demand for physical metal are temporarily disconnected. Going forward, essential items, like food and energy (especially crude oil) will account for a larger share of the “economic pie” as living standards decline and inflation increases. In contrast, items like luxury goods and diamonds (not a store of wealth) will suffer. I’m not planning on being short oil in 2012 as it strikes me as incredibly dangerous. The oil sector, along with defence, should benefit from the crossover of socialism from both the “left” and the “right” (military adventurism and the potential for conflict in the Middle East). Defence contractors are big beneficiaries of government contracts and lasting cuts to military spending rarely feature in declining empires. But of all the sectors which are “in bed” with governments, none come close to the major banks. However, I don’t care what happens to their share prices, EVERYTHING I have learnt as an analyst tells me not to touch them as investments. The accounting principles used for both the balance sheets and P&L accounts render them almost meaningless and that’s before taking account of OTC derivatives exposure and counterparty risk which can scarcely be imagined. You can’t even get close to analysing them properly and it’s legitimate to question whether professional investors managing money for pension funds, for example, should hold any major bank stocks at all?

Full report (pdf):

In 26 years on Wall Street, Nic Colas of ConvergEx, has worked for seven firms and reported to nine different people.  His insights make up a highlight reel of things those people have told him which have stuck in his memory over the years (for better or worse) and seemed worth sharing with a broader audience.  The most insightful: “Don’t make this game harder than it has to be.”  From the same boss, the most motivating: “Someone is getting the information before you.  Why don’t I fire you and hire them?”  On customer service: “What am I? A pimp?  Get me a black car.”  And possibly the most important for someone who makes their living serving the investment community on the sell-side: “Do you know what it means when a dog shows well?”

I have had the good fortune to make a living on Wall Street for just over 25 years, and during that time I have reported to nine different bosses.  All of them have held the reins with a light hand, but they all have at some point passed along some wisdom that has stuck in my head.  Today’s note is a compendium of their most notable sayings, with a brief explanation of the featured aphorism as well as a little context around them.

“We clean our trays.”

Like many investment professionals of my generation, I started during the great mutual fund boom of the 1980s.  My first job was in the customer service department of what is now one of the largest fund companies in the world, sitting in the mail room looking for checks from brokers to buy either a mortgage securities, small cap stock, or technology fund.  That was the extent of the offering at the time, which gives you a sense of how early the firm was in the development of its mutual fund offerings.

My first boss came out of the transfer agency world, and he spent most of his time on the road visiting the operations departments of our broker customers.  He was what we would now call an “Obsessive-Compulsive Disorder” neat freak, and the first thing he would do when boarding a plane was to check the cleanliness of his tray table.  If it wasn’t spotless, he would spend the rest of the flight worrying that the requisite airplane maintenance hadn’t been done properly.  His unofficial motto for our operation was “We clean our trays.”  We managed to stop him from putting that on the corporate t-shirts, thankfully.  The idea that little things matter did, however, stick with me.

“Do you know what it means when a dog shows well?”

After three years tending to mutual fund shareholders, including the 1987 crash, I went off to business school with an eye to getting a job in stock research.  At the time, the best sell-side firm for this discipline was the old Donaldson, Lufkin and Jenrette.  So in my second year of business school I ended up at DLJ’s offices in Manhattan interviewing with their head of equity sales.

I asked him what he looked for in a research analyst.  I expected to hear quantifiable attributes like deep fundamental understanding of their industry, or a real edge in accounting and financial modeling.  Instead, he asked me if I had ever been to a dog show.  I said yes.  He then explained that he was looking for people that “Showed well” – basically energetic presenters who enthusiastically engaged the client base.  I still embrace that message to this day, even though the canine comparison is a bit off-putting, to say the least. I never did get to work at DLJ – they ended up not hiring the year I came out of business school.  But this quote is too good to pass up, so I include it here.

“What am I?  A pimp?  Get me a black car.”

My eventual employer was First Boston, where I covered the auto industry.  One of the dirty secrets of the sell-side analyst world is that you spend considerable time tending to corporate management while carting them around to see clients.  Even the most laid-back CEO or CFO still likes to be treated well, and I learned that this means wildly different things to different people.

While traveling in Milan with one management team, the limo company sent us an old Bentley sedan in shining pearlescent white.  The CFO took one look at it, and asked if I thought he ran an escort service on the side.  He didn’t like the car, and even after a long flight from the States he was unwilling to ride in a conveyance unbefitting a U.S. corporate chieftain.  Half an hour and several frantic calls later, an ancient black Lincoln showed up (Lord knows why a Milanese car company has such a car) and all was good again.  But the lesson of “Know your customer” is a deep and occasionally unfathomable river, to be sure.

“You will make a lot of money, but you’ll be very unhappy.”

When I told my last boss at First Boston that I was going to a highly successful hedge fund, he shook his head like I was a puppy who had just soiled an expensive carpet.  “You won’t be happy there.  You are essentially a happy person.  You’ll be around very rich guys who are miserable all day long.  You are going to make more money than you can imagine, but you will regret this decision.”

At the time I could not fathom the notion that money and happiness were anything but happy bedfellows.  But he was more right than wrong.  I learned more about the markets and investing in six months in my new job than I had in nine years as a sell-side analyst.  At the same time, the all-consuming nature of the job fulfilled his prophecy.  Your job has to fulfill a whole range of personal requirements as well as pay the mortgage.

“Don’t make things harder than they have to be.”

“Early is the same as wrong.”

“I can make more money; I can’t make more time.”

“Some is getting this information before you.  Why don’t I fire you and hire them?”

All these quotes come from the same secretive multi-billionaire hedge fund manager who was my next boss.  What he taught everyone in the room was that information is only investable when it comes early and is different from what the market believes.  In that respect, managing money is a simple task.  Making this mandate more nuanced is a waste of time.  And more time is the one thing even a billionaire cannot buy.  Truly actionable information is hard to get, and it is the only job of anyone interested in running money.

“Dentist and doctors are lousy investors.”

After the hectic pace of the first hedge fund, I went to a second one, managed by a highly pedigreed value manager.  One of the deep dark secrets of the hedge fund world is that every manager needs two edges – how to manage money effectively, and how to get investors whose needs fit that investment approach.  Easier said than done, that second one, and in many ways just as difficult as the first.  His target audience was doctors and dentists, for he found that even the most accomplished medical groups were full of woefully incompetent investors.  My boss was not a smooth presenter for all his investment acumen.  But he came across as someone you could trust, and that was enough for his target investors.

The lesson here is that success comes in many forms.  Every hedge fund manager of any note has hundreds of meetings with potential investors on their way to their first $1 billion in assets under management.  The clever ones know that there are pockets of capital – some of them very deep indeed – that go under-serviced.  Who needs the smart New York based fund of funds when there is a successful dental practice in Islip with $25 million to invest or a group of dermatologists in Houston with $100 million burning a whole in their pockets?

“Everyone can be a real estate agent for one year.  It’s the second one that kills them.”

This last one comes from my current boss, and I am still surprised as to the number of circumstances to which this aphorism applies.  His point is that many businesses get off the ground with one trick.  For a real estate agent, it might be combing through their personal contacts for likely customers.  When they exhaust that pipeline of customers, likely with some early success, they have nothing in the bag to sustain the business in year two.

The underlying problem is one of competitive advantage, the most underappreciated challenge in everything from stock analysis to personal development.  Developing an edge as a company means finding your best advantages, honing them, communicating them to everyone from employees to investors, and forgetting everything else.  Can’t make more time, as the hedge fund manager boss told me.  As an individual, the lesson is essentially the same.  

Two years ago, in January 2010, Zero Hedge wrote "This Is The Government: Your Legal Right To Redeem Your Money Market Account Has Been Denied" which became one of our most read stories of the year. The reason? Perhaps something to do with an implicit attempt at capital controls by the government on one of the primary forms of cash aggregation available: $2.7 trillion in US money market funds. The proximal catalyst back then were new proposed regulations seeking to pull one of these three core pillars (these being no volatility, instantaneous liquidity, and redeemability) from the foundation of the entire money market industry, by changing the primary assumptions of the key Money Market Rule 2a-7. A key proposal would give money market fund managers the option to "suspend redemptions to allow for the orderly liquidation of fund assets." In other words: an attempt to prevent money market runs (the same thing that crushed Lehman when the Reserve Fund broke the buck). This idea, which previously had been implicitly backed by the all important Group of 30 which is basically the shadow central planners of the world (don't believe us? check out the roster of current members), did not get too far, and was quickly forgotten. Until today, when the New York Fed decided to bring it back from the dead by publishing "The Minimum Balance At Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market FUnds". Now it is well known that any attempt to prevent a bank runs achieves nothing but merely accelerating just that (as Europe recently learned). But this coming from central planners - who never can accurately predict a rational response - is not surprising. What is surprising is that this proposal is reincarnated now. The question becomes: why now? What does the Fed know about market liquidity conditions that it does not want to share, and more importantly, is the Fed seeing a rapid deterioration in liquidity conditions in the future, that may and/or will prompt retail investors to pull their money in another Lehman-like bank run repeat?

Here is how the Fed frames the problem in the abstract:

This paper introduces a proposal for money market fund (MMF) reform that could mitigate systemic risks arising from these funds by protecting shareholders, such as retail investors, who do not redeem quickly from distressed funds. Our proposal would require that a small fraction of each MMF investor’s recent balances, called the “minimum balance at risk” (MBR), be demarcated to absorb losses if the fund is liquidated. Most regular transactions in the fund would be unaffected, but redemptions of the MBR would be delayed for thirty days. A key feature of the proposal is that large redemptions would subordinate a portion of an investor’s MBR, creating a disincentive to redeem if the fund is likely to have losses. In normal times, when the risk of MMF losses is remote, subordination would have little effect on incentives. We use empirical evidence, including new data on MMF losses from the U.S. Treasury and the Securities and Exchange Commission, to calibrate an MBR rule that would reduce the vulnerability of MMFs to runs and protect investors who do not redeem quickly in crises.

And further:

This paper proposes another approach to mitigating the vulnerability of MMFs to runs by introducing a “minimum balance at risk” (MBR) that could provide a disincentive to run from a troubled money fund. The MBR would be a small fraction (for example, 5 percent) of each shareholder’s recent balances that could be redeemed only with a delay. The delay would ensure that redeeming investors remain partially invested in the fund long enough (we suggest 30 days) to share in any imminent portfolio losses or costs of their redemptions. However, as long as an investor’s balance exceeds her MBR, the rule would have no effect on her transactions, and no portion of any redemption would be delayed if her remaining shares exceed her minimum balance.

 

The motivation for an MBR is to diminish the benefits of redeeming MMF shares quickly when a fund is in trouble and to reduce the potential costs that others’ redemptions impose on non?redeeming shareholders. Thus, the MBR would be an effective deterrent to runs because, in the event that an MMF breaks the buck (and only in such an event), the MBR would ensure a fairer allocation of losses among investors.

 

Importantly, an MBR rule also could be structured to create a disincentive for shareholders to redeem shares in a troubled MMF, and we show that such a disincentive is necessary for an MBR rule to be effective in slowing or stopping runs. In particular, we suggest a rule that would subordinate a portion of a redeeming shareholders’ MBR, so that the redeemer’s MBR absorbs losses before those of non?redeemers. Because the risk of losses in an MMF is usually remote, such a mechanism would have very little impact on redemption incentives in normal circumstances. However, if losses became more likely, the expected cost of redemptions would increase. Investors would still have the option to redeem, but they would face a choice between redeeming to preserve liquidity and staying in the fund to protect principal. Creating a disincentive for redemptions when a fund is under strain is critical in protecting MMFs from runs, since shareholders otherwise face powerful incentives to redeem in order to simultaneously preserve liquidity and avoid losses.

Basically, according to the Fed, the minimum balance would make the financial system more fair, reduce systemic risk and protect smaller investors who can be left with losses if larger investors in their fund withdraw cash first. The proposal would require a "small fraction" of each fund investor's recent balances to be segregated into a sinking fund to absorb losses if the fund is liquidated. Subsequently redemptions of these minimum balances at risk would be delayed for 30 days, "creating a disincentive to redeem if the fund is likely to have losses." In other words: socialized losses. Where have we seen this before?

But the real definition of what the Fed is suggesting is: capital controls. Once this proposal is implemented, the Fed, or some other regulator, will effectively have full control over how much money market cash is withdrawable from the system at any given moment. At $2.7 trillion in total, one can see why the Fed is suddenly concerned about this critical liquidity and capital buffer.

The problem is that just as we said over two years ago, a brute force attempt to preserve a liquidity buffer is guaranteed to fail, as MMF participants will simply quietly pull their money out at the convenience when they can, not when they have to. Europe had to learn this the hard way - only after Draghi cut the deposit rates to 0% did virtually every European money market fund become irrelevant overnight, resulting in a massive pull of cash from the MMF industry. However, instead of going into equities as the Group of 30 and other central planners had hoped, the hundreds of billions of euros merely shifted into already negative nominal rate fixed income instruments. And who can blame them: money market capital does not seek return on capital but return of capital, to borrow Bill Gross' favorite line.

Another clue as to why the Fed is once again suddenly interested in money markets comes from an article we wrote back in September 2009: "Rumored Source Of Reverse Repo Liquidity: Not Bank Reserves But Money Market Funds" in which we said that, "the Chairman is rumored to be considering money market funds as a liquidity source. Reuters points out that the Fed would thus have recourse to around $4-500 billion, and maybe more, of the $3.5 trillion sloshing in "money on the sidelines", roughly the same amount as MMs had just before the Lehman implosion."

In a nutshell, money market funds (much more on this below), have always been one of the most hated liquidity intermediaries by the central planners: they don't go into stocks, they don't go into bonds, they just sit there, collecting no interest, but more importantly, are inert, and can not be incorporated into the rehypothecation architecture of shadow banking.

And perhaps that is precisely why the Fed is pulling the scab off an old sore. Recall that for the past year, our primary contention has been that the core reason for all developed world problems is the gradual disappearance of good collateral and money good assets.

Even if the MMF cash were to shift, preemptively, into bonds, or any other "safe" investments, the assets backing the cash can them enter the traditional-shadow liquidity system and buy time: the only real goal at this point. In the process, the cash itself would be "securitized" and provide at least a year or so in additional breathing room for a system that has essentially run out of good liquidity, and in Europe, out of any collateral.

Expect more and more efforts to disgorge the $2.7 triliion in money market funds as the world gets closer and closer to D-Day. And what happens with MMF, will then progress to all other real asset classes as the government truly spreads out its capital controls wings.

* * *

For a more nuanced read through of the implications of money market redemption denials, we suggest rereading our analysis of precisely this topic from January 2010. Just keep in mind: in the interim we have had two and a half years of ZIRP and NIRP based asset depletion, which means that the marginal requirement to get MMF cash "back" into the system is now higher than ever.

This Is The Government: Your Legal Right To Redeem Your Money Market Account Has Been Denied

When Henry Paulson publishes his long-awaited memoirs, the one section that will be of most interest to readers, will be the former Goldmanite and Secretary of the Treasury's recollection of what, in his opinion, was the most unpredictable and dire consequence of letting Lehman fail (letting his former employer become the number one undisputed Fixed Income trading entity in the world was quite predictable... plus we doubt it will be a major topic of discussion in Hank's book). We would venture to guess that the Reserve money market fund breaking the buck will be at the very top of the list, as the ensuing "run on the electronic bank" was precisely the 21st century equivalent of what happened to banks in physical form, during the early days of the Geat Depression. Had the lack of confidence in the system persisted for a few more hours, the entire financial world would have likely collapsed, as was so vividly recalled by Rep. Paul Kanjorski, once a barrage of electronic cash withdrawal requests depleted this primary spoke of the entire shadow economy. Ironically, money market funds are supposed to be the stalwart of safety and security among the plethora of global investment alternatives: one need only to look at their returns to see what the presumed composition of their investments is. A case in point, Fidelity's $137 billion Cash Reserves fund has a return of 0.61% YTD, truly nothing to write home about, and a return that would have been easily beaten putting one's money in Treasury Bonds. This is not surprising, as the primary purpose of money markets is to provide virtually instantaneous access to a portfolio of practically risk-free investment alternatives: a typical investor in a money market seeks minute investment risk, no volatility, and instantaneous liquidity, or redeemability. These are the three pillars upon which the entire $3.3 trillion money market industry is based.

Yet new regulations proposed by the administration, and specifically by the ever-incompetent Securities and Exchange Commission, seek to pull one of these three core pillars from the foundation of the entire money market industry, by changing the primary assumptions of the key Money Market Rule 2a-7. A key proposal in the overhaul of money market regulation suggests that money market fund managers will have the option to "suspend redemptions to allow for the orderly liquidation of fund assets." You read that right: this does not refer to the charter of procyclical, leveraged, risk-ridden, transsexual (allegedly) portfolio manager-infested hedge funds like SAC, Citadel, Glenview or even Bridgewater (which in light of ADIA's latest batch of problems, may well be wishing this was in fact the case), but the heart of heretofore assumed safest and most liquid of investment options: Money Market funds, which account for nearly 40% of all investment company assets. The next time there is a market crash, and you try to withdraw what you thought was "absolutely" safe money, a back office person will get back to you saying, "Sorry - your money is now frozen. Bank runs have become illegal." This is precisely the regulation now proposed by the administration. In essence, the entire US capital market is now a hedge fund, where even presumably the safest investment tranche can be locked out from within your control when the ubiquitous "extraordinary circumstances" arise. The second the game of constant offer-lifting ends, and money markets are exposed for the ponzi investment proxies they are, courtesy of their massive holdings of Treasury Bills, Reverse Repos, Commercial Paper, Agency Paper, CD, finance company MTNs and, of course, other money markets, and you decide to take your money out, well - sorry, you are out of luck. It's the law.

A brief primer on money markets

A very succinct explanation of what money markets are was provided by none other than SEC's Luis Aguilar on June 24, 2009, when he was presenting the case for making even the possibility of money market runs a thing of the past. To wit:

 

Money market funds were founded nearly 40 years ago. And, as is well known, one of the hallmarks of money market funds is their ability to maintain a stable net asset value — typically at a dollar per share. In the time they have been around, money market funds have grown enormously — from $180 billion in 1983 (when Rule 2a-7 was first adopted), to $1.4 trillion at the end of 1998, to approximately $3.8 trillion at the end of 2008, just ten years later. The Release in front of us sets forth a number of informative statistics but a few that are of particular interest are the following: today, money market funds account for approximately 39% of all investment company assets; about 80% of all U.S. companies use money market funds in managing their cash balances; and about 20% of the cash balances of all U.S. households are held in money market funds. Clearly, money market funds have become part of the fabric by which families, and companies manage their
financial affairs.

When the Reserve fund broke the buck, and it seemed like an all-out rout of money markets was inevitable, the result would have been a virtual elimination of capital access by everyone: from households to companies. This reverberated for months, as the also presumably extremely safe Commercial Paper market was the next to freeze up, side by side with all traditional forms of credit. Only after the Fed stepped in an guaranteed money markets, and turned on the liquidity stabilization first, then quantitative easing spigot second, did things go back to some sort of new normal. However, it is only a matter of time before the patchwork of band aids holding the dam together is once again exposed, and a new, stronger and, well, "improved" run on the electronic bank materializes. It is precisely this contingency that the SEC and the administration are preparing for by "empowering money market fund boards of directors to suspend redemptions in extraordinary circumstances to protect the interests of fund shareholders."

A little more on money markets:

Money market funds seek to limit exposure to losses due to credit, market, and liquidity risks. Money market funds, in the United States, are regulated by the Securities and Exchange Commission's (SEC) Investment Company Act of 1940. Rule 2a-7 of the act restricts investments in money market funds by quality, maturity and diversity. Under this act, a money fund mainly buys the highest rated debt, which matures in under 13 months. The portfolio must maintain a weighted average maturity (WAM) of 90 days or less and not invest more than 5% in any one issuer, except for government securities and repurchase agreements.

Ironically, the proposed change to Rule 2a-7 seeks to make dramatic changes to the composition of MMs: from 90 days, the WAM would get shortened to 60 days. And this is occurring at a time when the government is desperately seeking to find ways of extending maturities and durations of short-term debt instruments: by reverse rolling the $3.2 trillion industry, the impetus will be precisely the reverse of what should be happening, as more ultra-short maturity instruments are horded up, leaving a dead zone in the 60-90 day maturity window. Some other proposed changes to 2a-7 include "prohibiting the funds from investing in Second Tier securities, as defined in Rule 2a-7. Eligible securities would be redefined as securities receiving only the highest, rather than the highest two, short-term debt ratings from a requisite nationally recognized securities rating  organization. Further, money market funds would be permitted to acquire long-term unrated securities only if they have received long-term ratings in the highest two, rather than the highest three, ratings categories." In other words, let's make them so safe, that when the time comes, nobody will have access to them. Brilliant.

The utility of money market funds has long been questioned by such systemically-embedded financial luminaries as Paul Volcker (more on this in a minute). After all, what are money markets if merely an easy, and 401(k)-eligible option to not invest in equity or bonds, but in "paper" which is cash in all but name (maybe not so much after the proposed Rule change passes). And as money markets account for a huge portion of the $11 trillion of mutual fund assets as of November (per ICI, whose opinion, incidentally, was instrumental in shaping future money market policy), $3.3 trillion to be precise, and second only to stock funds at $4.8 trillion, one can see why an administration, hell bent on recreating a stock-price bubble, would do all it can to make money markets extremely unattractive. In fact, the current administration has been on a roll on this regard: i) keeping money market rates at record lows, ii) removing money market fund guarantees and iii) and even allowing reverse repos to use money markets as sources of liquidity (because we all know that the collateral behind the banks shadow banking arrangement with the Fed are literally crap; as we have noted before, we will continue claiming this until the Fed disproves us by opening up their books for full inspection. Until then, yes, the Fed has lent out hundreds of billions against bankrupt company equity, as we have pointed out in the past).  Money Markets are the easiest recourse that idiotic class of Americans known as "savers" has to give the big bank oligarchs, the Fed and the bubble-inflating Administration the middle finger. As you will recall, recently Arianna Huffington has been soliciting all Americans do just that: to move their money out of the tentacles of the TBTFs. In essence, the money market optionality is precisely the equivalent of moving physical money from TBTFs to community banks in the "shadow economy." Because where there is $3.3 trillion out of $11, there could easily be $11 trillion out of $11, which would destroy the whole concept of Fed-spearheaded asset-price inflation, and would destroy overnight the TBTFs, as equities would once again find their fair value. It is no surprise then, that the current financial system, and its political cronies loathe the concept of Money Markets, and have done all they could to make them as unattractive as possible. Below is a chart of the Net Assets held by all US money market funds and the number of money market mutual funds since January 2008:

Obviously, attempts to push capital out of MMs have succeeded: after peaking at $3.9 trillion, currently money markets hold a two year low of $3.27 trillion. Furthermore, the number of actual money market fund operations has been substantially hit: from 2,078 in the days after the Lehman implosion, this is now down to 1,828, a 12% reduction. At this rate soon there won't be all that many money market funds to chose from. While the AUM reduction is explicable through the previously mentioned three factors, the actual reduction in number of funds is on the surface not quite a straightforward, and will likely be the topic a future Zero Hedge post. Although, the impetus of managing money when one can return at most 0.6% annually, and charge fees on this "return" may be missing - the answer may be far simpler than we think. Why run a money market, when the Fed will be happy to issue you a bank charter, and you can collect much more, risk free, courtesy of the vertical yield curve.

Yet what is strange is that even with all the adverse consequences of holding cash in Money Markets, the total AUM of this "safest" investment option is still substantial, at nearly $3.3 trillion as of December 30, a big decline yes, but a decline that should have been much greater considering even the president since March 3 has been beckoning his daily viewership to invest in cheap stocks courtesy of low "profit and earning ratios" (that, and the specter of President's Working Group on Financial Markets). Could this action, whereby investors will no longer have access to money that historically has been sacrosanct and reachable and disposable on a moment's notice, be the last nail in the coffin of money markets? We believe so, however, we are not sure if it will attain the desired effect. With an aging baby boomer population, which would rather burn their money than invest in the stock market again and relive the roller-coaster days of late 2008 and early 2009, the plan may well backfire, and result in even more money leaving the shadow system and entering such tangible objects as deposit accounts (at community banks, of course), mattresses and socks. And speaking of the President's Working Group...

The Group of Thirty

When discussing the shadow economy, it is only fitting to discuss the shadow decision-makers. In this regard, the Group of 30, is to the traditional economic decision-making process as the President's Working Group is to capital markets. Taken from the website, the self-description reads innocently enough:

The Group of Thirty, established in 1978, is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia. It aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers. The Group's members meet in plenary sessions twice a year with select guests to discuss important economic, financial and policy developments. They reach out to a wider audience in seminars and symposia.  Of most importance to our membership and supporters is the annual International Banking Seminar.

Sounds like any old D.C.-based think tank... until one looks at the roster of members:

• Paul A. Volcker, Chairman of the Board of Trustees, Group of Thirty, Former Chairman, Board of Governors of the Federal Reserve System
• Jacob A. Frenkel, Chairman, Group of Thirty, Vice Chairman, American International Group, Former Governor, Bank of Israel
• Jean-Claude Trichet, President, European Central Bank, Former Governor, Banque de France
• Zhou Xiaochuan, Governor, People’s Bank of China, Former President, China Construction Bank, Former Asst. Minister of Foreign Trade
• Yutaka Yamaguchi, Former Deputy Governor, Bank of Japan, Former Chairman, Euro Currency Standing Commission
• William McDonough, Vice Chairman and Special Advisor to the Chairman, Merrill Lynch, Former Chairman, Public Company Accounting Oversight Board, Former President, Federal Reserve Bank of New York
• Richard A. Debs, Advisory Director, Morgan Stanley, Former President, Morgan Stanley International, Former COO, Federal Reserve Bank of New York
• Abdulatif Al-Hamad, Chairman, Arab Fund for Economic and Social Development, Former Minister of Finance and Minister of Planning, Kuwait
• William R. Rhodes, Senior Vice Chairman, Citigroup, Chairman, President and CEO, Citicorp and Citibank
• Ernest Stern, Partner and Senior Advisor, The Rohatyn Group, Former Managing Director, JPMorgan Chase, Former Managing Director, World Bank
• Jaime Caruana, Financial Counsellor, International Monetary Fund, Former Governor, Banco de España, Former Chairman, Basel Committee on Banking Supervision
• E. Gerald Corrigan, Managing Director, Goldman Sachs Group, Inc., Former President, Federal Reserve Bank of New York
• Andrew D. Crockett, President, JPMorgan Chase International, Former General Manager, Bank for International Settlements
• Guillermo de la Dehesa Romero, Director and Member of the Executive Committee, Grupo Santander, Former Deputy Managing Director, Banco de España, Former Secretary of State, Ministry of Economy and Finance, Spain
• Mario Draghi, Governor, Banca d’Italia, Chairman, Financial Stability Forum, Member of the Governing and General Councils, European Central Bank, Former Vice Chairman and Managing Director, Goldman Sachs International
• Martin Feldstein, Professor of Economics, Harvard University, President Emeritus, National Bureau of Economic Research, Former Chairman, Council of Economic Advisers
• Roger W. Ferguson, Jr., Chief Executive, TIAA-CREF, Former Chairman, Swiss Re America Holding Corporation, Former Vice Chairman, Board of Governors of the Federal Reserve System
• Stanley Fischer, Governor, Bank of Israel, Former First Managing Director, International Monetary Fund
• Philipp Hildebrand, Vice Chairman of the Governing Board, Swiss National Bank, Former Partner, Moore Capital Management
• Paul Krugman, Professor of Economics, Woodrow Wilson School, Princeton University, Former Member, Council of Economic Advisors
• Kenneth Rogoff, Thomas D. Cabot Professor of Public Policy and Economics, Harvard University, Former Chief Economist and Director of Research, IMF

and, of course:

• Timothy F. Geithner, President and Chief Executive Officer, Federal Reserve Bank of New York, Former U.S. Undersecretary of Treasury for International Affairs
• Lawrence Summers, Charles W. Eliot University Professor, Harvard University, Former President, Harvard University, Former U.S. Secretary of the Treasury

and many more. Given the choice of being a fly on the wall at a G7 meeting or that of the "Group of 30", we would be very curious to see who would pick the former over the latter. These are the people, whose "reports" and groupthink determines the financial fate of the world: their vested interest in perpetuating the status quo is second to none. Which is why we read with great interest a recent paper from the Group of 30: Financial Reform, A Framework for Financial Stability, released on January 15, 2009, deep in the heart of the crisis. While the paper has enough insight for many, non-related posts (we are already working on several), we will focus on the policy recommendations presented for money market funds.

Money Market Mutual Funds and Supervision

Recommendation 3:

 

a. Money market mutual funds wishing to continue to offer bank-like services, such as transaction account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value (NAV) at par should be required to reorganize as special-purpose banks, with appropriate prudential regulation and supervision, government insurance, and access to central bank lender-of-last-resort facilities.

 

b. Those institutions remaining as money market mutual funds should only offer a conservative investment option with modest upside potential at relatively low risk. The vehicles should be clearly differentiated from federally insured instruments offered by banks, such as money market deposit funds, with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV. Money market mutual funds should not be permitted to use amortized cost pricing, with the implication that they carry a fluctuating NAV rather than one that is pegged at US$1.00 per share.

The phrasing of "with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV" should be sufficient to whiten the hairs of every proponent of money markets as a "safe" investment alternative. Yet what the SEC has done, is to take the Group of 30 recommendation, and take it to the next level: not only will funds not have explicit assurance of any kind vis-a-vis funding, but in fact, the redemption of said funds would be legally barred upon "extraordinary circumstances."

Rule 22e-3

From the SEC:

Proposed rule 22e–3(a) would permit a money market fund to suspend redemptions if: (i) The fund’s current price per share, calculated pursuant to rule 2a–7(c), is less than the fund’s stable net asset value per share; (ii) its board of directors, including a majority of directors who are not interested  persons, approves the liquidation of the fund; and (iii) the fund, prior to suspending redemptions, notifies the Commission of its decision to liquidate and suspend redemptions, by electronic mail directed to the attention of our Director of the Division of Investment Management or the Director’s designee. These proposed conditions are intended to ensure that any suspension of redemptions will be consistent with the underlying policies of section 22(e). We understand that suspending redemptions may impose hardships on investors who rely on their ability to redeem shares. Accordingly, our proposal is limited to permitting suspension of this statutory protection only in extraordinary circumstances. Thus, the proposed conditions, which are similar to those of the temporary rule, are designed to limit the availability of the rule to circumstances that present a significant risk of a run on the fund. Moreover, the exemption would require action of the fund board (including the independent directors), which would be acting in its capacity as a fiduciary. The proposed rule contains an additional provision that would permit us to take steps to protect investors. Specifically, the proposed rule would permit us to rescind or modify the relief provided by the rule (and thus require the fund to resume honoring redemptions) if, for example, a liquidating fund has not devised, or is not properly executing, a plan of liquidation that protects fund shareholders. Under this provision, the Commission may modify the relief ‘‘after appropriate notice and opportunity for hearing,’’ in accordance with section 40 of the Act.

Lots of keywords there: "fiduciary", "impose hardships" but most notably "permit us to take steps to protect investors." Uh, SEC, no thanks. We can protect ourselves. Your protection so far has resulted in the Madoff scandal, the BofA fiasco, billions in insider trading profits and not one guilty person, who did not manage to escape unscathed with merely a wrist slap in the form of some pathetic fine. With all due respect, SEC, any proposal that involves you acting to "protect" us should be immediately banned and any further discussion ended.

Especially in this case: what the SEC is proposing is simple - the entire market structure has been converted to a hedge fund. When investors hear the word "suspend redemptions" they envisioned a battered, pro-cyclical, leveraged, permabullish hedge fund, that suddenly "found itself" down 30, 40, 50 or more percent, and to avoid instantaneous liquidation, had to bar redemptions. Forgive us, but is the SEC confirming that the entire market is now one big casino, one big government subsidized hedge fund, where as long as things go up, all is good, but the second things take a leg down, just like any ponzi, nobody will be allowed to pull their money? Maybe Madoff should have created the same redemption suspension: his fund would still be alive and thriving, now that the government has become the biggest ponzi conductor of all time. And nobody would have been the wiser. But instead, the Securities and Exchange Commission, in discussions with the Group of 30, Barney Frank, and any other conflicted individuals who only care about protecting their own money for one more year, has decided, in its infinite wisdom, to make money markets a complete scam. And this is the gist of regulatory reform in America.

Conclusion

At this point it is without doubt that even the government understands that when things turn sour, and they will, the run on the bank will be unavoidable: their solution - prevent money from being dispensed, when that moment comes. The thing about crises, be they liquidity, solvency, or plain-vanilla, is that "price discovery" occurs all at once, and at the very same time. And all too often, investors "discover" they were lied to, as the emperor, in any fiat system, always has no clothes. Just like in September 2008, when the banks were forced to look at each-others' balance sheet and realize that there are no real assets on the left backing up the liabilities on the right, so the moment of enlightenment occurs are the most importune time: just ask Hank Paulson. Had he known his action of beefing up Goldman's FICC trading axes would have resulted in the "Ice-Nine'ing" (to borrow a Mark Pittman term) of money markets, who knows- maybe Lehman would have still been alive. Perhaps risking the cash access of 20% of US households and 80% of companies was not worth the few extra zeroes in Goldman's EPS. But we will never know. What we will know, is that now i) the government is all too aware that the market has become one huge ponzi, and that all investment vehicles, even the safest ones, are subject to bank runs, and ii) that said bank runs, will occur. It is only a matter of time. And just as the president told everyone directly to buy the market on March 3, so the SEC, the Group of 30, and Barney Frank are telling us all, much less directly, to get the hell out of Dodge. Alternatively, the game of "last fool in", holding the burning hot potato, can continue indefinitely, until such time as the marginal utility of each and every dollar printed by Ben Bernanke is zero.

Submitted by Lance Roberts of Street Talk Live,

For some time now we have been warning about the danger to portfolios given the deteriorating fundamental, economic and technical backdrop in the markets.  Our warnings, for the most part, have been ignored as individuals continue to chase stocks in hopes that "this time will be different", and somehow, stocks will continue to ramp higher even though all three support legs are weakening.  Currently, it is the imminent arrival of the next round of Quantitative Easing (QE) that keeps "hope" elevated but further Central Bank intervention is unlikely in the near term leaving the markets at risk of a further correction.

My job is to analyze the trend of the data, both economic, fundamental and technical, to build a frame work of possibilities and probabilities about what might happen soon.  Like any good poker player before making a "bet," which requires putting my capital at risk of loss, I want to make sure that the odds are in my favor of winning.  If I am highly confident of success - I bet a lot.  If not - I do not.  The same philosophy goes into managing money.  Wall Street tells you to be invested all the time because that is how they make money.  However, the reality is that investing is very akin to playing poker - you are making bets today based on the possibilities of some future outcome. 

The reason for this framework is that I have been negative on the markets since early April.  The weight of evidence has clearly been negative.  While the mainstream media continues to look for glimmers of "hope" - hope is not an effective investment strategy.  However, when the flow of data changes and price action becomes more constructive - my outlook will also. (Read "Thoughts On Long Term Investing")

For new readers, welcome to the site, here is a brief compendium of previous articles which have been guiding our readers through the current market correction process that began in early April:

• April 9th - The Correction Has Started
• May 21st - Sell Signal Confirmed - Initial Targets Set
• June 6th - Forecasting The Rebound And Bottom
• June 26th - June Rally Complete - Summer Sell Off Ahead?
• July 3rd - Coming This Fall The Best Time To Invest

Major Sell Signal Is In

This bit of history leads us to our latest, and most important, sell signal to date.  With the economy continuing to weaken, corporate earnings, showing severe signs of strain and the Eurocrisis emerging once again - the risk at the moment is clearly to the downside.  The continued deterioration, in both the fundamental and technical frameworks, has significantly increased the risk of further equity market declines. 

The decline in the markets on July 24th pushed the two main moving averages that we follow into negative territory initiating a major SELL signal for the markets.  These major sell signals should not be ignored.  The first chart plots our two moving averages relative to the S&P 500 over the last 12 years.  During this time frame there has only been 7 "sell" and 6 "buy" signals.  As with all investment strategies and disciplines there is always the possibility of getting a false signal.  The same is true for this particular indicator.  Since 1930, there have been a total of 51 major "sell" signals of which 9 gave a false reading translating into a 17.6% failure rate.  As I said, no indicator is perfect, but as an investment manager I am willing to make investment decisions based on an indicator that has an 82% success rate. 

More importantly, as shown in the chart, this strategy helped us avoid the bulk of the last two recessionary market debacles.  The problem is that while it is easy to assume that the current correction could be shallow, like previous two summers as the Federal Reserve stepped in to prop up asset prices, there is always a chance that it could be a much bigger correction.  Following the signals previously would have limited downside risk while keeping you primarily invested in for the majority of bullish trends.

The next chart shows the similarities of the 2011 and 2012 markets.  In both cases rallies in June, post a May decline, led to sloppy sideways trading in July.  The major "Sell" signal occurred on August 5th of 2011 as the markets began a steep sell off.  While there is no guarantee that the market is about to plunge towards the 1200-1250 level this August - the striking similarities of market action certainly does suggest a more cautionary stance be taken.

Sell Into The Bounce

Technical signals must be put into "context" based on current market conditions. In order to strip out the "noise" in our analysis we use weekly instead of daily price data.  This smoothing of the daily data allows for better clarity of the trends in the market.   However, due to this smoothing process by the time a signal is given the markets are generally overbought, or oversold, on a daily basis and are generally close for a reflexive bounce.  That bounce should be sold into.

The problem for most investors is that when the market bounces in order to correct the short term oversold condition they assume that the "sell signal" was incorrect.  More than 80% of the time, as our data shows, the market will bounce and then decline to lower levels.  Therefore, the rules are simple:

• In negative trending markets - sell rallies.
• In positive trending markets - buy dips.

The technical and fundamental setup is currently a negatively trending market.  It is very likely that, in the current environment, we will retest the May lows, if not ultimately set new lows, in August.  Those lows will likely coincide with further weakness in the economy which should be the perfect setup for the Fed to launch a third round of Quantitative Easing.  Should that occur that will provide the best opportunity to take the cash we are holding in reserve and increase equity exposure at lower price levels. 

The caveat to all of this is if the Fed acts early with QE 3 at the end of this month.  I don't think this is likely but it is a possibility.  In that event the boost to asset prices will reverse the current signal and we will need to add equity exposure back into portfolios.  However, until then, with the major "sell" signal in place it is more important to remain cautious, and conserve investment capital, until a better risk/reward opportunity presents itself.

Transcribed from a speech given by Paul Singer of Elliott Management

Investing is an art, more so than a science. And for me, what I get paid for is managing the “dark art,” if you will, of risk management and trying to be a visionary and having a dark vision at all times about what can go wrong.

It’s a particularly fruitful and impactful time to be thinking about risk management and the thing I want talk about today is what I’ve described as “The Shape of the Next Crisis.” That doesn’t mean we’re going to be talking about the timing of it or exactly what to short or how to make money from it. But it’s to provoke thought about what the elements are, the current landscape, the various aspects that will shape the timing, as well as the amplitude, the predictability, the suddenness of the next crisis.

It’s not something that I can talk about in any kind of hierarchical fashion. There are a number of elements that are in play, some of which are novel, completely new in virtually the human landscape.

But they combine in what I think of, when I’m thinking of risk management and how to hedge my portfolio, what I think of as kind of “an evil stew.”

But here they are, and it should be obvious when you really think about it, but you have to bring these elements from other facets of life to see how they impact trading and investing.

On Modern Communications and Information Processing

It is increasingly the case (and I’ll give you a couple of recent examples) that people coalesce, form, and reform ideas in a much more powerfully focused, and abrupt, and stark way than they ever have in the past.

 

One of the most interesting examples of this is the so-called “Arab Spring” where the forces underlying these societies – totalitarianism, security services, violence, oppression, etc. – have existed in the countries that have been affected for decades. All of the sudden it started in January with a singular small event in Tunisia. And now it’s a few months later and there are 11 countries in various stages of more or less similar wide-spread revolts.

 

And how did this happen? You speak to experts in the Middle East, you speak to experts in that area or in those particular countries, and you don’t get a satisfactory answer. You get “totalitarianism.” The answer, I believe, relates to social media and the way people are connected - it’s the Internet, it’s Facebook, it’s Twitter – and the way people process information enabling people to develop the same thoughts simultaneously and to act and coalesce physically as well as emotionally.

 

The vector changes with something like this are virtually instantaneous. In 6 months, for 11 countries that have been more or less family run or totalitarian, to be in revolt is a very, very powerful illustration of this point. The Flash Crash about a year ago in stocks, where all of the sudden, the technology of the marketplace and the way the exchanges had their rules about processing orders in relationship with other exchanges, coalesced one afternoon, to have hundreds of stocks virtually evaporate all at once - within seconds or minutes or five minutes or half an hour.

 

This is a very powerful element and will serve as an accelerant in the next crisis so hold that one up on the blackboard, metaphorically speaking, while I talk about the next elements.

On The Financial System And Leverage

Let’s talk about financial institutions and the financial system. The major message that I want to give you (and I’ve invited challenge on both parts of my thesis here and I’ve never had anybody challenge it): The major financial institutions in the US and around the globe are utterly opaque; and The next financial crisis will happen faster, more suddenly.

 

We cannot (I have 110 investment professionals), and I surmise that you cannot, understand the financial condition of any bank, major financial institution. You can’t see the actual size of the balance sheet. You have no idea what that derivatives section means…it’s 10 to 100 times the size of the actual balance sheet.

 

So when people say, “Well, it used to be 40x leveraged,” (some of them were 90x leveraged) “but now they’re 15 to 20 times leveraged.” Well that’s just great. Except you go to the derivatives and see numbers in the trillions and trillions and trillions and there is no clue, you have no clue, no understanding, of what that is actually composed of. Is that composed of trades that are basically unwound where all you have is counterparty risk? Is that composed of actual hedges of upper tranches the way we would have in an admitted hedge fund?

 

So you are looking at balance sheets without any real understanding of how the balance sheets and the companies would perform in the event of a crisis. Which of these trades or trillions of dollars of trades, which in normal times oscillate like this [very small motion] and that’s why they’re so big, would in really bad times start going like this [large motion]. And if you actually have capital of only half a percent, or one percent or five percent of your actual footings, not just unwound trades that happen to still be on balance sheet, but actual footings, you’re in trouble.

 

The kind of thing that wound up the financial system three years ago is expected to be different in form than the kind of things that would unwind the financial system the next time. But I’m going to argue that the next time will be faster. If you think back to ’07 and ’08, it was episodic. It wasn’t just suddenly that in the second or third week in Sept that Lehman goes under and that’s the crisis and the whole world collapsed. No, there were several episodes leading up to that.

 

After that, what kept the entire financial system from coming to a grinding halt was quite simple. It wasn’t that all of the other firms were in much better shape than Lehman. It’s very simple, it’s that governments, here and in Europe, underwrote the entire system. Ben Bernanke, of whom I’m not a fan... at all, has been quoted as saying that in the absence of the government guarantee and underwriting, 12 of the 13 biggest banks in the world would have gone out of business following Lehman. Whether it’s 12/13, or 13/13, or 6 or 8 of 13, is completely imponderable, but the point is actually well-taken. In the absence of that guarantee there would have been a cascading collapse because of the opacity.

 

There are people in this room that are on trading desks or manage trading operations at investment banks. You know for a fact that you knew nothing about the financial condition of your five biggest counterparties. And so your relationships, and your willingness to trade, with those counterparties was dependent on rumor or credit spreads widening or not widening. And that’s a very terrible place for the financial system to be in.

 

So take the opacity, take the fact that you can’t really understand the financial condition, and take the fact that the leverage hasn’t really been rung out. And what you realize is that the lessons of ’08 will actually result in a much quicker process, a process that I would describe as a “black hole” if and when there is the next financial crisis.

 

The next financial crisis obviously can only happen if, believably, the governments either cut loose the major financial institutions - believably and credibly unwound the guarantee - or even more difficult and scary, if the government guarantee were not enough. And that’s one of the next elements in the shape of the next crisis. As you know, risk has migrated upward, it’s migrated from lenders and borrowers really to governments. It’s gone on the balance sheet of the US, the ECB (the various countries of Europe, particularly Germany, France, etc.). That the credit of Europe, the credit of America, is being called into question in the starkest way is part of what will shape the next crisis.

 

But before I get to that part, and explain how I think that impacts, I want to come back to the trader and trading part of this. The lesson of ’08, which is indelibly stamped upon every hedge fund forehead and trading desk head, is: Move your assets first, stop trading first, sell the paper first, and ask questions later. Those that moved from Lehman days or weeks before the end were happy. Those that sat there thinking that they were protected in prime brokerage accounts or protected in some other ways, or that firms like Lehman wouldn’t be allowed to go under were stuck in the company (of course Lehman is still in bankruptcy) with claims trading at 20-something cents on the dollar, depending on where you are in the capital structure.

On 'Orderly Liquidation' And How Dodd-Frank Has Made The System More Brittle

 So, I want to put one more element in place in the trading and financial institution part of the equation.

 

And that’s the law that was signed into law a few months ago, Dodd-Frank. I don’t know what it’s actually called, but it is the financial institution reform law and it is designed purportedly to make the system safer. “Safe” actually, not just “safer.”

 

In my opinion, what Dodd-Frank has actually done is to make the system more brittle and complete the picture, in my mind, of a black hole, meaning a very vicious, sharp and abrupt process if you put together all of the things that I’ve said so far.

 

So what is it about Dodd-Frank that contributes to this black hole, or contributes to this brittle, unsafe condition? It’s the “Orderly Liquidation Authority,” a very humorously named part of this law because what I think it actually represents is a very disorderly process. Under this authority, which was purportedly designed to provided a “not-Lehman” outcome (you know, no government bailout and a calm resolution of large financial institutions), under this process the FDIC has the authority, contrary to all US bankruptcy practice and law, to seize financial companies which are quote “in danger of default.”

 

Under previous bankruptcy law, companies had to default, actually default, or managements voluntarily put them in bankruptcy in order for them to be in bankruptcy.

 

“Danger of default,” if you think about that, plus with the other parts of this that I’ll describe, means that if a company is in trouble, and it’s large and opaque, then it’s in danger of default and can be seized any day. And if I say any moment it’s only a slight exaggeration, because by statute the process of throwing a company into the Orderly Liquidation Authority is about 48 hrs long, and is effectively unreviewable (even though there is an injunction attached to this process with the Treasury secretary and a couple of other people looking at it).

 

So companies can be seized that are in danger of default, and what is the FDIC ordered to do and what can it do? It is ordered to throw out management…quite bizarre. It is enabled to discriminate among classes of creditors similarly situated... strange. It’s enabled to move assets around and transfer assets to bridge companies. And it’s enabled to go against people in or out of the company who are quote “responsible for the financial condition.”

 

Let me define Systemically Important Financial Institutions first and then continue on. Under this legislation, the government is supposed to designate certain companies as “systemically important.”

 

I’ve been quoted as saying that I feel that’s nutty. It’s nutty because no financial institution should be too big to fail. All financial institutions should be governed by the same rules regarding leverage and risk. And companies can become systemically important, or un-become systemically important, extremely quickly in today’s world as a result of taking on leverage, changing their positions.

 

Let’s put that all together. If you are trading with a big company and that company or other companies have been identified as systemically important institutions, if you are observing a large company getting into trouble, what you know is that you have to pull your assets because those assets can be transferred (regardless of the financial condition of the subsidiary that your assets are a part of, whether it’s a prime brokerage subsidiary or otherwise). You don’t know how your claim will be treated, so you have to sell the bonds that you own; if the guy down the block, Bob’s Big Bank [is a similarly situated creditor and] has been designated as systemically important, that guy may be getting a priority recovery.

 

So the whole thing militates toward stepping away abruptly from any company that is designated as systemically important. So I think that the opacity, the lessons of ’08, the vicissitudes and thoughtlessness of Dodd-Frank, militate in favor of a very, very abrupt resolution.

On Japan And The Confidence-Destroying Implications Of Monetary Policy

There isn’t time to flesh out in detail the other accelerants of what the next financial crisis might look like, but let me just say a word or two on monetary policy. Monetary policy, which is now doing virtually all of the job creation work in the United States (in particular) and of course in Japan also, has created a very distorted recovery and some people think, including myself, that it’s been at least partially responsible for inflation in commodities and gold.

 

Quantitative easing which is this duration shortening mechanism, zero interest rates which is extraordinarily unusual and is now in the United States as well as Japan, as well as the long term entitlement insolvency in the United States, are platforms for a possible loss of confidence.

And In Conclusion

I think people who are managing money or investors who are trying to figure out what the next crisis may look like, should be processing these elements and thinking about how they can interact, together with the modalities of modern communications and the way people process information, to create something very sudden.

 

Nobody in America has actually seen, or most people probably can’t even contemplate, what an actual loss of confidence may look like. What I’m trying to struggle with as a money manager, who really seriously doesn’t like to lose money, is how to protect our capital and how to think about the next crisis.

 

If you think about some of these elements and how they might interact, you might come up with other paths of transmission or risk and pain. But I wouldn’t go about your business thinking it’s business as usual in a typical post-crisis, post bear market recovery.

Questions And Answers Section...

Q: [Thoughts on Europe]?

A: Yeah, that’s really important. My view about Europe starts with my view 15 yrs ago (and by the way, on Wall St if you’re early, you’re wrong). My view 15 yrs ago was that the Euro was an inappropriate backdoor experiment on quasi-sovereignty. And all it would take would be a stark variation in economic performance or geopolitical or military considerations or interests. And here we are and there’s been a stark divergence and the Euro is in the process of centrifugal force and breaking up.

Will it break up? It’s entirely unclear, and I’m not going to predict that it’s going to break up or whether Greece is going to actually leave it. What I will say is that it doesn’t make sense for the underperforming countries to actually be part of this. Everyone looked like they were getting benefits during the period of time when there was convergence. Exports for Germany, lower interest rates for Greece and Portugal and Spain and the rest.

Big risks were built up, big variations in performance, and now Germany in particular is writing out checks. As long as Germany keeps writing out checks, the euro can limp along, Greece can limp along.

But the answer to your question is the fixes to this, even if to kick the can down the road, are deflationary, they’re harmful to growth despite the fact that a breakup of the euro would fall upon Greece. Pulling out by Greece from the euro would trigger other consequences in several of these other countries, would create a banking crisis which would have to be dealt with.

So there is near term pain in doing, in my view, the right thing. But the medium- to longer-term pain of writing out checks to insolvent countries like Greece (insolvent, it’s not a liquidity crisis, insolvency), is ultimately something that’s going to be dampening growth in Europe, dampening global growth, possibly creating the transmission mechanism for the next banking crisis. So I think we’re watching it. And by the way, how do I think it’s going to actually happen that the situation is resolved? It’s going to be from the bottom up, the political process. It’s going to be on the streets, it’s going to be hundreds of thousands of Greeks, or hundreds of thousands of Germans demonstrating against the bailouts.

The elites want to keep writing the checks because their paradigms, their desire to have this experiment (because that’s what it is, it’s only 12 or 13 yrs old) continue. That’s what their dream was: one Europe - sovereign. And they were going to get to sovereignty through the back door. It isn’t working out at the moment; I don’t think it’s going to work out. And the fact that it’s not working out is quite painful and the way they’re doing it is stretching out the pain.

Q: [Insights on using CDS on sovereign debt to hedge your portfolio]?

A: Very good question. The question was about buying credit default swaps on countries or companies in order to hedge your positions, as a general risk management tool. I think that’s a really great question, it’s one that people like us really struggle with.

One of the things that 2008 (I had forgotten to say this before, so thanks for reminding me) showed us about risk management was that some of the tools that we thought that we had for risk management were actually tools that could be harmed or defeated by the actions of governments. And governments have shown an increasing inclination to push us around, us as a community. Meaning overnight bans on short selling, statements and the beginnings of action against credit default swaps, so-called “naked” credit default swaps.

Credit default swaps in the abstract, or actually in practice up till recently, are very effective at bringing liquid tools for taking judgments long and short about securities, and countries, companies that otherwise would be completely illiquid. Borrowing sovereign debt to sell short is not easy.

When countries and companies get into trouble, it’s very easy and very standard to be blaming speculators and credit default swaps as one of the reasons, or the main reason why a spread is blowing out and why the country or company is in trouble (because when a spread blows out, financing opportunities and possibilities diminish, etc.). Who can say what portion of CDS trading is so big that it actually creates prices rather than just discovers prices?

But one of the very difficult parts about running a portfolio that is aimed to be absolute return or very risk conscious and trying to avoid the consequences of the next crisis, is that it’s very difficult to predict using tools like that, which of these tools will be left unimpaired, or which will be suddenly impaired or destroyed by government action.

One of the things that bothers me about running a gold position is (since gold is, really to me, a thermometer about how people think about real money versus fake money or versus paper money possibly for the first time in people’s lives of anybody in this room), if gold actually is starting to be priced at a price that would represent real fear about paper currencies, what will governments do to derivatives or actual gold to keep themselves from being subject to what they feel is inflation caused by speculators?

So I think everyone who is using these complicated instruments needs to understand that governments have sent out a shot across the bow that they are not in the mood to allow for free markets, when the free markets challenge the “everything-is-fine-and-we-can-kick-the-can-down-the-road” way of governing.

Wondering why AAPL is finally soaring after stagnating for days? Because the market finally knows that Whitney Tilson sold his handful shares of AAPL. We learn all this and much more in today's humorous interlude - the first annual letter out of Kase Capital. What is Kase Capital? "Now that I’m managing money solo, I’ve adopted the name “Kase”, so our fund is now doing business as the Kase Fund. The letters of “Kase” come from the four most important people in my life: my wife, Susan, and three daughters, Alison, Emily, and Katharine. May they bring all of us as much good fortune as they’ve brought me!" And yes, the always "imaginative" 13F-ghoster took that particular idea from Barry Rosenstein's Jana Partners.

The full letter is presented below, but the first two paragraphs are worth the price of admission alone:

After 11½ strong years, the fund has lagged badly over the last 2½ years. To turn things around, I’ve made many changes (discussed below), most importantly returning to my roots of managing money solo.

 

In June, Glenn and I decided to each run our own funds, and began doing so on July 1st. As part of this process, I took our fund to cash so that I could rebuild the portfolio from scratch. However, I wasn’t able to exit a handful of illiquid positions, most notably the Iridium warrants, which impacted performance in the second half of the year, but today I’m pleased to say that the portfolio is where I want it, conservatively positioned in my very best ideas. My mind is clear and focused on the long term, and I’m looking forward with confidence and optimism.

And the conclusion:

After a strong 12-year run, 2011 and 2012 were lost years. I feel very badly about this and apologize to you. But I know you don’t want an apology – you want performance! To that end, I’ve reflected on the mistakes I’ve made, learned from them, and taken significant steps to maximize our chances of success going forward: I’m now the sole portfolio manager and have dramatically simplified, focused, and de-risked the fund. I’m confident that my strategy is sound, I will execute it well going forward, and we will all profit.

 

I’m heartened and humbled that the vast majority of the fund’s partners have chosen to maintain their investment. I’m determined to reward your vote of confidence and want to thank you for your patience, confidence and support.

It is unclear just which extended family members he is referring to. And no, there is no mention of Tilson's recently favorite Herbalife short anywhere.

By EconMatters

© EconMatters All Rights Reserved | Facebook | Twitter | Post Alert | Kindle

Capitalism may have bested communism a few decades ago, but exactly how our economic system allocates society’s scarce resources is now undergoing its first serious transformation since the NYSE’s founding fathers met under the buttonwood tree in 1792.  Technology, complexity and speed have already transformed how stocks trade; but As ConvergEx's Nick Colas notes, the real question now is what role these forces will play in long-term capital formation and allocation.  Rookie mistakes like the Twitter hack flash crash might be easy to deride, but make no mistake, Colas reminds us: the changes that started with high frequency and algorithmic trading are just the first step to an entirely different process of determining stock prices.  The only serious challenge this metamorphosis will likely face is a notable crash of the still-developing system and resultant regulation back to more strictly human-based processes.

Via Nick Colas, ConvergEx,

Last week’s Twitter hack and resultant mini-crash in U.S. stocks made for a few minutes of confusion and several days of humorous commentary.  It is, however, also a sign of the times.  That a system of communication where Justin Bieber, Lady Gaga and Katy Perry are the lead dogs could encroach on “Orderly and fair markets” should force some discussion of where U.S. stock markets are heading.  “I crashed the market and I liked it…” isn’t a top 40 song. Yet…

Let’s begin with a few basics about what role equity markets are supposed to play in a modern capitalist economic system:

• Stock markets exist to determine the value of publicly held companies using all legally available information that may impact their future cash flows and strategic positions.  There are a lot of items on this menu of value drivers, from prevailing interest rates to the quality of a given management team.  The benefits to any individual or group of investors to predicting enough of these inputs correctly on a consistent basis are, of course, sizable.
• The resulting prices are signals to the broader economic system about the ongoing value of the company’s business model.  Well-considered companies with high valuations can purchase the assets of laggard enterprises with low valuations and operate them better.  Poorly run businesses fail, freeing up society’s intellectual and physical capital to pursue better uses.  Private equity can purchase underperforming assets as well, hopefully to re-engineer the business and return some or all of it to better health.
• Through the IPO process, equity markets allow promising enterprises to tap a large pool of capital that allows for further growth.  Once public, they can make acquisitions for stock and reward productive employees with real ownership in the business.
• Stock grants to management in well-run businesses – old and new - can allow the operation to entice the best available intellectual capital to join the firm and maximize their focus while employed there.  This ideally allows society to ensure that the scarcest of all economic resources – people – flow to their best possible uses.
• Stock prices provide valuable economic signals to society at large – labor, capital, government and all other economic actors.  This, by the way, is why the Federal Reserve and other central banks care so much about rising equity values.
• Public ownership of private capital allows society to “Spread the wealth around” through the individual ownership of equity assets.  Individuals can buy diversified portfolios of public companies and earn returns on their capital that mirror the trends in return on investment capital for the businesses they own.
• Yes, I know it’s fashionable to pick apart these idealistic characteristics at the moment.  At the same time, free market capitalism has a reasonable track record over history for improving the lives of large chunks of the human race.  So until we get a race of incorruptible philosopher-kings in the mix, this structure is the best thing going.

The Twitter hack is the most notable example of “How” this process has changed, specifically in the real-time valuation of U.S. stocks.  To understand where we are, you first need to parse out the important changes that have occurred in stock trading over the last +10 years.  Over that period, market structure moved from having one dominant exchange for a given stock (IBM on the New York Stock Exchange, Microsoft on the NASDAQ) to a highly fragmented system of multiple “exchanges” – pools of buy and sell orders managed by very fast computers.

Technology – very fast, efficient, even ruthless – is therefore the backbone of the modern U.S. equity market.  It should be no surprise that this development is not without controversy.  The multitude of trading venues takes some pretty amazing processing horsepower to keep in sync.  The computer code needed to arbitrage prices among them needs to be highly efficient and operate faster than a human can literally blink an eye.  And the physical plant – cutting edge servers located near the data centers for the major exchanges, connected by microwave or high-speed data lines – costs billions to build and maintain.

With all this infrastructure in place, the logical question is “What’s next?”  To answer that larger question, we need some additional context:

Point #1: Human based active equity management has had a tough slog since the Financial Crisis, especially as it relates to U.S. stocks.  Money flows out of domestic equity mutual number in the hundreds of billions, and there hasn’t been a three-month period for positive flows in years.  That’s a significant development because this base of assets historically funded much of Wall Street’s traditional single-stock research efforts.  Sell-side analysts still have their role, to be sure, but over the last decade the job has been more of a concierge for management meetings and conferences than single-source experts on the investment merits of individual stocks.

Hedge funds do still gather assets, but their investment process values internal resources and evaluation over traditional broker-supplied research.  This group is the primary customer for newer products, ranging from satellite imagery of store parking lots to cyber-tracking of online web companies’ traffic patterns.  They also have the luxury of focusing their efforts on just a few investment ideas rather than needing to cover the entire investment waterfront.

Point #2: Passive management of U.S. equity assets continues to grow in popularity.  Nowhere is this more visible than in the ever increasing asset base of U.S. listed exchange traded funds, where $39 billion of the total year-to-date ETF money flows of $65 billion have gone straight into domestic equities.  The single most popular deomstic stock ETF by this measure is a relative newcomer: the iShares MSCI Minimum Volatility Index Fund, which only launched in October 2011.  The investment goal for the index underpinning this product is to provide equity returns in the context low overall price volatility.  Everything is done with mathematical analysis, rather than having a team of human analysts make stock-by-stock evaluations of potential investments with the help of Wall Street research.  That’s a very different approach from the old-school methods of managing money anchored in human judgment, to be sure.  How this approach does over time is anyone’s guess.  But it is a useful signpost for how money management as a business is changing.

Point #3: We work with a variety of quantitatively based investment managers at ConvergEx, and their appetite for research skews strongly to datasets and real-time indicators of business fundamentals.  In an increasingly open world, and thanks to our ever-increasing reliance on technology, there is no shortage of new resources to feed a numbers-based investment discipline.

A few examples serve to highlight this growing field.

• One research provider I know has permitted access to the contents of hundreds of thousands of individual email accounts.  Any personal identifiers are stripped out before they get the data, but what’s left is a very useful amalgam of information about buying trends for everything from online retailers to video content providers.
• Another product we’ve seen recently offers up essentially real-time satellite imagery of retail store parking lots around the country.  Forget walking the mall; you can count cars parked next to 200 representative stores for your favorite retailer. And if U.S. retail is too prosaic, they can get you images of virtually any place on the planet, cloud cover permitting. 
• Lastly, one product which has been out for several years scours the websites of every airline around the world to see how much these businesses are charging for tickets and how full the flights are getting.  It’s not a perfect source of information – you need a handle on cost structures to know earnings – but it is a great starting point to understand near term business fundamentals for a very volatile sector.

The upshot here is that the technology of market structure – large, expensive and complex – is looking for a dance partner and our increasingly tech-based society is increasingly able to play that role.  The critical questions to this inevitable direction are pretty straightforward:

• Can anything change this glide path to an ever more technology-based system of stock analysis?  I can only think of one: a very large system failure that causes a recession in the U.S.  We’ve seen individual brokerage firms teeter on the brink of failure after a systems glitch caused a large trading loss.  The momentum behind the current migration to technology-based data analysis in order to assess stock prices is strong.  At this point, only regulation can likely reverse it.  And regulation in the U.S. only comes after large systemic failures – never before.
• How will capital markets assess stock prices in 5, 10 or 20 years?  There’s a saying in the tech world, especially among hackers: “Information wants to be free.”  On Wall Street, information is supposed to be expensive, since it can be used to generate profits.  Now that technology is being used to generate fundamental insights into corporate performance and the direction of stocks, which approach will win?
• Over the next decade, as investors in U.S. stocks continue to expand their use of datasets and online resources to analyze securities, information will likely continue to be expensive.  We’re still in the early days of this transition, after all.  Thousands of institutional investors still use analyst-based resources and personal judgment to allocate capital and this process isn’t going away.  Many are adapting as the world changes, offering up new sources of investment insight through an effective hybrid approach. 
• Over the long term – and I am talking decades here – it does seem inevitable that the analytical function behind assessing stock prices will change dramatically.  Will equity research based solely on human judgment go the way of the neighborhood bookstore, a quaint anachronism in an ever more connected world?  I can’t help but think that the answer is “Probably.”

Will capital markets become more efficient as a result?  If computerized algorithms with access to petabytes of real-time fundamental data can perform single stock analysis efficiently and without human biases, shouldn’t we welcome the development?  Stock market volatility might diminish with all that finely parsed data, and capital markets could become more accurately predictive of future corporate profits and strategic outcomes.

At the same time, technology has a way of creating distance between humans just as much as it can bring them together.  Just ask any parent with a college-aged child for the ratio of text messages to actual phone calls from their offspring.  Will an equity market running on algorithmic autopilot serve to tie the managers of capital (senior executives) to the ultimate owners (shareholders) as robustly as one dominated by flesh-and-blood money managers?  It seems a stretch to think so.

• Record unemployment, low inflation underline Europe's pain (Reuters)
• The ponzi gets bigger and bigger: Spanish banks up sovereign bond holdings by more than 10% (FT)
• China’s Growing Ranks of Elderly Beset by Depression, Study Says (BBG)
• Tokyo Prepares for a Once-in-200-Year Flood to Top Sandy (BBG)
• Morgan Stanley Cutting Correlation Unit Added $50 Billion (BBG)
• IMF warns over yen weakness (FT)
• Rising radioactive spills leave Fukushima fishermen floundering (Reuters)
• California Lawmakers Turn Down Moratorium on Fracking (BBG)
• India records slowest growth in a decade (FT)
• What’s Inside the Government’s Deal With Citigroup? (BBG)
• Three more coronavirus deaths in Saudi Arabia (Reuters)

Overnight Media Digest

WSJ

* Analysts differ on whether a sharp May rise in long-term interest rates signals a bursting bond bubble, the aftereffect of clumsy Fed communication or a welcome sign the U.S. economy is, at last, on the mend.

* The top-selling class of blood pressure drugs is under attack from an unusual source: a senior regulator at the Food and Drug Administration. Bucking his bosses, Thomas Marciniak is seeking stronger warnings about the drugs known as angiotensin receptor blockers, or ARBs, according to internal documents reviewed by The Wall Street Journal.

* China already owns ThinkPad laptops, Volvo cars and AMC movie theaters. Can it sell Smithfield Ham? A look at past Chinese purchases suggests that the answer is likely, "Yes." Chinese companies have stumbled in efforts to build homegrown brands in areas ranging from autos to tennis shoes. But with a few hitches - notably Volvo's in the sputtering European car market - the companies have managed to keep existing global brands healthy by investing and persuading senior managers to stay on board.

* Blackstone Group LP backed out of the bidding for Dell Inc last month. Yet many of the buyout firm's investors still are part of the tussle. One of them is the New Jersey Division of Investment, an agency managing money for seven state pension funds. It committed $50 million to the investment fund Blackstone would have tapped to finance a bid for the computer maker.

* Corporate profits declined and the government pulled back even more than first thought early this year, but consumers showed resiliency despite higher taxes. U.S. gross domestic product, a measure of all goods and services produced in the economy, advanced at a 2.4 percent seasonally adjusted annual rate between January and March, a small downward revision from last month's 2.5 percent reading, the Commerce Department said on Thursday. Consumers were the overwhelming driver of the moderate growth in the quarter. Personal consumption expenditures were revised up to a 3.4 percent gain - the largest increase in the category since the fourth quarter of 2010.

FT

The British government will next month announce 15 billion pounds ($22.82 billion) extra spending for infrastructure projects in the future, as part of new capital expenditure plans to stimulate the economy and revive growth.

Royal Bank of Scotland has narrowed a list of prospective bidders for hundreds of branches it must sell, and informed Apollo and JC Flowers that their bid was unsuccessful, according to people familiar with the matter.

British engineering company Smiths Group is in early-stage talks to sell its medical division, which played a role in the first successful IVF treatment, for potentially more than 2 billion pounds, said people familiar with the talks.

Major consumer products groups such as Johnson & Johnson and Anheuser-Busch InBev are delaying payments to advertisers and commodity producers leading to supply chain issues and constricted cash flows.

Google Inc has made a $12 million investment in a solar power project in South Africa, highlighting the attractiveness of Africa's largest economy to global investors.

Singapore Airlines Ltd said it would spend more than $17 billion to buy 30 Airbus and 30 Boeing Co aircraft, representing one of the biggest orders ever placed by the airline.

NYT

* After several deadly factory disasters in Bangladesh, Obama administration officials remain conflicted over what measures would work best to improve labor conditions there.

* The initiative began two decades ago, with the best of intentions, after apartheid fell and southern Africa's future brightened. Today that program, the Southern Africa Enterprise Development Fund, is in its death throes, apparently victimized by mismanagement, insider dealings and a lack of oversight by federal officials.

* The U.S. Transportation Department made its first formal policy statement on autonomous vehicles on Thursday. In a nonbinding recommendation to the states, it said that driverless cars should not yet be allowed, except for testing. But it said that semiautonomous features, like cars that keep themselves centered in lanes and adjust their speed based on the location of the car ahead, could save lives.

* Dr Peter Butler, chairman of endocrinology at the University of California, Los Angeles, who initially declined a request to test drugmaker Merck's new diabetes drug Januvia, found worrisome changes in the pancreases of rats, that could lead to pancreatic cancer. The discovery, in early 2008, turned Dr Butler into a crusader whose follow-up studies now threaten the future of not only Januvia but all the drugs in its class, which have sales of more than $9 billion annually and are used by hundreds of thousands of people with Type 2 diabetes.

* Japan inched closer to the end of deflation and factory output picked up, government data showed Friday, offering proof that the real economy is slowly catching up to the high expectations set by its recent bold economic policies.

* The health care law is injecting more competition into insurance markets nationwide, drawing additional companies into states long dominated by a few carriers, Obama administration officials said on Thursday.

* Newly minted university graduates who have landed coveted jobs on Wall Street may have impressive resumes and sought-after references. But often, nuts-and-bolts skills like spreadsheet building and database extraction are not part of university curriculums. When millions of dollars can be won or lost on one calculation, firms are finding it essential that their new hires can tell the difference between a pivot table and a header row. Enter specialized boot camps where - for fees that sometimes exceed $1,000 a day - would-be masters of the universe can perfect Excel modeling techniques and financial analysis.

Canada

THE GLOBE AND MAIL

* Toronto Mayor Rob Ford, the embattled leader who has now seen five of his employees depart since he was accused of using crack cocaine, has vowed to remain at Toronto City Hall, guaranteeing his name will be on next year's election ballot. Ford spoke with reporters about the two latest employee resignations on Thursday. He spent 90 seconds reading a prepared statement, then about 2 minutes fielding questions, five times swatting away inquiries about the drug scandal with the phrase: "Anything else?"

* The Harper government was forced to put further distance between itself and Senator Mike Duffy after an email surfaced suggesting the Prince Edward Island politician, under fire for illegitimate expense claims, had lobbied for a cabinet post and more compensation given his role as a fundraising star for the Tories. "Duffy has never held a cabinet position and has never been considered for cabinet," Andrew MacDougall, director of communications for Prime Minister Stephen Harper, said in a bluntly worded statement on Thursday.

Reports in the business section:

* Chile President Sebastian Pinera says Barrick Gold Corp must follow 23 steps to comply with orders from his country's environmental regulator, a message that underscores the tough road ahead for the company to get its crucial Pascua-Lama gold project back on track. Pinera, in Ottawa to discuss Canada-Chile economic relations, admonished Barrick for its handling of the $8.5 billion mine development so far.

* About 700 protesters, some on horseback, besieged a gold mine run by Canada-based miner Centerra Gold Inc in Kyrgyzstan, demanding its nationalization and more social benefits, officials said on Thursday. As part of the protest that has been going on for several days, the demonstrators earlier this week cut road access leading to the Kumtor mine operated by Centerra.

NATIONAL POST

* The negotiations over the free trade deal between Canada and the European Union offer plenty of fresh evidence that Canada's own worst enemy is its unwieldy constitutional structure. Ottawa is set to sign a free trade deal with the EU when Stephen Harper visits Europe for the G8 conference next month. But there are fears that Newfoundland and Labrador may walk away from any agreement that does not protect its fish processing industry.

* With serious accusations being hurled throughout the media and mass resignations hitting Rob Ford's office, a senior Ford staffer said the mayor's former chief of staff is out to "kill the mayor, politically and otherwise." The source said Mark Towhey, who was fired by the mayor last week, has an "axe to grind" with the mayor's office and accused him of leaking "revisionist history" in the Toronto Star.

FINANCIAL POST

* China is counting on "breakthroughs in energy trade" with Canada to help fuel economic growth in the world's most populous country, one of the country's top diplomats said on Thursday. Speaking to a Calgary business crowd, Zhang Junsai, China's ambassador to Canada, said his country is prepared to "deepen" ties with Canada on infrastructure development to help move the country's oil and natural gas to the West Coast for export.

* The lengthy battle by Bre-X investors to recover billions in Canada's largest mining fraud appears to be over in what one of the original plaintiff lawyers in the case called a "sad day" for accountability in Canada. Under a settlement approved on Thursday by the Alberta Court of Queens Bench, the remaining class action suits were dismissed against the main defendants in the case, the estate of Bre-X's late founder and chief executive, David Walsh, and Chief Geologist John Felderhof.

China

PEOPLE'S DAILY

-- President Xi Jinping's forthcoming visit to the United States and three other American countries in early June will help create favourable external conditions for a new round of China's economic growth, this newspaper, which reflects views of the ruling Chinese Communist Party, said in a commentary.

SHANGHAI SECURITIES NEWS

-- There are still doubts about whether China's Shuanghui International Holdings Ltd could successfully acquire U.S. Smithfield Foods Inc as some foreign experts believe Shuanghui's bid price at $4.7 billion was relatively low.

-- Assets managed by China's trust industry are poised to exceed 10 trillion yuan ($1.63 trillion) in the first half of this year from 7.47 trillion yuan at the end of last year, with risk mounting due to the extraordinary expansion of the sector.

CHINA SECURITIES JOURNAL

-- China will step up reforms this year to liberalise its interest rates and to make the yuan fully convertible under the capital account, Xu Shaoshi, head of the National Development and Reform Commission, the top economic planner, told the annual meeting of economic structure reforms opened in Beijing on Thursday.

-- China's central bank is likely to keep liquidity in the country's money markets relatively tight next month.

CHINA BUSINESS NEWS

-- A new round of urbanisation in China may mean that regulators would loosen tight grip on debt issuance by local government financing vehicles even after warnings of high risk involved in such debt.

CHINA DAILY

-- More European companies are planning further investment in China amid signs that the country will carry out more economic reforms, the paper said, citing the European Union Chamber of Commerce in China.

SHANGHAI DAILY

-- China is studying the possibility of joining the U.S.-led Trans-Pacific Partnership trade talks, Shen Danyang, a spokesman for the Ministry of Commerce, said.

ANALYST RESEARCH

Upgrades

CME Group (CME) upgraded to Market Perform from Underperform at Keefe Bruyette
Calpine (CPN) upgraded to Buy from Hold at Deutsche Bank
HomeAway (AWAY) upgraded to Overweight from Neutral at Piper Jaffray
Morgan Stanley (MS) upgraded to Buy from Hold at Deutsche Bank
NorthWestern (NWE) upgraded to Outperform from Neutral at RW Baird
Oaktree Capital (OAK) upgraded to Outperform from Market Perform at Keefe Bruyette

Downgrades

Aon plc (AON) downgraded to Market Perform from Outperform at Keefe Bruyette
CIBC (CM) downgraded to Neutral from Buy at BofA/Merrill
Cepheid (CPHD) downgraded to Hold from Buy at Jefferies
Charles River (CRL) downgraded to Underperform from Market Perform at Raymond James
Golar LNG Partners (GMLP) downgraded to Sector Perform from Outperform at RBC Capital
Mellanox (MLNX) downgraded to Neutral from Buy at UBS
Myriad Genetics (MYGN) downgraded to Hold from Buy at Jefferies
Panera Bread (PNRA) downgraded to Neutral from Buy at Lazard Capital
Scotts Miracle-Gro (SMG) downgraded to Underperform from Market Perform at BMO Capital

Initiations

Alexion (ALXN) initiated with a Neutral at Credit Suisse
Balchem (BCPC) initiated with an Overweight at Piper Jaffray
BioMarin (BMRN) initiated with a Neutral at Credit Suisse
Boston Scientific (BSX) initiated with a Neutral at Wedbush
CVS Caremark (CVS) initiated with an Outperform at Wells Fargo
Catamaran (CTRX) initiated with a Market Perform at Wells Fargo
Dynegy (DYN) initiated with a Neutral at Goldman
Express Scripts (ESRX) initiated with a Market Perform at Wells Fargo
Haemonetics (HAE) initiated with a Neutral at Goldman
Medtronic (MDT) initiated with a Neutral at Wedbush
Melco Crown (MPEL) initiated with an Outperform at Oppenheimer
RPM (RPM) initiated with an Overweight at Piper Jaffray
SeaWorld (SEAS) initiated with an Overweight at Barclays
St. Jude Medical (STJ) initiated with an Outperform at Wedbush
Tiffany (TIF) initiated with an Outperform at Credit Suisse
Valeant (VRX) initiated with an Outperform at BMO Capital

HOT STOCKS

DISH (DISH) commenced tender offer of $4.40 for outstanding Clearwire (CLWR) shares 
Crest sent letter to Clearwire (CLWR) urging repeal of recommendation of Sprint (S) merger
Clearwire's (CLWR) special committee to review unsolicited DISH (DISH) offer 
Dell (DELL) recommended shareholders vote for transaction with Michael Dell, Silver Lake
Samsung (SSNLF) selected Intel (INTC) "Clover Trail" processor to be in upcoming Galaxy 3 Tablet, Reuters reports
American Realty (ARCP) acquired $807M GE Capital (GE) portfolio of 471 net lease properties
Ford (F) surpassed previous hybrid sales record in first five months of FY13
Acacia Research (ACTG) entered into license agreements with Costco (COST), Target (TGT)

EARNINGS

Companies that beat consensus earnings expectations last night and today include:
Pall Corp. (PLL), OmniVision (OVTI), Krispy Kreme (KKD), Envivio (ENVI), Guess (GES), Palo Alto (PANW), Lionsgate (LGF)

Companies that missed consensus earnings expectations include:
Copart (CPRT), Uroplasty (UPI), Esterline (ESL)

Companies that matched consensus earnings expectations include:
Splunk (SPLK)

NEWSPAPERS/WEBSITES

• A group of top government officials is expected to decide Monday whether several large, nonbank financial firms should be designated as "systemically important" and subjected to increased government scrutiny, sources say. Prudential Financial (PRU), AIG (AIG) and GE Capital (GE) are being considered, the Wall Street Journal reports
• Boeing (BA) is powering up efforts to put the three-month long grounding of its Dreamliner behind it, re-focusing on increasing production and accelerating a spate of new jets it hopes to design, build and deliver before the end of the decade, the Wall Street Journal reports
• Carlyle Group (CG) and Blackstone Group (BX) as well as Indian outsourcers L&T Infotech and Tech Mahindra Ltd, are lining up bids for Hewlett-Packard’s (HPQ) $1B stake in India's MphasiS Ltd, sources say, Reuters reports
• Toyota Motor (TM) has a "good chance" of selling a record number of luxury Lexus vehicles this year, an executive said, as a weaker yen adds to the brand's allure globally and in its biggest market the U.S., Reuters reports
• California lawmakers rejected a bill that would have stopped drillers from using hydraulic fracturing to free oil and natural gas from shale beds until state regulators implement rules for the controversial practice, Bloomberg reports
• Armour Residential REIT (ARR) has about $22.5B of government-backed home-loan debt, and has lost 13% this year, including reinvested dividends. It’s now leading the declines in mortgage REITs as concern grows that the Fed will slow its bond-buying program as soon as June, Bloomberg reports

SYNDICATE

Air Lease (AL) 8M share Secondary priced at $26.75
Epizyme (EPZM) 5.142M share IPO priced at $15.00
Graphic Packaging (GPK) files to sell 15M shares of common stock for holders
Magnegas (MNGA) to offer common stock and warrants

While we found it modestly comedic (and certainly ironic) that CNBC's crack team celebrated the recovery from the initial knee-jerk drop in stocks after the FOMC by top-ticking that suspension of reality; we suspect the following post-mortem from Goldman on the minutes is what confirmed concerns across the street... "Minutes from the July 30-31 FOMC meeting were generally consistent with our view that tapering of asset purchases is likely to occur at the September meeting, coincident with an enhancement of the forward guidance."

Via Goldman Sachs' Jan Hatzius,

BOTTOM LINE: Minutes from the July 30-31 FOMC meeting were generally consistent with our view that tapering of asset purchases is likely to occur at the September meeting, coincident with an enhancement of the forward guidance.

MAIN POINTS:

1. Regarding discussion of asset purchases, while nearly all Committee members agreed that a change in the pace of asset purchases was not yet appropriate at the July meeting, the forward-looking description of where members stood was less clear."A few" members emphasized the possibility of being patient while "a few others" thought that it would soon be appropriate to slow the pace of purchases. Elsewhere, "a number" of participants (including non-voting Presidents) noted that "market expectations of the future course of monetary policy, both with regard to asset purchases and with regard to the path of the federal funds rate, appeared well aligned with their own expectations," at least as of late July. Overall, we think this information is consistent with September tapering, but this is by no means certain.

2. In addition, there was a discussion of whether additional information on the Committee's outlook for asset purchases?which the minutes noted would reaffirm Chairman Bernanke's remarks on this topic at the last post-FOMC press conference?should be added to the policy statement. There appeared to be broad support for explicitly adding this information to the statement in the future.

3. The minutes revealed fairly extensive discussion of forward guidance at the meeting, with "several" participants willing to contemplate lowering the unemployment threshold if "additional accommodation were to become necessary or if the Committee wanted to adjust the mix of policy tools." Chairman Bernanke has strongly suggested that the Committee is interested in adjusting the mix of tools in recent public remarks. "A number" of participants also suggested providing "additional information on the Committee's intentions regarding adjustments to the federal funds rate after the 6 1/2% threshold was reached, in order to strengthen or clarify the forward guidance." (Emphasis added.) We see these remarks as consistent with the Committee enhancing the forward guidance at the September meeting.

4. The economic assessment expressed in the minutes was generally a bit more pessimistic, with the staff noting that growth in the first half was weaker than expected."A number" of participants were less confident about a near-term pickup in growth due to higher mortgage rates, higher oil prices, slow global growth, and continued fiscal worries. In addition, overall labor market conditions were described by participants as remaining "weak."

5. There was a special presentation on long-run planning for monetary policy implementation, which included a briefing on potentially establishing a "fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market rates." Because the minutes note that "a wide range of market participants" could be eligible to participate, this facility would presumably be intended to address the fact that not all fed funds market participants are eligible to earn interest on excess reserves, and so interest on excess reserves has not acted as a floor on the fed funds rate as it should in theory.

• Republican Civil War Erupts: Business Groups v. Tea Party (BBG)
• Budget fight leaves Boehner 'damaged' but still standing (Reuters)
• Madoff Was Like a God, Wizard of Oz, Lawyers Tell Jury (BBG) - just like Bernanke
• Republicans press U.S. officials over Obamacare snags (Reuters)
• Brilliant: Fed Unlikely to Trim Bond Buying in October (Hilsenrath)
• More brilliant: Fed could taper as early as December (FT)
• Russia Roofing Billionaires Seen Among Country’s Youngest (BBG)
• Ford's Mulally won't dismiss Boeing, Microsoft speculation (Reuters)
• China reverses first-half slowdown (FT)
• NY Fed’s Fired Goldman Examiner Makes Weird Case (BBG)
• Italian protests against Letta government disrupt transport (Reuters)
• Transit workers strike again, will hamper Bay Area commute (Reuters)

Overnight Media Digest

WSJ

* SAC Capital and federal prosecutors have agreed in principle on a penalty exceeding $1 billion in a potential criminal settlement that would be the largest ever for an insider-trading case.

* Insurers say the federal healthcare marketplace is generating flawed data that is straining their ability to handle even the trickle of enrollees who have gotten through so far.

* Chinese PC maker Lenovo is actively considering a bid for all of BlackBerry and has signed a non-disclosure agreement with the smartphone maker. ()

* A late surge of cases against low-level offenders will push the SEC's case total close to last year's levels, masking a steep drop in enforcement actions related to the financial crisis. While the total hasn't been announced, it likely will be down at least 5 percent from a near-record high of 734 enforcement cases in fiscal 2012.

* Google posted a 12 percent increase in third-quarter revenue, as it tries to keep pace with its users' shift to mobile devices.

* Video-streaming service Hulu on Thursday named Mike Hopkins as its new chief executive, effective immediately. Hopkins has been president of Fox Networks Group, a division of 21st Century Fox Inc, since 2008 and a member of Hulu's board since 2011.

* A U.S. district judge ordered subprime lender Household International Inc - now part of HSBC Holdings PLC - to pay investors $2.46 billion in a class-action lawsuit, a move that comes several years after a jury found the company liable for securities fraud.

* IBM is shaking up leadership of its growth-markets unit, following disappointing third-quarter results that prompted a critical internal email from CEO Virginia Rometty. She wrote that IBM's strategy is correct, but criticized the company for failing to execute in sales of computer hardware as well as in the growth markets unit, whose sales territory includes markets in Southeast Asia, Eastern Europe, the Middle East and Latin America.

FT

Paul Tucker, the Bank of England's outgoing deputy governor, said regulators need to keep a stronger eye on hedge funds and shadow banks and added it would be disastrous if the economic fragility of banks was recreated outside the mainstream banking sector.

The U.S. Federal Reserve could begin reducing its asset purchases as early as December after the government shutdown sabotaged a crucial month of data and dealt a blow to the world's largest economy.

The next U.S. monthly employment report became a casualty of the U.S. government shutdown with the Department of Labor saying the data would be released after a delay of more than two weeks on Tuesday.

Scottish National Party leader and Scotland's first minister, Alex Salmond was involved in the talks between the management and workers Grangemouth refinery and petrochemicals complex. The management has closed off the refinery demanding that workers accept changes to pay, pensions and union representation in what has turned out to be Scotland's biggest industrial dispute in years.

Google shares rose 8 percent to a record high after the company managed a smooth transition of its advertising business to smartphones and tablets from PCs.

Goldman Sachs managed to protect its profits by slashing the amount of money set aside for year-end bonuses after its fixed-income trading was worse than any other large Wall Street bank's.

Barclays has approached the Court of Appeal to overturn an earlier ruling that allowed Guardian Care Homes, which is suing Barclays over interest-rate swaps, to amend its claim to include Libor-related allegations.

UK Ministers will look at the green measures that have contributed to rising fuel bills after British Gas became the second energy company to increase energy prices.

NYT

* Britain said on Thursday that it would allow Chinese firms to buy stakes in British nuclear power plants and eventually acquire majority holdings. The agreement, which comes with caveats, opens the way for China's fast-growing nuclear industry to play a significant role in Britain's plans to proceed with construction of its first new reactor in nearly two decades.

* The hedge fund SAC Capital Advisors is moving closer to a plea deal with prosecutors that would force it to wind down its business of managing money for outside investors, punctuating its decline from the envy of Wall Street to a firm caught in the government's cross hairs. An agreement to stop operating as an investment adviser is one feature of a larger agreement SAC is negotiating as it seeks to resolve insider trading charges, according to people briefed on the case.

* On Thursday Goldman Sachs Group Inc announced that revenue in its fixed-income, currency and commodities division, a powerful unit inside the bank that in better years has produced more than 35 percent of its entire revenue, dropped 44 percent from year-ago levels. The weakness renewed worries about the headwinds that Goldman and other banks are facing in big money-producing areas like fixed-income trading.

* Google Inc impressed investors, but people's changing behavior on mobile phones and even on desktops threatens the company's main business. The results revealed the company's deep challenges: as its desktop search and advertising businesses mature, along with overall business in the United States, its growth rate is slowing and the amount of money it makes from each ad it sells is falling.

* The United States government sputtered back to life Thursday after President Obama and Congress ended a 16-day shutdown, reopening tourist spots and clearing the way for federal agencies to deliver services and welcome back hundreds of thousands of furloughed workers.

* There is a confusion over the text of the deal that Congress just approved and President Obama signed, but it does not kill the debt ceiling. At first glance, the "default prevention" section of the bill seemed to imply that the president would have the authority in the future to increase the country's debt unilaterally, and that Congress could stop him only by passing a bill forbidding it.

* Roughly 1,500 fires burn above western North Dakota because of the deliberate burning of natural gas by companies rushing to drill for oil without having sufficient pipelines to transport their production. With cheap gas bubbling to the top with expensive oil, the companies do not have an economic incentive to build the necessary gas pipelines, so they flare the excess gas instead.

* As European interest in American craft beers begins to mirror the mania for them stateside, the Duvel Moortgat Brewery of Belgium on Thursday announced a deal to buy the Boulevard Brewing Co, a craft brewery in Kansas City, Missouri.

Canada

THE GLOBE AND MAIL

* Canadian provinces have approved the free-trade agreement with the European Union, but key players Ontario and Quebec are insisting the federal government open its wallet to mitigate some of the impact, notably by compensating dairy producers. Prime Minister Stephen Harper arrived in Brussels on Thursday night and plans to meet with Jose Manuel Barroso, president of the European Commission, on Friday afternoon to sign the agreement.

* The shortage of skilled employees in Canada is deepening, and government policies that tightened the rules governing foreign workers have made the situation worse. That is the message of a new study from global recruiting firm Hays Plc, which surveyed the skills gap in 30 developed countries around the world.

Reports in the business section:

* Lenovo Group Ltd is joining the list of suitors considering a bid for BlackBerry Ltd , raising concerns that the Canadian company's ultra-secure communications network for the global elite might end up owned by a firm based in China.

* Imperial Oil Ltd is looking at a major revamp of its Mackenzie gas project that would see the stalled northern venture reborn as part of an expansive liquefied natural gas development, the company's chief executive says. A shift to LNG is under "serious" consideration as the Mackenzie pipeline's economics remain weak due to the flood of cheap shale gas across the continent, CEO Rich Kruger said in an interview at the company's Calgary headquarters.

NATIONAL POST

* The Quebec government has announced that it will contest the latest nomination to the Supreme Court of Canada, adding a new layer of controversy to the process. The provincial government says it is weighing different options to block the Harper government's appointment of Marc Nadon, which is already under attack.

FINANCIAL POST

* Canada's campaign to win approval in the United States for the Keystone XL pipeline may seem pricey, aggressive, and perhaps out of character - but it is a drop in the bucket compared with the resources and tactics of those rallying against it.

* Air Canada's chief executive, Calin Rovinescu, says he is pleased investors are starting to get on board with the dramatic transformation underway at his airline, including the near-elimination of its multi-billion-dollar pension funding deficit that has twice threatened to upend the company in recent years. But he said there are still plenty of challenges ahead for the country's largest carrier.

China

CHINA SECURITIES JOURNAL

- The China Securities Regulatory Commission approved China Everbright Bank Co Ltd's request to list H shares on Wednesday, according to sources. The bank plans to list in Hong Kong as early as November, but listing is subject to Hong Kong Stock Exchange approval.

- China has started laying the foundations for its fifth-generation mobile telephony network, said Dai Xiaohui, the deputy director of the Ministry of Science and Technology on Thursday at a communications forum.

CHINA DAILY

- China has investigated 129 officials at prefectural level or higher for suspected corruption and bribery from January through August this year, the Supreme People's Procuratorate said on Thursday.

PEOPLE'S DAILY

- Chinese officials should not blindly follow customary practices if such practices lead to waste or are not legal, said a commentary in the paper that acts as the government's mouthpiece. The article highlighted extravagance during opening and closing ceremonies as an example of a traditional practice best curbed.

SHANGHAI DAILY

- Beijing will take half the cars off the city's roads and suspend school classes when there are three straight days of heavy pollution, an official said on Thursday. The plan includes measures to increase buses and extend subway operating hours.

Fly On The Wall 7:00 AM Market Snapshot

ANALYST RESEARCH

Upgrades

AMAG Pharmaceuticals (AMAG) upgraded to Outperform from Neutral at RW Baird
Align Technology (ALGN) upgraded to Buy from Hold at Cantor
Amazon.com (AMZN) upgraded to Buy from Neutral at UBS
CBOE Holdings (CBOE) upgraded to Buy from Neutral at UBS
Essex Property Trust (ESS) upgraded to Buy from Neutral at UBS
Intuit (INTU) upgraded to Buy from Neutral at BofA/Merrill
Peabody Energy (BTU) upgraded to Outperform from Market Perform at BMO Capital
Union Pacific (UNP) upgraded to Buy from Neutral at Goldman
VMware (VMW) upgraded to Overweight from Neutral at JPMorgan
Verizon (VZ) upgraded to Buy from Hold at Deutsche Bank

Downgrades

AMD (AMD) downgraded to Neutral from Buy at BofA/Merrill
Alpha Natural (ANR) downgraded to Underperform from Market Perform at BMO Capital
Amarin (AMRN) downgraded to Neutral from Buy at Citigroup
Aspen Technology (AZPN) downgraded to Neutral from Overweight at JPMorgan
Baxter (BAX) downgraded to Market Perform from Outperform at Raymond James
Fairchild Semiconductor (FCS) downgraded to Hold from Buy at Canaccord
Home Bancshares (HOMB) downgraded to Market Perform from Outperform at Raymond James
International Rectifier (IRF) downgraded to Market Perform at Wells Fargo
LG Display (LPL) downgraded to Neutral from Outperform at Credit Suisse
Monolithic Power (MPWR) downgraded to Market Perform from Outperform at Wells Fargo
Navistar (NAV) downgraded to Underweight from Equal Weight at Barclays
Qualys (QLYS) downgraded to Neutral from Overweight at JPMorgan
SL Green Realty (SLG) downgraded to Hold from Buy at Cantor
Total (TOT) downgraded to Neutral from Buy at UBS
Ultratech (UTEK) downgraded to Hold from Buy at Canaccord
UnitedHealth (UNH) downgraded to Hold from Buy at Cantor

Initiations

Clean Harbors (CLH) initiated with an In-Line at Imperial Capital
Covanta (CVA) initiated with a Hold at Stifel
Fidelity National (FNF) initiated with a Neutral at Janney Capital
Finish Line (FINL) initiated with a Neutral at UBS
First American (FAF) initiated with a Buy at Janney Capital
Gaming & Leisure (GLPIV) initiated with an In-Line at Imperial Capital
Masonite International (DOOR) initiated with an Outperform at RBC Capital
New Residential (NRZ) initiated with a Buy at Sterne Agee
Spectrum Brands (SPB) initiated with an Outperform at BMO Capital
Stewart (STC) initiated with a Neutral at Janney Capital
U.S. Cellular (USM) initiated with an Underperform at FBR Capital

HOT STOCKS

Google CEO said 40% of YouTube traffic comes from mobile
Schlumberger (SLB) said global economic outlook remains unchanged
Fitch cut Darden (DRI) IDR to 'BBB-' from 'BBB', outlook stable
LabCorp (LH) board authorized additional $1B share repurchase program
AMD (AMD) sees PC shipments down 10% in 2013 and 2014
Waste Management (WM) to build renewable natural gas facility

EARNINGS

Companies that beat consensus earnings expectations last night and today include:
Sensient (SXT), F.N.B. Corp. (FNB), AMD (AMD), Las Vegas Sands (LVS), Capital One (COF), Covenant Transportation (CVTI), WD-40 (WDFC), Google (GOOG), Align Technology (ALGN)

Companies that missed consensus earnings expectations include:
Valmont (VMI), Kaiser Aluminum (KALU), B&G Foods (BGS), athenahealth (ATHN), Greenhill & Co. (GHL), Acacia Research (ACTG), Stryker (SYK), Chipotle (CMG)

Companies that matched consensus earnings expectations include:
OceanFirst Financial (OCFC), Western Alliance (WAL), Werner (WERN)

NEWSPAPERS/WEBSITES

• The long-running drama about when the Fed will start scaling back its $85B a-month bond-buying program might now last longer. It isn't clear when the first move will occur. The Fed is unlikely to start curtailing its bond buying at its next policy meeting Oct. 29-30, the Wall Street Journal reports
• Bank of America (BAC) is considering a checking account that wouldn't permit customers to overdraw their balances at an ATM or when making an automatic bill payment, sources say, the Wall Street Journal reports
• Ford (F) CEO Alan Mulally would not confirm or deny media reports that he is being sought to join Boeing (BA) and Microsoft (MSFT), Reuters reports
• Air France -KLM (AFLYY) is open to giving Alitalia its rightful role in a merged entity but only if certain conditions are met, CEO Alexandre de Juniac told French television. He said Alitalia needs deeper restructuring if Air France is to eventually hike its 25% stake and take control, Reuters reports
• DBS Group (DBSDY) is among banks that have advanced in bidding for Societe Generale’s (SCGLY) SA’s private banking assets in Asia, sources say. The division oversees about $13B, Bloomberg reports
• JPMorgan Chase (JPM) agreed to sell 1 Chase Manhattan Plaza to Fosun International, the investment arm of China’s biggest closely held industrial group, for $725M, Bloomberg reports

SYNDICATE

Cinedigm Digital (CIDM) files to sell 7.91M shares of Class A common stock
Crestwood Midstream (CMLP) files to sell 14M common units for limited partners
EV Energy (EVEP) files to sell 5M common units for limited partners
Evercore Partners (EVR) files to sell 3M shares of common stock
Stemline (STML) files to sell $90M of common stock
Voxeljet (VJET) 6.5M share IPO priced at $13.00

Submitted by Lance Roberts of STA Wealth Management,

The market correction that begin in January appears to be subsiding, at least for the moment, as Yellen's recent testimony gave markets the promise of the continuation of Bernanke's legacy.  A synopsis of her "accommodation supportive" comments (courtesy of Bill King) is below:

* The recovery in the labor market is far from complete.

 

* The hope is that by stimulating more borrowing and spending, lower interest rates can jumpstart the economy.  [Of course, we are still waiting for that to actually happen]

 

* QE tapering is "not on a preset course. The Committee's decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases."

 

* Asset prices are not at "worrisome levels." [This statement caused the midday surge.]

 

* The Fed will have to keep rates near zero "well past the time" that unemployment crosses below the 6.5 percent threshold; and the Fed will be an active participant in increased bank regulation, specifically focusing on avoiding the too-big-to-fail problems

With the markets back into rally mode, for the moment, this week's "Things To Ponder" focuses on some of the bigger issues concerning the effectiveness of QE, investing and that chart of 1929 that has been making the rounds.

1) QE Is A Mistake - A Big Oneby Allan Meltzer of E21

If you review the Yellen's comments above, she stated that the"hope" of QE was to stimulate more borrowing and spending.  Unfortunately, as shown in the chart of M2V below, it has simply not been the case.

Allan Metzer wrote a terrific article for E21 driving home this point:

"The Fed deserves high praise for the first round of QE in 2008. However, the benefits ended long ago. More than 95 percent of the reserves that the Fed supplied under QE 2 and 3 sit idle on bank balance sheets. M2 money growth for the year to the end of January 2014 is less than 5.5 percent. There is no mystery about why inflation remains low.

 

The mistaken results of QE policy include Federal Reserve financing of outsize budget deficits. No one should require a tutorial about the longer-term consequences of using central banks to finance government deficits. Sooner or later the results are inflation, always and everywhere."

2) The Cash On The Sidelines Mythby Pater Tenebrarum via Zero Hedge

In a recent interview by JP Morgan's Tom Lee, he asserted that:

“This could be only the middle innings of what could be one of the longest bull markets in history," Lee said in a "Squawk Box" interview. "There is a lot of firepower to fuel this rally. There is a lot of cash on the sidelines, consumers have delevered."

Pater dismantles this very ill-founded argument, a pet peeve of Cliff Asness as well, in great detail.

"Let us think about this statement for a moment. What is 'cash on the sidelines' even supposed to mean? We submit that it is a meaningless concept. All stocks are owned by someone at all times, and all cash is held by someone at all times. When people trade stocks, all that happens is that the ownership of stocks and cash changes hands. There is as much 'cash on the sidelines' after a trade concludes than there was before. There are no owner-less orphan stocks flying about in the Wall Street Aether, waiting to suck up cash.

 

In other words, the 'cash on the sidelines' argument is a really bad argument, or rather, it's not an argument at all."

3) Can Earnings Get Better Than This? by Tom McClellan via Pragmatic Capitalist

"The conventional stock market analysis world revolves around earnings.  'Earnings drive the stock market,' they say.  This myopic view is akin to the belief that carbon dioxide is the driving force behind the greenhouse effect (water vapor actually accounts for 90-95% of it, but you don’t hear that).  People believe that earnings are everything because they have been told that it is so, and everyone thinks so,  therefore it must be so.  Circularity of logic and contradictory evidence do not seem to be significant impediments to the acceptance of this belief system.

This week’s chart looks at the BEA’s data on corporate profits.

Why doesn't everyone look at earnings this way? My answer is that Wall Street has a fascination with its own forecasts of earnings, and with the reported earnings of listed companies stocks. But those are a pair biases which excluded private company earnings, and which also accept earnings estimates which are notoriously subject to revision. I prefer to deal in hard data. The next BEA report on earnings is not due out until Feb. 28, so using these data means accepting the inherent reporting lag.

 

What we see now is an indication that the reading for overall corporate profits as a percentage of GDP is at one of the highest levels of recent years. And when it cannot get higher, it can only get lower. It is true that this measure has been higher in the distant past, but that was back in the 1960s and earlier, when GDP was a bit different than it is now, and when accounting standards for measuring profits were also different. The current high reading has only been exceeded once in the past 46 years, and that was at the real estate bubble top for earnings back in 2006. And we all know how that ended."

 

4) Everything I Know About Investing I Learned From Drivers Edby Jason Zweig

Jason's articles are always a must read as he has a brilliant ability to very complex issues into an understandable, and enjoyable, format.  His recent piece on investing is no exception and well worth your time to read.

"Only recently did I realize that his messages apply at least as much to investing as they do to driving. Here are the pithy expressions Mr. Terry taught us about driving – and how I think they apply to investing as well.

 

Put Your Head on a Swivel - Risk is all around you, and the likeliest places to look for it are the places that appear to be the safest. That’s where the next danger will come from – just where and when nobody is looking.

 

Edge On, Edge Off- Making a sudden change in your plan is usually a mistake. Making a sudden, big change in your plan almost always is.

 

 

Get in the Ground-Viewing Habit - It’s what is beneath eye-level that matters

 

Give Him Room and Let Him Zoom - People who try to get rich quick don’t end up any farther along – and take a lot more risk, and incur a lot more cost, to get there. You don’t get bonus points in investing for arriving at your destination ahead of time. The only thing that matters is getting there in one piece."

5) The 1929 Scary Chartvia Bill King, The King Report

The chart below, which compares the 1929 stock market to today, has been making the rounds stirring up quite a bit of angst.  I thought Bill did a good job of dispelling some of these concerns.

"There is another factor that drove stocks higher on Tuesday – some of the 1928-1930 algorithm followers are now covering their shorts. [Especially after the S&P 500 blew threw 1800]"

"In our missive on Monday we stated: We believe that the current stock market will now diverge from the 1928-1930 algorithm. For the near future we cannot see or fathom a catalyst for a stock market crash. Plus, it's the wrong time of the year for a dramatic decline in stock prices.

 

PS- Several people voiced irritation with our forecast that stocks would not tank in coming days.

 

Apparently a critical mass of traders now realize that stocks are diverging from the 1928-1930 algorithm. This unleashed massive short covering on Tuesday.

 

This story by Mark Hulbert appeared yesterday on Drudge: Scary 1929 market chart gains traction

 

There are eerie parallels between the stock market's recent behavior and how it behaved right before the 1929 crash...

 

Tom Demark [has a huge hedge fund and institutional following] added in interview that he first drew parallels with the 1928-1929 period well before last November.

 

'Originally, I drew it for entertainment purposes only,' he said—but no longer: 'Now it's evolved into something more serious.'"

I agree with Bill.  Statistically speaking, the odds are high that the markets will diverge from the pattern.   While history does indeed rhyme, it often does not repeat exactly.  Do I think that eventually the markets will have another major reversion?  Absolutely.  The natural ebb and flow of market dynamics tells us this will be the case.  Unfortunately, we just don't know when or what will cause it.

Bonus Reading:  77 Reasons You Suck At Managing Moneyby Morgan Housel

"People usually get better at things over time. We're better farmers, faster runners, safer pilots, and more accurate weather forecasters than we were 50 years ago.

 

But there's something about money that gets the better of us. If you look at the rate of personal bankruptcies, financial crises, bubbles, student loans, debt defaults, and savings rates, I wonder whether people are just as bad at managing money today as they were in previous generations, maybe even worse. It's one of the only areas in life we seem to get progressively dumber at."

Yes, there are indeed 77 charming nuggets of wisdom contained within the article, all of which are worth every minute you spending reading them.  They are funny, enlightening and humbling with insights like:

"You get upset when you hear on TV that the government is running a deficit. It doesn't bother you that you heard this on a TV you bought on a credit card in a home you purchased with a no-money-down mortgage."

He concludes with the most salient point:

"You nodded along to all 77 of these points without realizing I'm talking about you. That goes for me, too."

Have a great weekend.

Fundamentally oriented investors tend to think that quants, like blondes, have all the fun. As ConvergEx's Nick Colas notes - it all looks like easy money - scalping trades with lightning fast computers, front running news with preferential access to press releases, or managing leveraged portfolios with thousands of small but profitable positions – but quants face their own significant challenges. Finding common rule sets that work in a wide array of stocks is not easy, and markets adapt quickly to close opportunities that seem historically profitable - the number of potential signals is seemingly endless; and regulators are now aware of quantitative investing and, in some cases, don't like what they see. Here are 10 reasons why why "it's not easy being a quant."

In summary, Colas points out, the fundamental/quant investor divide is a case of “The grass is always greener on the other side of the fence.”

Via ConvergEx's Nick Colas,

Have you ever had one of those dreams where you are out in public and suddenly realize you’ve forgotten to put on your pants?  Everyone is staring at you, and for a while you just wonder why.  Do you look especially attractive today?  No, that can’t be it; some people are laughing at you.  Then you realize: no pants!  General embarrassment ensues.  And then, hopefully, you wake up.

I had an analog experience today while presenting at a conference entitled “Quantitative Investing with News & Sentiment Analysis” hosted by Deltix and RavenPack, two preeminent vendors in the front-page world of quant investing.  The organizers asked me to give the lead-off talk to the room of about 100 number-crunchers, the topic of which was basically “What does the rest of the investment world think about quants?”   My message was as follows:

Capital markets connect investors, managements, employees, retirees and other savers – basically everyone in society – together into one economic ecosystem.  As such, markets are hugely important and their credibility is a lynchpin social issue.

 

Fundamental investors – I used famed Fidelity Magellan Fund manager Peter Lynch as one example – are useful spokespeople for capital markets.  They connect what goes on in asset prices, especially equities, to economic outcomes in a way people can understand.  And, if they do as well as Peter Lynch did for his investors, these “Heroes” of capital markets can act to give the broad population some confidence that market-based capitalism really is a sensible way to organize the allocation of scarce resources.

 

The issue quant investors face is that their newer approach to capital allocation, based on technology and math and speed, hasn’t yet developed the utility of their narrative back to society as whole.  Indeed, its opaque and fragmented nature can engender suspicion from existing capital markets participants and regulators.

The whole “Hero” narrative, I thought, was a neat way to explain both why fundamentally minded investors have trouble with quant investors and to recommend some solutions to bring this Hatfield – McCoy style divide a bit closer together.  Perhaps it was the fact that I was the first speaker, or perhaps the coffee didn’t kick in, but at the close of my brief chat it took a little while to get some questions from the audience.  Always an embarrassing moment, that part where you say ‘Any questions?’ in a chirpy voice but only hear crickets in return.  I checked to see if the whole pants thing was the problem, but no…  They even matched the jacket.

Later, as I listened to several presentations by other speakers and the very lively discussions about their back tests, mathematical equations and statistical regressions, it struck me just how truly different the quantitative approach to investing is from the fundamental school.  As a long time adherent of the latter, I have always been a bit jealous of the former.  As it turns out, the grass isn’t necessarily greener on the quant side of the fence.  Come to think of it, It might not even be grass over there…

Later in the day, I jotted a quick Top 10 list of ‘Why it is actually tough to be a quant after all”:

1. They are just as lost as any fundamental investor.  As I listened to the morning’s presentations, I expected to hear about wildly successful algorithms and quantitative processes that had excellent back tested results and were delivering outsized returns with minimal risk.  The gating element I expected to hear about was computing power, or execution speed, or access to large and complex datasets.

 

The reality is that quant investing is still in a relative infancy, with debates like “How much does news really move a stock?”  Fundamental investors simply try to forecast specific events like better than expected earnings or revenue shortfalls.  Quants need to know that, plus how much, on average, will such news change the stock price?  Not easy stuff, and the targets change frequently.

 

2. Developing common rule sets for different stocks in various sectors/markets is difficult.  Imagine coming up with a common set of trading guidelines that could apply to all the stocks you know well.  Some are easy – a big earnings beat, or a surprise dividend boost.  But how about news in the supply chain?  Or the customer base?  The former, as it turns out, has less impact than the latter.  But figuring that out takes time.  A lot of time.

 

3. The relationships between stocks, fundamentals, and news changes constantly.  Remember the move off the 2009 lows for U.S. stocks, as low-quality companies had much larger returns than their high-quality peers?    Makes all the sense in the world to a fundamental investors, since the highly leveraged third-tier player in a tough industry with a $3 stock will bounce to $10 long before the #1 company in a great industry will even double.  To a quant that killed it from 2006-2009, however, that’s nightmare material.  Worse than the pants dream.  Their model was likely tuned to own quality companies and short the bad ones.  How do know when to flip the whole process on its head?  And would your investors forgive you if you got it wrong?

 

4. Math both helps and gets in the way.  Make no mistake – quants know numbers.  And models.  And they have access to a myriad of financial information.  But they also only have 24 hours in a day – the same as the rest of us.   They can be caught in analysis paralysis the same as a fundamental investor can feel the need to visit every single operation of a complex company before they make a recommendation.

 

5. The good stuff is very difficult to use.  Twitter is a big topic in quant land at the moment.  Everyone in the room seemed excited by the prospect of this fire hose of information.  At the same time, there was general agreement that social media generally is very heavy lifting indeed if you want to include it in an investment process.  How do you know a tweet is positive, or sarcastic?  Sure, a 12 year old knows.  But a computerized algo reading it?  As if…

 

6. It doesn’t work all the time.  Good investors of any stripe – fundamental or quantitative – know they are playing a numbers game.  If you can win 66% of the time, you are doing a great job.  However, unlike their fundy-counterparts, quants rarely hold a stock long enough to make a huge return.  So they must rely on their process to grind out steady returns with generally short-ish holding periods, without the benefit of a +100% return on the sheet from a long term anchor investment.

 

7. Everything starts with a back test.  Most things, anyway.  Back tests, where you show that your idea for an investment process or data set worked in the past, is a big part of the quant world.  But every quant is keenly aware that past is not always prologue.

 

8. Signals are everywhere… And nowhere.  In the modern information age, data is everywhere.  Want an hour-by-hour weather report for every Wal-mart story location?  No problem.  Daily pings to Google Trends to see what the world is searching for?  No problem.  Data on search term traffic for popular momentum stocks?  No problem.  But knowing where to prioritize your time and efforts?  Not so easy.

 

9. Quant investing is now in the regulators’ crosshairs.  While it didn’t come up in the sessions I listened to, conference attendees must have been aware of the recent decision by Warren Buffett’s Business Wire to cease selling high-speed access to their news flow.  Now, not all quants are high frequency traders, so perhaps it didn’t matter all that much to them.  Still, one of the original advantages to quantitative investing was the inherently compliance-friendly nature of the process.  Take publicly available information, crunch the numbers better than the next computerized trader, and make money with little risk of stepping across any regulatory lines.  Now, how quickly quants get information is clearly a front-and-center issue for regulators.  What might be next for their focus?  Hard to say.

 

10. More and more competition.  Attendance at the Deltix/RavenPack conference was excellent.  Standing room only in a large venue.  No mid-morning fade, and no post-lunch dropoff in headcount.  Quant-oriented investing is still clearly popular, and therein lays a challenge for everyone in the room.  Just as when hedge funds started to run rings around the long-only community in the 1990s, only to see returns fade in the 2000s, managing money with computerized algorithms and ever more complex datasets is getting very competitive.

In summary, my short time living in the quant world gave me a renewed appreciation for just how difficult investing in highly competitive markets has become, regardless of your discipline.  Their super-fast computers and programmers and Russian accents and high math does, at first blush, seem like something akin to magic.  But the quant world, to borrow from an old saying, has to put its pants on one leg at a time, just like the rest of us.