Altair Monthly Commentary – July

Stock market activity for June was a tale of two markets.  The first 26 days of the month were characterized by stock prices falling 8% as the market wrestled with the crisis in Greece and the ending of the Fed’s QE2 program.  On June 21, Greek Prime Minister George Papandreou survived a no-confidence vote leading to the subsequent passage of a Greek austerity package.  Despite days of rioting in Athens, the markets viewed the austerity (more specifically the cash infusion Greece will receive because of it) as a major positive and rallied 6% in the last four trading days – ending the month with a 1.6% loss.


As investors returned to embracing risk, the expiration of QE2 put substantial pressure on the bond market.  During the last four days of the month, yields on the 5-Year Treasury rose from 1.37% to 1.76%.  Thus far, the end of QE2 has had the most impact on the short end of the yield curve, though longer-dated maturities have fallen in value as well.


From a macro perspective, the resolution of the Greece’s mid-term fiscal plan takes some pressure off European Banks and the possible spill-over into U.S. money markets.  The 12 billion Euro bailout tranche expected to be delivered in early July will cover Greece’s financing needs until mid-August.  Meanwhile, the French have floated a plan for holders of Greece bonds to roll-over 70% of their maturing bonds in exchange for receiving 30-Year paper in a special-purpose vehicle with a minimum yield of 5.5%.  This idea, while elegant, is not without its problems.  First, it is not clear that the ratings agencies would let this restructuring occur without declaring it a default.  Second, the plan would require the European Central Bank to hold its Greek debt to maturity – and it is questionable that the ECB would agree to such a restriction.  Third, the interest rate that will be required on the rolled-over debt will be a significant burden on Greece.  Considering these factors, Greece remains a point of interest from a risk-control standpoint.


As this is the end of the second quarter, we will be watching corporate earnings reports quite carefully for signs that the economy is not sliding back into recession.  The lack of negative guidance leading up to the quarter-end has been encouraging, but the expectations for strong earnings have set the bar rather high.


Altair Hedged Equity’s 10th Anniversary


June 30 marked the 10th anniversary of Altair Hedged Equity’s launch.  For me, that milestone brought two things to mind:  First, it warrants a sincere “thank you” to the clients who have trusted us over the past decade with stewardship of their wealth.  We are fortunate to have a great client-base that has stood with us through what can only be characterized as an “interesting” decade.  Second, it seemed like a good time to reflect on where the Fund has been over those years.  Viewed from the tree-top level, we’ve been through two bear markets and two bull markets – all of which tended to be fairly dramatic.


The Fund’s focus on delivering consistent returns was tested immediately upon its launch.  From July 1, 2001 to October 9, 2002 the stock market dropped by 37% as the tech bubble burst.  Hedged Equity made it through that stretch with a total loss of 6.8% and was back to break even eight months later.


From those October 2002 lows, the stock market went on a four year bull market run – gaining over 101% before reaching its apex October 9, 2007.  During that same timeframe, Hedged Equity posted gains of 73%.


Next in line were the financial crisis and the associated bear market in stocks.  From its peak to its nadir on March 9, 2009 the stock market shed nearly 57% of its value.  Hedged Equity traversed this bear market with a 9.3% decline in value.  That 9.3% decline proved to be the largest drawdown Hedged Equity would have experienced in its history, and was recovered in 14 months.


Finally, we had QE2 and the stock market’s melt-up.  With remarkable persistence against major macro-economic headwinds, the market nearly doubled – adding 95%.  This period, from March 2009 through June 2011, represented Hedged Equity’s most difficult time-frame from a relative performance perspective – as the Fund increased by just over 15%.


Taking these four cycles together, the stock market is up 31% since our launch, while Altair Hedged Equity has gained 69%.


And while we take a modest amount of pride in the totality of our work over these past 10 years, we continually apply a critical eye to our performance; both in relative and absolute terms.  The basis of this critique is always in the context of our stated objective:  To deliver consistent of returns over a full market cycle.


During the past few quarters, I have had some enlightening conversations with our clients.  Some shared our cautious macro view; others became increasingly uncomfortable with the disparity between our Fund’s returns and those of the stock market.  One such conversation involved a gentleman I’ve known for the past 28 years and who has been a client for the past 10.  He was the boss at my first job out of college, became a business associate in later years, and ultimately a client.  Because of our history, we speak quite candidly.  The crux of the conversation came down to this:  his overall target rate of return when we began working together was 8%.  With the losses incurred during the financial crisis, his annualized return was closer to 6%.  He viewed the past 27 months as an opportunity for his portfolio to “catch up, ” and we failed to keep pace with the market.


As is often the case in relationships that began in a mentor/student environment, the client took the time and effort to help me dissect the Fund.  We discussed our macro view in great detail.  We went down the list of our sub-advisors one-by-one, covering their strategies, their performance, and their outlook.  We shared our thoughts about the future of interest rates, equity valuations, commodities, and the regulatory environment.  In the end, we agreed on nearly every philosophical and mechanical point – we just could not reconcile the disconnect in relative performance.  Ultimately, we decided to part ways, remain friends, and I worked closely with his new advisor to insure a smooth transition.  The client did reserve the right to come back to Altair at a later date if he had a change of heart!


I share this story because I think it is important to provide some insight into what we have been thinking lately.  That includes our self-analysis as well as the acknowledgement that some of our clients have sincere questions about our relative performance since March 2009.


As I mentioned earlier, consistency of returns is our primary objective.  To achieve that objective, we use the same tools in both bull and bear markets.  Those tools include diversifying to avoid unique risk, short-selling to reduce systemic risk, and sourcing returns from areas unrelated to the direction of the stock market.  Sometimes, like 2002 and 2008, the success of this approach is gratifying.  Other times, it is one of the most difficult parts of our job.  But how we feel about our strategy over different time frames is largely beside the point.  We are paid, to put it quite simply, to assess possible outcomes, assign probabilities to those outcomes, and allocate capital in a way that reflects these probability-weighted outcomes.


There is nothing emotional about that process.  Whether the feeling is fear like that after the collapse of Lehman, or joy as the stock market doubles, succumbing to the emotion would lessen the likelihood that we could continue to deliver consistent returns.  And if we fail at that, we would forfeit our reason for existing as part of someone’s portfolio.


So, as Hedged Equity starts on its second decade, I want to thank you all again.  And, as always, I invite you to call or stop in for a visit if you have any questions or comments.

Stocks are Cheap!…no wait they aren’t…what should i do?

If you follow Barry Ritholtz who writes The Big Picture blog, you may have noticed a post of his that only stayed up for a brief time yesterday. He was opining on the investment information put out by the major news outlets and how useless it was. He even commented that he doesn’t read the Wall Street Journal until the following night to reconfirm to himself that it merely contains old news. While we couldn’t agree more with him, we had to laugh that he likely was forced to take the post down after the news outlets that pay him read his comments. Below are two links that confirm Mr. Ritholtz’s theory. While we favor one view over the other,  one can always make the case for a conceivable outcome. The key is having a process and following it and not reacting to the flavor of the day.

Depending on who you listen to there is a case to be made for both sides of where stocks are currently valued.

Stocks Cheapest in 26 years

Run, Don’t Walk, Away From P/E Ratios








Altair June Commentary

The End of QE2 and the Probability (Possibility) of QE3


During the run of QE2, the end of which is rapidly approaching, we discovered an interesting phenomenon.  There would be days when the stock market would open lower, only to begin a major bounce-back around 10 a.m.  This was occurring with such frequency that “buy the dip” became the mantra of many traders.  What we noticed, while visiting the homepage of the NY Fed on these days, was that Permanent Open Market Operations were being conducted at the same time the markets were finding their bottom – with regularity.  The point being…  QE2 arguably added artificial price stability to equities (and to other risk assets) and its ending in June should remove some of this stability.  I emphasize the word “should, ” because the normalization of the market’s pricing mechanism will be largely dependent on whether there is a QE3 or some form of a stealth extension of QE2.


The idea of a potential QE3 moved to the front over the past few weeks with declining ISM numbers, weak Non-Farm Payroll numbers, dismal housing numbers, and faltering consumer confidence.  Additionally, by falling for the past 5 consecutive weeks and 5 consecutive sessions, the stock market returns seem to be “suggesting” to the Fed that additional QE might be desired.


While it’s doubtful that the American people have an appetite for an overt QE3, we believe that the Fed will, for the foreseeable future, maintain the size of its balance sheet by reinvesting the proceeds as bonds “roll-off” its balance sheet.  In this way, they can “keep interest rates exceptionally low for an extended period, ” as has been the Fed’s repeatedly quoted position.  And while cheap money is unquestionably a stimulant for the stock market, the fact that the economy remains so weak that a Zero Interest Rate Policy must be perpetuated should give everybody a reason to pause.


We are likely nearing an inflection point as QE2 winds down, so we are keeping our betas to a minimum.


The European Bailout and Long-Term Viability of the Euro


Here are a few headlines from the past few days (in no particular order):


  • Greek Government Faces Revolt Over Second Wave of Austerity Measures
  • Seven Years for Ireland to Fully Recover, Warns Banker
  • S&P warns EU over Greek Debt
  • Obama Says European Debt Crisis Must Not Endanger Recovery
  • Riots in Greece Over IMF-imposed Setbacks to Workers


In our analysis, Greece has no choice but to default – either via debt restructuring, technical default, or outright failure to pay.  A recent Moody’s downgrade places the likelihood of a Greek default at 50%.  While many pundits argue that Greece, and Ireland for that matter, are too small to matter, we would argue that the impact on the Eurozone as a whole and the Euro as a currency could be severe.  The fact that Trichet recently began pushing for a European fiscal union to pair up with the existing monetary union would support our point.  It was the lack of a fiscal union that allowed Greece to spend into oblivion while more fiscally conservative countries, like Germany, were left holding the bailout bag.  Now, the citizens of each country have little appetite for what needs done to correct this deficiency (assuming to can be corrected).  The May 5 riots in Greece that resulted in the deaths of 3 bank employees present an ominous example of the friction between workers and their government.  There is a real chance that it may be too late for the fiscal union idea to be of any use in this crisis.


We continue to be short European banks in Hedged Equity as a hedge against what we believe to be an upcoming elevation in the crisis.


Housing in Double Dip


In May, the Case-Shiller Home Price Index fell below its April 2009 low to officially enter the area of “double-dip.”   For the month ending March 31, 2011, 19 out of the 20 cities in the index saw price declines.  Washington D.C. was the only market to post a gain on both a monthly and an annual basis – Washington is growing while the rest of the nations is shrinking…is anybody shocked?   Minneapolis saw a 10% decline for the year, indicating that the housing crisis is being felt hard in the Midwest.  The quarterly annualized decline for the overall index was 5.1%.


As home prices continue to decline and the pace of foreclosures hastens, we expect the real estate market to remain soft for the foreseeable future.  Such softness would be a bad thing for consumer confidence and consumption, as well as the financial sector as a whole.


We believe there is a silver-lining to housing issue that should show itself in the next 2 or 3 years.  The excess supply of homes is shrinking – currently at about 1.3 million units down from 1.8 million only 6 months ago.  Factoring in new home construction, 2011 should come up roughly 1.25 million homes built short of what should be needed to keep up with population growth.  That trend is unsustainable.  Additionally, the laws of supply and demand are becoming a factor.  As more people seek to be renters, the cost of rent is rising.  There will be a cross-over point somewhere in the not-so-far-in-the-future-to-care, where the price of rent will make homeownership an economical venture once again.  The convergence of reduced housing supply with increased rental costs could provide a significant tail opportunity in the coming years.


China May Be In Trouble


Stealth Bailout in Progress

Earlier in the week I read an article from Societe Generale’s Dylan Grice about a Reuters’ report regarding China’s Local Government Financing Vehicles (LGFV).  It was reported that China’s central government was “taking on responsibility” for up to $463 billion of bad loans made to LGFV to fund various infrastructure and development projects as a part of the stimulus package. Basically, this amounts to a stealth bailout.  It’s not clear yet how this will be done, but if it is handled in a fashion similar to that used during the recapitalizations of Chinese banks, asset management companies will buy up the bad assets, which they will pay for with non-tradable government-guaranteed bonds.  These bonds do not show up in the official measures of government debt.  Since the bonds are off the official records, it’s like the bailout never happened.  But the problem hasn’t gone away. As Grice noted, a bail-out of $463 billion is half the size of the TARP for an economy which is only one-third the size of the US’.  So adjusted for GDP, China has enacted a bailout equal to one and a half TARPs.  If we calibrate the magnitude of the economic crisis with the size of the bail-out, one and a half TARPs implies a financial crisis one and half times the order of magnitude of 2008.  With China quietly buying up its own bonds, there is a real possibility that their demand for US bonds may wane – causing US interest rates to rise.  One more reason we are short US Treasuries.

Says Grice: “The critical issue in both cases is the artificial suppression of volatility in the name of stability. We know that the longer volatility is artificially suppressed, the more emphatic will be its release when it does come.”


Energy and Food Inflation

With energy and food prices rising at a heady pace, China has had no choice but to restrain credit and money growth.  Protests such as the recent truckers strike indicate this is not going to be an easy sell to the population. Chinese consumer expectations have been plummeting, and are now at their lowest level since late 2008.  Car sales, which were exploding during the massive stimulus injections, are now growing at low single digit annual rates.  And finally, housing starts are running at +40% year-over-year, but sales are falling at a -5% annual rate. There is a lot of faith being priced into the market that the Chinese authorities will be able to engineer a soft landing for the economy, but given the extraordinary imbalances that have built up, that will be increasingly difficult.

Altair February Commentary

The Middle Eastern turmoil that began in Tunisia and Egypt spread to Yemen, Bahrain, and Libya in February, driving oil prices to $100 per barrel. At the same time, bond spreads in Greece, Ireland and Portugal continued to widen (albeit under the radar) as investors demand a higher premium to embrace the risk of these sovereign issuers. In fact, as I write this, the Greek 10-year yield has surged to 12.76% while the Portuguese 10-Year moved to 7.66%. The tumult drove gold prices up by nearly 6% in February, closing the month at $1, 411 per ounce. In February, the US Government racked up its largest monthly deficit in history — $233 billion. To put this into some kind of perspective, February’s deficit was larger than deficit for the entire year of 2007.

February brought with it, however, some encouraging news. People seeking unemployment benefits fell to the lowest level in nearly three years during the last week of the month. Both retailers and the service sectors have posted positive reports, and the unemployment rate dropped below 9% — ending February at 8.9%. Manufacturing activity (as defined by the ISM report) rose to its highest level in nearly 7 years; marking the 19th consecutive month of expansion for the economy as a whole.

Against the backdrop of these conflicting ominous and encouraging indicators, and a nearly 2% stock market decline during the last week of the month, the S&P 500 managed to add 3.4% to its already massive (+28%) gain since the Fed’s Jackson Hole meeting last August. For yet another month, Quantitative Easing coupled with pockets of good news pushed investors into risk assets with little regard for macro-environmental risk.

Our position has been (and remains to be) that the forces driving the economic recovery are not particularly solid and based almost exclusively on massive amounts of liquidity. Further, we continue to contend that the global financial issues that were exposed during the crisis remain largely unresolved, and for the most part, politicians and policymakers have merely attempted to push the problem into the future rather than structurally repairing it today.

To quote Citigroup’s Steven Englander, “It’s hard to argue with this line of analysis except that it has been dead wrong in market terms.”

Englander also made an observation that is dead-on with what we have observed in this uni-directional market: Investors have grown tired of being told to hedge against risks that have not emerged. In fact, he opines, the downward trend in volatility (as the stock market continues to melt up) may reflect that too much capital was dedicated to hedging risks that didn’t happen and that capital is now being deployed back into the market.

Since 2007, we have taken the position that the probability of a high magnitude, negative event (or a series of such events), remains higher than normal. We were rewarded for that observation in 2008 and penalized for it in the succeeding years. Like Mr. Englander, we have increasingly heard from more clients and prospects that either resist or reject the notion that such events may occur in the near- or intermediate-term. Basically, the line of reasoning is that they have heard this song many, many times since 2009, while the markets for all things risky have marched onward and upward.

If you subscribe to the theory that the ending of the financial crisis of 2008 and the subsequent recovery in risk asset prices is almost exclusively the result of trillions of dollars of money creation, it begs the question as to what policy tools remain to address a future crisis. Do countries simply print more and more money? Do they draft new, more restrictive and cumbersome legislation? Do they try to find new and creative ways of deferring the painful solutions to yet a later date?

I am not confident that policy-makers possess the tools required to address another significant crisis; and as a result, the absolute magnitude of a negative event has risen while the probabilities have, at best, remained the same. At worst, the probabilities have increased as well.

I will not go into itemizing the specific risks we see in the present environment. Those who have read our monthly letters or listened in on our prior calls should be acutely aware of the factors we view as problematic. Rather, I’ll conclude my prepared remarks with another quote from Mr. Englander: “When we see volatility so cheap in a world that appears to be so risky and in which policymakers do not hold a terribly strong hand, it makes a strong case for hedging tail risk, even if price action is apparently indicating otherwise.

Altair January Commentary Expanded

The liquidity-fed rally in domestic stocks continued in January with the S&P 500 gaining 2.3%. Smaller stocks, however, did not fare as well; with the Russell 2000 actually falling by 1.1%. Internationally, monthly returns were a mixed bag, with the UK, Brazil and China falling (-0.3%, -3.2%, and -3.5%) France and Japan were the strongest regions with their indexes rising 5.5% and 0.1% respectively.

January was characterized by increasing macro risks, juxtaposed against a demonstrably improving US economy. On one hand, turmoil in the Middle East, continued European bond downgrades, and runaway pricing on agriculture commodities provided ample worries for the near-term future of global growth. On the other hand, solid earnings from US corporations, coupled with upgraded GDP projections for 2011 (3.2%) counterbalanced the scales nicely. The factor that tipped the scales in favor of the equity bulls, in my opinion, was the continuing Open Market Operations by the Fed. As the Fed continues to dump billions of new dollars into the markets, risk assets like stocks will have a tailwind in the form of the “Bernanke Put”.

That said, it is hard (if not impossible) to predict how long this US stock rally will continue. QE2 is set to end this summer, but if unemployment continues to persist, might we see QE3? Conversely, if QE2 is allowed to expire, how does the Fed begin mopping up all this excess liquidity without causing a dislocation in the bond markets and precipitating a spike in the US Dollar? Finally, how much of our exported inflation (prices in cotton, corn, wheat, oats and soybeans) can the developing world tolerate before social unrest becomes even more widespread? While I don’t pretend to know the answers to these questions, we keep our portfolio positioned to shield our assets against these uncertainties while looking to gather gains in a prudent way.

I’ve spent a good deal of time during the month of January insuring that, as a firm, we are not falling victim to “confirmation bias” – that is, the tendency to favor information that confirms your preconceptions or hypotheses regardless of whether the information is true. Confirmation bias is more difficult than ever to avoid, given that, if you have any idea you can likely find information to support it on the Internet. Confirmation bias is one of the primary factors we investigate when deciding to terminate a manager from our Fund-of-Funds. To quote Wikipedia, “Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Hence they can lead to disastrous decisions, especially in organizational, military, political and social contexts.”

Our investment hypotheses have been presented openly in numerous past letters and monthly calls, but they basically boil down to this kernel: The various macro risks confronting the stock market, while having only modest probability of occurring, are embedded with such high magnitude negative outcomes that the risks outweigh the potential rewards.

If this were a ballgame that began at the March 2009 stock market lows, the score would emphatically indicate that our hypotheses were wrong. That said, I can easily provide mountains of evidence from reputable sources reinforcing why our hypotheses are correct and why the market is behaving temporarily irrational. But, that would be the very definition of confirmation bias! I believe my time would be better used trying to gather data regarding the source and timing of the market’s divergence from where we believe it should be.

I began by investigating the “where” and the “how much” relating to the cash flows that are driving the markets upward at nearly a 45 degree angle. Looking at the Investment Company Institute’s data of weekly net flows into or out of US stock funds, we found that over a 36 week period ending in January, 35 of those months’ showed net outflows amounting to nearly $110 billion. Recently, this trend has changed, with net inflows of $6.7 billion. So, all-told, $100 billion or so has left the stock mutual fund complex. Just since August, retail investors have taken out $38 billion more than they have added. So I think it’s safe to say that the retail investor has not been the driver of market gains. (As an aside, the recent re-entry of the retail investor could be viewed as an indicator that this rally may be getting “long in the tooth.”)

At the same time, the Federal Reserve has “created” nearly $400 billion of new base money within the financial institutions of this country. It stands to reason that these institutions are (much to the Fed’s pleasure) fueling the upward bias. To quote Chris Martenson, “the stock market has become a liquidity gauge first and a discounting machine second.” The liquidity explanation for the market’s performance helps to clarify our recent relative underperformance, but it does not provide much evidence of “staying power”.

Another impact from all this “new money” is a major decline in the US Dollar. Since its peak in June, the US Dollar Index has declined 12.8%. Partially as a result of this decline, and partially due to demand changes, agricultural commodities have soared. In the past 12 months, cotton is up over 150%, corn +85%, oats +73%, and soybeans +57%. Gold was up a mere 21%. The global social impact of these price hikes is beyond the scope of this writing, except to say it may be exacerbating the unrest bubbling in the Middle East and elsewhere. What is relevant is the impact on the share values of commodity-based stocks. Here are a few examples of performance over the past twelve months: Gold Miners ETF (GDX) + 31%, Agribusiness ETF (MOO) +42%, Base Metal Company ETF (XME) +55%. Even the financial sector is posting record profits on the back of free-money spreads. These profits are reflected, for example, in the 23% 12-month gain in the Financial Sector ETF (XLF).

So, what are our conclusions from this exercise? First, the Fed has thus far accomplished what it wanted by elevating asset prices, setting the stage for improved corporate profitability, and generating positive GDP. Second, corporations have enough excess capital to continue improving productivity, thereby increasing margins, and ultimately profits. Third, our decision to avoid making a bet on the height and duration of a liquidity-based market rally has muted our performance.

Circling back to confirmation bias… Spending a month focusing primarily on research that refutes our position has been an interesting exercise. Sometimes it was downright uncomfortable. But, in the end, I find our position to be largely unchanged.

Structurally, we continue to believe that the stock market is damaged. Few lessons were learned from the Flash Crash and fewer actions were taken to prevent it (or even a more severe version) from recurring. From a macro perspective, we continue to believe that inflation is a global problem as evidenced in commodity prices. Geo-politically, we are in the midst of happenings that history may well consider being watershed events. We also think that when the Fed ultimately is forced to remove liquidity, the impact on stock prices and bond yields will be dramatic – and not in a good way. To analogize, the broad picture is akin to a rubber band being stretched: Solid US profits, growth, and share prices being tugged upon by inflation, structural flaws, and geo-political strife. Since people who invest with us seek consistent returns and vigilant dedication to preserving capital, this is a tug-of-war on which I choose not to bet.

I’ll conclude by sharing an anecdote about the Egypt ETF (EGPT). On January 28, during the height of unrest, money began flooding into this ETF – an ETF with an average volume of about 51, 000 shares. The money flow was apparently buying, driving the ETF up 14% while volume spiked to over 1 million shares. Be mindful, during this time the Egyptian stock market remained closed, causing the fund to trade, at its peak, at 14% over its Net Asset Value. This is indicative of how free capital presently views risk. It’s also evidence of why we choose to look elsewhere for investment returns.

Legendary value investor Benjamin Graham observed, “Speculators often prosper through ignorance; it is a cliché that in a roaring bull market knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss.”