Friday, August 14, 2009

Blue Ridge Discloses New Stake In PennyMac Mortgage (PMT): 13G Filing

In a recent 13G filing with the SEC, John Griffin's hedge fund Blue Ridge Capital has disclosed a 9.5% ownership stake in PennyMac Mortgage Investment Trust (PMT). The filing was made due to activity on July 29th, 2009 and they now own 1,584,000 shares. PMT just recently IPO'd back on July 30th, with 16 million shares priced at $20.00 per share. Obviously, given that this was an IPO, this is a brand new position for Blue Ridge. John Griffin (pictured far right with mentor Julian Robertson) hasn't been very active in terms of SEC filings, as the last time we covered them in-depth was their Q1 2009 portfolio. And, seeing how 13F filings are pouring in this week and next, those positions will be updated.

One thing of interest from Blue Ridge recently though is their recommended reading lists. We posted up a compilation of their favorite books by category, which you can see below:

- Blue Ridge Capital's Recommended Analytical Reading

- Blue Ridge Capital's Recommended Historical/Biographical Reading

- Blue Ridge Capital's Recommended Behavioral Finance Reading

- Blue Ridge Capital's Recommended Economics Reading

Taken from Google Finance, PennyMac Mortgage Investment Trust is "a real estate investment trust. The Company operates as a specialty finance company that will invest primarily in residential mortgage loans and mortgage-related assets. The Company’s objective is to provide risk-adjusted returns to its investors over the long-term, primarily through dividends and secondarily through capital appreciation. The Company focuses on investing in mortgage loans, a substantial portion of which may be distressed and acquired at discounts to their unpaid principal balances."

The Future Of Hedge Fund Regulation

Just yesterday, we had an intriguing guest post regarding the future of hedge funds. Today, we follow it up with another excellent guest post examining the future regulation of the hedge fund industry. The following is a guest post from Hedge Fund Blog Man, who covers articles of note regarding the hedge fund industry.

The Future of Hedge Fund Regulation in the United States


Over the last couple of years there has been a lot of political discourse about the need for greater regulation of the financial industry, including hedge funds. Much of the information (and rumors) about possible hedge fund regulation is somewhat contradictory. We will wade through the debate and provide a summary of current proposals for hedge fund regulation in the US and discuss hedge fund regulation in the EU and other countries.

Though it was highly regulated financial institutions that are widely believed to be the cause of the recent financial crisis and subsequent economic malaise, there is talk of regulating hedge funds and private equity firms as well. There have been a huge number of proposals for regulating hedge funds ranging from registration requirements for just the largest to funds, to almost authoritarian regulation for all private money managers. However, the current proposals with the most support appear to be hedge fund registration requirements, without significant additional oversight.

Current Hedge Fund Regulations

Under the existing system hedge funds and private equity firms are far less regulated than mutual funds and other investment vehicles open to the public. Though some hedge funds are registered with the SEC, a couple clauses in the Investment Company Act of 1940 allow must hedge funds to operate without registering with the SEC or any other government agency. Probably fewer than half of all hedge funds are currently registered as investment advisors with the SEC. For funds that are registered, the SEC requires certain filings, but does not provide operational oversight.

The Need for Hedge Fund Regulation

Hedge funds were clearly not the major players in the current financial crisis. However, the $50 billion fraud perpetrated by Bernard Madoff sparked plenty of public outrage and there have been a couple of multi billion dollar hedge fund failures since 2007. Additionally, many politicians still fear another hedge fund collapse ala Long Term Capital Management, the giant hedge fund that collapsed in 1998 and necessitated a Federal Reserve orchestrated bailout.

Treasury Secretary Timothy Geithner voiced his concern in April, "Today, the consequences of (hedge funds') failure is greater. They need to be subject to a higher set of standards.”

Proposals for Regulating Hedge Funds and Recent Developments (2009)

In January 2009, Senators Charles Grassley (R-Iowa) and Carl Levin (D-Mich.) introduced the Hedge Fund Transparency Act of 2009. The Act would affect funds with more than $50 million in assets (“large firms”). All funds in excess of $50 million would be required to register with the SEC and maintain books and records according to SEC requirements. It would also require disclosure of including information regarding the identity (including addresses) of the fund’s “beneficial owners,” the amount of the fund’s assets, the fund’s equity structure, affiliations the fund may have with other financial institutions, the minimum investment commitment required of investors, and the total number of investors. The bill did not get to a vote.

In March of 2009, Larry Summers , Director of the National Economic Council for Barack Obama, said the U.S. wants large hedge funds and private-equity firms to be subjected to "rigorous public scrutiny," compared with the minimal oversight they now face. Before joining the Obama Administration, Summers was a Managing Director with one of the worlds largest hedge funds, D.E. Shaw Group.

Then in late April, President Obama lashed out at hedge funds refusing to accept a government offer for Chrysler debt. "A group of investment firms and hedge funds decided to hold out for the prospect of an unjustified taxpayer-funded bailout," Obama said, "They were hoping that everybody else would make sacrifices, and they would have to make none. Some demanded twice the return that other lenders were getting. I don't stand with them."

In July, the Obama Administration, released TG-214, a fact sheet with the Administration’s proposals for regulating hedge funds. Funds with more than $30 million would be required to register with the SEC. Once registered funds would be subject to:
• Substantial regulatory reporting requirements with respect to the assets, leverage, and off-balance sheet exposure of their advised private funds
• Disclosure requirements to investors, creditors, and counterparties of their advised private funds
• Strong conflict-of-interest and anti-fraud prohibitions
• Robust SEC examination and enforcement authority and recordkeeping requirements
• Requirements to establish a comprehensive compliance program
The main rationale for the above requirements is to “protect the financial system from systemic risk”

The most recent House of Representatives proposal for hedge fund regulation, from Aug 6, 2009, seems to have lost some of the initial enthusiasm and would regulate hedge funds under less-stringent conditions than banks and lenders. According to House Financial Services Chairman, Barney Frank, “How can you regulate a hedge fund like a mortgage? It doesn’t make any sense. It will be a form appropriate to them.” In apparent moment of bipartisanship, both Democrats and Republicans seem to be in agreement that hedge fund and private equity firms should be more lightly regulated than other traditional financial firms. It should also be noted that hedge fund industry groups spent almost $4 million in lobbying in the first half of 2009.

Hedge Fund Regulation in Europe

Europe has been quicker to attempt hedge fund regulation and proposals there have generally been more severe than in the US. Likewise, hedge funds and private equity firms in the EU have been more vocal in their opposition to regulation than their US counterparts. The most contentious issue in EU hedge fund regulation appears to be an attempt to limit or place caps on the amount of leverage funds can employ. Because of the possibility of regulatory arbitrage, look for the EU and US to finalize regulations that are relatively consistent.

When Will We Get New Hedge Fund Regulations?
Though there are ongoing talks, there is currently no bill for hedge fund regulation in Congress that is likely to pass. It is unlikely any new regulation will be finalized until 2010. Because compliance with new rules could be costly and time consuming, it is conceivable that new hedge fund regulations might not be enforceable until 2011.


Thanks to HFBM for the excellent write-up as we will definitely be watching the developments on this front going forward. Regulation and transparency have been big talking points given the crisis, forced liquidations, frauds like Madoff, and numerous other crazy events that have happened recently. The above was a guest post from Hedge Fund Blog Man, who covers articles of note regarding the hedge fund industry.

What We're Reading 8/14/09

Practical ways to hold down costs with bond ETFs [Index Universe]

Comparing the 1929 & 2009 major rallies [ blog]

Don't be too bearish on bonds, seriously [zero hedge]

Interview with hedge fund manager Paul Sonkin of the Hummingbird Value Fund [Street Capitalist]

H is for Hedge Fund [Epicurean Dealmaker]

On smart communities and Stocktwits [zero beta]

Thursday, August 13, 2009

John Paulson: Long Financials Including Bank of America, Capital One, Goldman Sachs & More

John Paulson's hedge fund Paulson & Co has disclosed long positions in numerous financial stocks, most notably Bank of America (BAC). In their 13F filing just released yesterday (detailing their positions held as of June 30th, 2009), they reveal a massive $2.2 billion stake in shares of BAC which they received at a nice price of around $10 per share. BAC shares now trade well north of $15, so they've already profited handsomely on that play. And, more importantly, Paulson sees fair value at around $30 within the next 2 or 3 years. We actually noted that we had been hearing Paulson had a large BAC stake earlier on in our recent piece on Dan Loeb's hedge fund Third Point. And, the release of this 13F obviously confirms that. (Dan Loeb's Third Point also owns BAC around $10 and put on a similar play to Paulson). While Paulson's entrance into financials is by no means new, it is definitely more emphatic this time around. Paulson is definitely focused on the recovery meme for now, as he also will be starting a real estate recovery fund.

When we covered Paulson's portfolio last quarter, we noted that he had picked up stakes in Capital One (COF) and JPMorgan Chase (JPM). This time around though, he has expanded his arsenal of financials and has also added Bank of America (BAC), Goldman Sachs (GS), Fifth Third Bancorp (FITB), Regions Financial (RF), First Horizon National (FHZ), Marshall & Ilsley (MI), State Street (STT), Suntrust Bank (STI), and People's United Financial (PBCT).

In order of size, Paulson's top 5 largest financial plays are:

1. BAC: $2.2 billion

2. COF: $372 million

3. GS: $295 million

4. JPM: $238 million

5. RF: $141 million

We also would be remiss if we didn't mention the fact that Paulson has picked up an $83 million stake in the exchange traded fund (ETF) ProShares Ultrashort Financial (SKF), presumably as a hedge to his position. His election to use this vehicle as a hedge is quite curious, as its flaws as an investment vehicle have been well chronicled. Ultrashort funds are leveraged and carry more inherent risk. At the same time, they seek to replicate 2x inverse the *daily* performance of their underlying index (in this case, the financial index). Since it resets performance daily, the fund experiences compounding issues over time. So, the longer you hold the vehicle, the potentially further you drift from accurately tracking the index. While the vehicles do a good job of tracking on a *daily* basis, they are simply better suited for trades, not holding positions.

Daytraders galore will swear by SKF as it minted many of them a pretty penny last October and November when financials were tanking on a daily basis and SKF was soaring. So, it strikes us as very odd that Paulson would use this as his hedging mechanism. You'd think a hedge fund of their reputation and research ability would know the mathematical flaws inherent in the vehicle they've selected. Maybe they are completely aware of it and decided to use it anyways, rather than shorting an index, buying puts on the index, or buying puts on their individual holdings. Who knows... it is all speculation on our part. The main thing to take away here though is still Paulson's large exposure to financials, namely through Bank of America.

At the same time, they undoubtedly have short positions in the sector as well. We have been hearing that Paulson is complementing their long moneycenter banks play by going short select regional banks that have major exposure to commercial mortgage-backed securities (CMBS) and commercial real estate (CRE) in general. This falls under the thesis that these firms would not have to write it down until later this year or until next year and do not have sufficient loan loss reserves set aside. Additionally, we've heard they have shorted select European financials as well. Back in June, we detailed how Paulson had covered their Barclays (BCS) short. We now wonder which institutions they may be targeting, since they had previously been short Lloyds too.

Overall though, the 'recovery' theme plays on for Paulson. Over the past few months, we've seen Paulson go long financials, buy distressed debt he was once shorting, start a real estate recovery fund, and more. One other notable thing to point out about Paulson's portfolio is their massive gold position as they continue to hold a large stake in the SPDR Gold Trust (GLD). However, we want to make sure everyone realizes that this has been labeled a hedge for their fund share class that is denominated in gold. At the same time though, one has to wonder why they also have large positions in gold miners too.

This is not our usual in-depth look at the hedge funds we report on when covering a 13F filing. So, rest assured that we will still be covering Paulson in our upcoming second quarter 2009 edition of our hedge fund portfolio tracking series. We just wanted to cover this major point for now as mainstream media will undoubtedly run like the wind with this development. Stay tuned for more!

The Future of Hedge Funds

We here at Market Folly are always looking to expand our coverage of various topics scattered throughout the hedge fund industry. One bit that has intrigued us is the emergence of more female fund managers in the industry. While there are a few prominent hedge fund women (Karen Finerman on CNBC is probably the most visible), they are still playing on a playing field primarily occupied by males. At the same time, the future of the hedge fund industry has been a pressing issue lately as well, given how things have played out with the crisis. As such, we thought it would be poignant to combine the two and to take a look at the current hedge fund landscape through the eyes of some females involved in the industry.

Below is a guest post by Liz O'Donnell of, an "award-winning blog and online community created for women executives in finance, law, technology and big business."

New data from Hedge Fund Research, Inc., (HFRI) shows assets invested in the industry increased by $100 billion in the second quarter of 2009, ending at $1.43 trillion. This is the first quarterly increase in assets since second quarter of 2008. HFRI attributes the growth to gains shown during the quarter. The HFRI Fund Weighted Composite Index returned 9.13 percent. This is the best quarterly gain since the last quarter of 1999, although still below the highest peak, reached in 1997. And while investors are still redeeming capital, the pace of the redemptions has slowed from recent years.

But looking past the most current returns, what does the future hold for the hedge fund industry given the tremendous impact of the global financial crisis and amid discussions of government regulations? And what about the outlook for women? Will the recent inflow mean more opportunities or will women still be virtually missing from the industry this time next year?

“Right now hedge funds are a hot topic,” says Kelly Chesney, principal and co-founder of Pluscios Management LLC, a women-owned investment management firm. “I think they really got some negative press and sentiment last year and they are starting to turn around. There is more publicity when hedge funds don’t perform well, but they did much of what was expected.”

Following what she calls “an economic tsunami”, Chesney, and others, see consolidation and regulation as key issues that will impact the industry. “I think it will be choppy and we’ll have various events happen over the next few years. We need to be nimble and adaptive and hedge funds are good at that,” Chesney says.

Certainly the industry has already seen the beginnings of consolidation. After a rapid growth spurt, (the number of funds grew from 610 in 1990 to approximately 9,000 today) 15 percent of funds have disappeared. State Street, in its recently released report “Alternatives: New Views of the Hedge Fund Industry” says that half of all hedge funds may disappear before the crisis shakes out.

Eloise Yellen Clark, founder and CEO of OmniQuest Capital LLC, agrees consolidation will be a continuing trend. “More and more money is going to the bigger players where traditionally there was a bunch of little players. It gets awfully expensive for smaller (funds) to survive.”

As far as what the future holds, Clark says, “Everybody’s talking regulation. I really don’t think it’s a big deal and I think it’s a good idea.” Clark points out that many hedge funds and many managers are already registered with the SEC. She believes more regulation around the issue of transparency would be valuable. Of course, just how far the government takes regulation could be an issue. “On the whole, reasonable regulation that respects fair markets is good. Transparency is good. But limiting the ability to buy and sell is bad,” said Clark.

Chesney says “absolutely” regulation will be a factor moving forward. “It’s not like there hasn’t been regulation.” But that regulation could increase. “It depends on what it is,” she says. “It could be wide ranging — from every fund must register—or it could be a ban on short selling.”

Some funds are “hedging” their bets. Aimee McCarty, marketing director for Ascentia Capital Partners, LLC, says her firm closed its hedge fund and now offers a mutual fund. According to McCarty, the new product combines the benefits of hedge funds with the features of mutual funds to offer a product that is “regulated, transparent, and liquid.” AQR Capital Management LLC added a mutual fund to its product offering earlier in the year.

Diversification might spell survival for some financial firms. Chesney believes it will get more expensive to run a fund, as compliance with regulations will add a new level of management. “There will be a higher barrier to entry,” she says.

That high cost of entry might not bode well for women. Already, there are very, very few women in the hedge fund industry. Currently only three percent of hedge funds are led by a woman. A recent report from The National Council for Research on Women, which we reported on here , asserts that one of the major reasons there are so few women in the industry is that gaining access to capital is harder for women than it is for men.

Says Chesney, “Typically women who get frustrated in other industries go out and start their own thing. But it’s tougher for women on Wall Street (because of) getting assets to manage.” None the less, Chesney is hopeful about the future of women in hedge funds. “I think there are going to be a lot of opportunities.”

Says Clark, who currently sees very few women in the business, “It’s my belief that women are different in business than men. Any organization that combines that is optimal.”

Chesney agrees. “Key in any fund management is diversification.” Whether that diversification extends beyond the fund and to the fund managers, is still to be seen.

The above was a guest post by Liz O'Donnell of, an "award-winning blog and online community created for women executives in finance, law, technology and big business." Thanks to Liz and the Glass Hammer team for a great piece and head's up on their blossoming community. If you're a female Market Folly reader (or a male interested in the topics for that matter), it's definitely a site worth checking out.

Doug Kass Turns Bearish

While we haven't covered the musings of Doug Kass in a while, we found his latest piece on to be timely and insightful. Some of you may remember that Kass, noted short-seller and manager of hedge fund Seabreeze Partners, was very bullish back in March and essentially nailed 'the bottom' as a great trade. Our hats off to him as that was an excellent market timing call. He seems to zig when others zag and this occasion is no different. While bullish sentiment is reaching highs and everyone seems to think that risk has abated from the markets, Kass thinks otherwise. He is bearish now and points out many signals telling him to be so, writing


1. Cost cuts are a corporate lifeline and so is fiscal stimulus, but both have a defined and limited life.

2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the consumer, which is still the most significant contributor to domestic growth.

3. The consumer entered the current downcycle exposed and levered to the hilt, and net worths have been damaged and will need to be repaired through higher savings and lower consumption.

4. The credit aftershock will continue to haunt the economy.

5. The effect of the Fed’s monetarist experiment and its impact on investing and spending still remain uncertain.

6. While the housing market has stabilized, its recovery will be muted, and there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.

7. Commercial real estate has only begun to enter a cyclical downturn.

8. While the public works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye as most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.

9. Municipalities have historically provided economic stability — no more.

10. Federal, state and local taxes will be rising as the deficit must eventually be funded, and high-tax health and energy bills also loom.


Insightful stuff from Kass and it will be interesting to see if he can time the market so perfectly yet again. We wouldn't doubt it, as we've been noticing much of the same rampant bullishness amidst a still tepid economy. When everyone is headed one direction, tides almost always find a way to change. We also note that Kass joins prolific hedge fund manager Paul Tudor Jones in the act of calling for a pullback. Last week, Tudor noted that he thought the current market euphoria is a bear market rally.

Kass posted up his 'signs needed for a market recovery' back in February and it's interesting to look over them again. While some of them have partially come true, there is still plenty of room left for improvement. For those of you interested in more of Kass' thoughts, we posted up Kass' model portfolio update back in the middle of June. We'll check back in on Kass' bearish call in a few months, but our guess is that he'll be right on this one as well.

Source: TheStreet

Wednesday, August 12, 2009

Hedge Fund Atticus Capital Shutting Down

Big news out of hedge fund land as manager Timothy Barakett has decided to close his Atticus Capital funds. To be honest, this didn't surprise us too much. After all, we have been covering Atticus' portfolio for some time now and it has been a ridiculous rollercoaster of a ride. We'd been postulating that Atticus' ship was never truly stabilized after they survived a scare in 2008. Barakett says in his farewell letter that he wants to spend more time with family and on philanthropic efforts but it's hard not to wonder if the hellish 2008 for them made his decision that much easier. While redemption issues are not to blame here, it's almost as if they've had trouble recuperating and adjusting to the volatility and wild swings of a bear market.

Let's quickly walk through the timeline of Atticus' portfolio we've covered here on Market Folly. Back in September of 2008 we saw that their European fund was -42.5% for the year and their Global fund was -27.2%, thus subjecting them to liquidation rumors. While those rumors proved to be untrue, the poor performance and mass of investors heading for the exits was certainly the first (and largest) warning sign that things were not necessarily well at the firm. As such, Atticus found themselves ranked #2 on a list of the Top 10 Asset Losers in hedge fund land.

The massive deleveraging that went on at their hedge fund was evident in their SEC filings as they went from reporting a portfolio worth billions of dollars down to reporting only $500 million. This was the first drastic turn on the rollercoaster known as Atticus' portfolio. Then from Q3 of 2008 to Q4 of 2008, Atticus' reported assets rose from $500 million back up to $1.9 billion. It was evident that they liquidated positions the quarter prior in an effort to stop the bleeding and to meet any redemptions. The following quarter, they then ramped their portfolio back up. However, the vast majority of their positions were bought via Call options, something we hadn't seen from them before. (We detailed the portfolio changes in their entirety here). What's even more intriguing is that for the most part, they bought the exact same positions they held previously. Except, instead of buying common stock like last time, they were now almost exclusively using Call options. This was the second major peculiar act we took note of.

Then, when we examined their first quarter 2009 portfolio, we saw that they held a mere five long equity positions. While Atticus typically ran a concentrated portfolio, they by no means ran a book as small as this prior to that particular filing. Yet again, we wondered what exactly they were doing over there. In early August they started to sell shares of Sotheby's and Transatlantic Holdings. Then just last week we covered the fact that Atticus was selling shares of their only holding in UK markets. And below, we learn that Barakett has been selling the rest of his portfolio as he winds down his funds.

Here is the letter Barakett sent out to investors announcing the closure, posted up by FT Alphaville:

August 11, 2009

Dear Investor in Atticus Global, Ltd. and Atticus Global, LP:

I am writing to inform you of my decision to close the funds I manage, including Atticus Global, Ltd. and Atticus Global, LP (together, the “Atticus Global Fund”). This decision will come as a surprise to most of you, especially given that we have received redemptions of less than 5% of capital and your loyal support over the past 15 years.

I have used the market’s recent strength to begin liquidating a significant amount of our holdings. We currently expect that the portfolio will be fully liquidated by September 30th and that we will be in a position to return approximately 95% of your capital in early October. The balance of investor capital will be returned after the final audit is completed, which should be later this year.

My decision is solely a personal one. After fifteen years of being singularly focused on building and managing Atticus, I believe it is time to reassess my future. I intend to spend more time with my family, pursue my philanthropic interests and establish a family office to manage my own capital and charitable foundation.

Atticus (the management company) will continue to operate, and the Atticus partnership will remain intact. In addition, it is my partner David Slager’s intention to continue to manage the Atticus European Fund.

I founded Atticus in 1995 and launched our first fund in January 1996 with less than $6 million under management. The Atticus Global strategy was launched in December 1996 and has compounded investor’s capital at over 19% net annually since inception.1 I am very proud of the Atticus Global track record and our net returns through July 2009 are shown below:

Atticus Global S&P 500
1 year -13.3% -20.0%
3 year 0.8% -6.2%
5 year 9.3% -0.1%
10 year 13.6% -1.2%
Inception 19.3% 3.9%
Cumulative 835.3% 62.3%

I am also very proud of Atticus’ overall investment results: from the inception of our first fund in January 1996 through July 2009, funds managed by Atticus have generated
almost $7 billion of profits for our investors.

I have been blessed with great investors, partners, employees, and a lot of good luck. I am thankful and sincerely appreciative of the trust and confidence you have placed in me and our organization.


/s/ Timothy R. Barakett

Timothy R. Barakett
Founder, Chairman & CEO


It's sad to see Barakett go because he truly did have a solid track record minus the bump encountered over the past year or so. But that just goes to show you how hard bear markets can be to adapt to. We now add Atticus to an ever-growing list of hedge fund closures throughout this crisis. And while Atticus did not truly implode like many other funds on the list, they have still closed nonetheless. This is another major fund closing that we've covered on the blog, as we've previously detailed the closure of James Pallotta's Raptor Capital, William von Mueffling's Cantillon Capital, and Art Samberg's Pequot Capital among many other major names.

We'll end this piece re-emphasizing this interesting statistic that Barakett noted: "from the inception of our first fund in January 1996 through July 2009, funds managed by Atticus have generated almost $7 billion in profits for our investors." Now that is simply astonishing. To see the positions they hold/held/are liquidating, head to their hot-off-the-press 13F filing for Q2 2009 which was just released. Ironically, they finally now disclose a healthy & normal $4.5 billion worth of long positions. Imagine that.

R.I.P. Atticus, we'll miss tracking your rollercoaster of a portfolio.

Bill Ackman's Pershing Square Reduces Target (TGT) Position

In an amended 13D filing, Bill Ackman's hedge fund Pershing Square Capital Management is now showing a 4.4% ownership stake in Target (TGT). This is down from their previous 7.8% ownership stake in the company. Pershing Square reduced their overall position through a combination of transactions including the sale of options and purchase of common stock. Originally, Ackman's 7.8% stake was comprised of 3.3% in common stock and 4.5% in stock-settled call options. Now, Ackman's reduced 4.4% stake is comprised of 3.5% worth of stock and 0.9% worth of options. They are now showing an aggregate amount of shares beneficially owned of 32,994,586.

Ackman recently discussed his position in TGT (among others) in Pershing Square's investor letter. In the letter, Ackman "continues to believe that Target offers attractive potential reward for the risk of ownership at current prices." The problem is, his actions conflict with his words here. But to be fair, he could just be bringing the position back down to preferred allocation levels, as shares of TGT have rallied 22% thus far in 2009. While we would love to give him the benefit of the doubt here, we prefer to follow and trust actions, not words. Additionally, we've also covered some of Ackman's past commentary on his Target position as well. Pershing runs a concentrated portfolio and Target has been their largest holding for some time now. However, with Ackman's reduction here, the gap may have narrowed between other top holdings.

One of Pershing's other most publicized positions has been General Growth Properties. Back in June we covered their presentation on General Growth Properties (GGWPQ) from the Ira Sohn Conference. That investment conference featured numerous prominent hedge fund managers who each presented investment ideas where GGWPQ was Ackman's pick.

For more background and information, be sure to check out our biography/profile on Bill Ackman & Pershing Square.

Taken from Google Finance, Target "operates Target general merchandise stores with an assortment of general merchandise and food items, as well as SuperTarget stores with a line of food and general merchandise items. offers an assortment of general merchandise, including many items found in the Company’s stores and a complementary assortment, such as extended sizes and colors, sold only online. The Company operates in two segments: Retail and Credit Card."

Hedge Fund Glenrock Global July Update

Thanks to a reader for the latest July update from hedge fund Glenrock Global. RSS & Email readers will need to come to the blog to view the embedded document. Alternatively, you can attempt to download the .pdf here directly (should the link still work).

Glenrock July 2009 LP Update

Tuesday, August 11, 2009

Dan Loeb's Third Point Likes Selective Automotive Plays: Investor Letter

In his recent hedge fund letter to investors, Third Point LLC's Dan Loeb said that he feels like a kid in a candy store. Why, might you ask? Well, it's because of all the opportunities he is seeing in distressed debt these days. And, he anticipates even more options going forward. Just last week we covered Dan Loeb's recommended investing books and now we're back to cover his latest take on the markets, as per his investor letter.

Investment Outlook

In the letter, Loeb comments on their take on the economy and markets by writing, "our view that the robust governmental response to economic problems here and abroad had averted a global financial meltdown led us to become more constructive about the investment climate. With such doomsday scenario off the table, we put capital to work during the second quarter in a number of significantly undervalued turn-around, distressed debt, and other compelling special situations." Later on we'll look at the specific positions Loeb is referring to. But for now, let's continue to focus on his macro outlook. As we hinted in the beginning of the piece, Loeb is seeing a ton of opportunities in distressed debt. A lot of Third Point's gains thus far were from buying bonds when they were oversold. However, while Loeb has already been profiting from such plays, he believes the most enticing opportunities are yet to come. He specifically notes that restructuring of defaulted securities will be the most compelling stage of this distressed debt cycle. While he has already been busy in this arena, it looks like the best is yet to come (at least according to him). And we don't doubt that, seeing how Third Point has an excellent reputation as an event-driven fund. This echoes what Loeb was recently saying in a video where he discussed Third Point's investments during the crisis.

Portfolio Positions

Turning now to some of their specific positions, we see that Third Point has played Fortis very nicely. Loeb details their rationale behind picking up Fortis equity, convertible securities, and 'other hybrids' and reveals that they are up about 160% on their investment. They continue to hold common stock and mandatory convertibles as they seem them as very undervalued. This is an event driven play in numerous iterations. Third Point capitalized on the April 29th shareholder meeting and next they will look to capitalize on the release of half-yearly financial statements.

Automotive Industry Plays:
Third Point has numerous plays in this sector as 12% of their current portfolio is auto-related and it is 25% of their overall credit exposure. They have positions in the following plays: Ford Motor Credit, Ford Motor Company, Dana Holding, Delphi, and Lear. We highlight this because in one of David Einhorn's recent investor letters, he revealed that his hedge fund Greenlight Capital liked Ford debt as well.

Third Point also invested in Chrysler Financial 1st and 2nd lien debt. These positions were among some of the biggest gainers for Third Point as they took advantage of the complex situation there. They took profits on their 2nd lien position after the bankruptcy (they initially picked them up in the 30's). Then, more recently, Third Point was able to repurchase the 2nd liens as they saw another catalyst. Loeb writes that, "We believe (Chrysler Financial) has generated a significant cash balance since entering run-off and will use this cash to repay a large portion of the 1st lien (thereby also increasing the value of the 2nd lien) or possibly seek to repurchase 2nd lien paper at a discount during the next six months. Either of these events should result in meaningful appreciateion for both loans." Additionally, the automotive industry as a whole has piqued Loeb's interest as he cites numerous figures in automotive seasonal-adjusted annual rate of sales. He cautions that this is a risky industry right now and there will most definitely be landmines hidden within. He believes his firm can navigate the sector safely though.

Bank of America:
Third Point also picked up BAC preferred stock at 57 cents on the dollar and then converted it into common stock at $10. BAC shares now trade north of $16, so you do the math on that play... it's a healthy profit. They continue to hold the equity as they see it as undervalued here. Also, we've been hearing that John Paulson's hedge fund Paulson & Co is a large BAC shareholder these days too after he also took BAC up on their share offer.

Distressed Mortgages:
We mention Paulson above simply because Loeb's next play is also a Paulson favorite. Third Point has started to make investments in the mortgage securities arena. However, they are still cautious on CMBS (commercial mortgage backed securities) due to further expected declines in commercial real estate and the like. They have made limited investments in that area. But, for the most part, they are targeting mortgage plays that will yield a 17-20% return under their main economic assumptions. In their extreme scenario, Third Point argues that with 100% defaults and another 20% decline in home prices, they want to purchase securities that still yield 10%. So far, they've invested $160 million in this arena. We mention Paulson again simply because after notoriously profiting from the decline in housing in the years prior, Paulson's hedge fund has now begun buying distressed assets and has started a real estate recovery fund as well, so Loeb could be in good company here.

Deutsche Boerse:
Lastly, we also see that Loeb is bullish on the one-time hedge fund favorite Deutsche Boerse. They like the fundamentals again and note their 50% EBIT margins and high market share as attractive. Curiously enough, Loeb also cites the fact that two major shareholders dumping their long positions as as a reason to be bullish on the name. It looks like even prominent hedge funds themselves like to keep track of what other firms are holding... imagine that. This is what we here at Market Folly strive to do on a daily basis. We are simply aiming to shine the light on the dark investment corners where hedge funds are quietly building positions. Avid hedge fund followers will remember Deutsche Boerse because hedge fund Atticus Capital previously had a very large position in the name.

Performance & Portfolio Metrics

For the second quarter and year-to-date for 2009, here is how Third Point's funds fared:

Partners: +8%, +5.6%
Partners Qualified: +7.9%, +5.5%
Offshore: +10%, +7.1%
Ultra Funds: +12.2%, +8.5%

Additionally, you can view Third Point (and many other funds') June performance in our performance numbers post. Third Point's portfolio exposure flows along the timeline as follows: They were net short in April and then became dramatically net long by the end of June. Their allocation to both risk arbitrage and credit expanded significantly, up to 20% and 40% of the portfolio, respectively. Loeb wasn't lying when he said he's seeing a lot of opportunity.

Closing Remarks

It appears that Loeb's main fancy right now is obviously distressed debt in general, with a focus on the automotive industry. He also likes risk arbitrage here, although he did seem to take a swipe at the Citigroup Preferred/Equity exchange that many hedge funds were burned by. He laments the fact that there were (and we quote), "usurious rates charged to borrow the stock." But that debacle aside, Loeb likes risk arbitrage plays here. Last but not least, Loeb also touches on some firm changes as they have modified their lock-up period and have eliminated the '3% off-Anniversary Redemption fee.' Those interested in the details of this can read up on it in Third Point's investor letter embedded below. For more resources of Third Point, be sure to check out Dan Loeb's list of recommended investing books that we just posted. This list is derived from comments he made in a recent video we posted where Loeb detailed Third Point's timeline throughout the crisis, among other topics. Additionally, you can check out our previous coverage of Loeb's portfolio here.

Attached below is Third Point's second quarter 2009 hedge fund investor letter. RSS & Email readers will need to come to the blog to view the embedded document. Alternatively, you can try to download the .pdf here while the link lasts.

Third Point Q2'09 Investor Letter

Sprott Asset Management Playing Defense In the UK

Thanks to a reader's help we are continuing our coverage of the UK positions that various prominent hedge funds hold. This time around we're focusing on Sprott Asset Management (Eric Sprott). Of all the funds tracked here on Market Folly recently, Sprott Asset Management has surely been the most circumspect. This caution is reflected in both their gloomy analysis of the economy's prospects and their defensive portfolio positioning. Whilst Sprott are currently focused on playing defense, it’s important to remember that their track record shows that in the past they have also been able to go on the offensive. They were ranked 49th in Barron's top 100 hedge funds for 2009.

Here is a quick recap of Sprott's analysis of the current economic situation. In their report of July 2009 entitled “It’s the Real Economy Stupid” they argued that we are in the early stages of a depression. They suggest the current bear market may be similar in magnitude to the great depression of the1930s. Back in July, they pointed out that we were in week 90 of 149 in comparison to the 1930’s bear market.

Sprott’s view is that the only thing propping the market up is investor sentiment. They are particularly worried that investors might turn their backs on stocks, thus sending the market lower. Using Robert Shiller’s S&P 500 historical data and P/E ratios they set out three scenarios for the future. It is interesting to note that in all three scenarios they expect the S&P 500 to trade below the March 2009 low of 666.

1. In the first scenario, they see earnings staying constant; P/E ratios hit cycle lows: We (Sprott) assume a scenario where investors are nervous, people need to sell stocks to pay for lost wages, or for retirement, but the companies continue to perform as of June 2009. Assuming a P/E of 6, which is close to the all time low, and using an earnings value of $63.04 for the S&P 500 Index, we derive an S&P 500 Index value of 378.16

2. In the second scenario, earnings get halved; P/E stays constant: Earnings have been half of their current value three times over the last 30 years – so it is entirely within the realm of possibility that they could be halved once again. In the late 1970’s, early 1980’s and early 1990’s the S&P 500 Index generated half the earnings per share that it did this year in 2009 dollars. Using today’s P/E multiple of 16.08 results in an S&P 500 value of 506.

3. In the third outcome, earnings get halved; P/E ratios hit cycle lows: double trouble. If we combine these cases where earnings are cut in half from today and the P/E ratio drops to a cycle low, it implies an S&P 500 Index value of 189 (depression territory).

Let’s now briefly review Sprott’s portfolio. If you believe the stock market could fall in the way that Sprott do, it’s unsurprising that they have few if any of the growth stocks beloved by many hedge fund managers. In fact, they have very few stock positions in sectors other than basic materials at all. As of March 2009, Sprott had a huge 42.9% of their net asset value invested in gold and silver bullion. They then followed this up by continuing the theme with another 22.2% in mining stocks and precious metal plays. In addition, they had 33.5% of their NAV in cash and short-term investments. It will be interesting to see whether they have made changes to this Armageddon portfolio when the next round of filings is received. In the mean time, we can provide some details of two positions in the UK market that we have not reported before. There are no prizes for guessing what the holdings are in. Because, if you've followed them at all... you already know. Drumroll please...

Cluff Gold Plc – On 4/21/09 (U.S. date format for our European readers) the London Stock Exchange reported that Sprott owned 6,900,000 shares in Cluff Gold Plc, representing 5.9% of the ordinary shares issued.

Cluff Gold plc is focused on the identification, acquisition, development and operation of gold deposits in West Africa that are amenable to open-pit mining and low cost production techniques. The Group has assembled a portfolio of mineral interests at various stages of development in Côte d’Ivoire, Burkina Faso, Sierra Leone and Mali. The Company is incorporated in England and Wales and its ordinary shares are dual listed on the AIM market of the London Stock Exchange and the Toronto Stock exchange.

Medusa Mining Limited – On 05/09/09 it was reported by the London Stock Exchange that Sprott owned 8,955,395 ordinary shares in Medusa which represents 5.4% of the shares outstanding.

Medusa has been a gold miner in the Philippines since 2003. Medusa's gold production operations focus on producing high grades at low production costs. Medusa produce approx 40,000oz of gold per annum although they hope to expand this as new mines open. The Company’s ordinary shares are dual listed on the AIM market of the London Stock Exchange and in Australia.

That wraps up their UK positions for now. And, as you can see, they've continued with their precious metals theme and overall defensive stance. This article is a part of the new series we are doing where we track prominent hedge funds' positions in the UK. Our hedge fund portfolio tracking series typically focuses on SEC filings that detail holdings in American markets. And, in an effort to cover all things hedge fund, we are now also focusing on positions in other markets. In this series we've already covered the UK positions of Stephen Mandel's Lone Pine Capital as well as Timothy Barakett's Atticus Capital. Check back daily as we expand our coverage thanks to a reader's help.

For more resources on Sprott Asset Management, we've started covering them more in-depth and just yesterday posted up their July market update. Additionally, you can also peruse their insightful yet gloomy market commentary. And last but not least, we have also covered the long and short positions of their Canadian Equity Fund for those interested.

Crude Oil & Gold: Both Bounce Off Fibonacci Retracements

Wanted to link up a few different technical analysis videos we've seen recently for those who may be interested. These are a bit more educational in nature since they were filmed a few days back, so just a head's up on that. They're always a great resource for those looking to fine-tune this analysis within your investing or trading arsenal. And specifically, these videos focus on Fibonacci retracements, a tool that many technical analysis gurus swear by.

Firstly, the guys over at MarketClub are back looking at a video of both Crude Oil and Gold. And, they noted a similarity between the two: both recently bounced off Fibonacci retracements. In a previous video we highlighted, they thought Gold would retrace to around $924 or so and that's exactly what happened. They are now targeting $980 to the upside before the metal encounters more resistance. And, of course, $1000 is the key level for gold on the upside in order to breakout and really start running. Adam suggests putting on a trade with a stop around $950 and you can see the other key technical levels he's identified in this separate gold video. Oil on the other hand reversed off the $63 level which coincides right with a Fibonacci retracement as well. They said they were looking for crude to run into more resistance there around $74 in the near-term. You can watch the video showcasing these two very recent Fibonacci retracements here.

If you're unfamiliar with Fibonacci retracements, we highly suggest learning about them and there is a great educational video on Fibonacci's here. And of course, if you're new to technical analysis altogether, we'd suggest checking out our recommended reading list on the subject.

Whitney Tilson (T2 Partners) Talks Berkshire Hathaway

Hat tip to Farnam Street for posting up an excerpt from hedge fund T2 Partners July investor letter. Whitney Tilson details some of his thoughts/plays on Warren Buffett's Berkshire Hathaway (BRK.A).

"In late November Berkshire Hathaway tumbled into the mid-$70,000 range, at which point we backed up the truck, confident that we were seeing a once-in-a-decade buying opportunity for this superior company. At this price, we were only paying for Berkshire’s investment portfolio and getting all of its operating businesses for free. We were quickly rewarded, as the stock rose above $107,000 within a few weeks and we sold quite a bit of our position.

We were wrong, however, about it being a once-in-a-decade buying opportunity. As the market collapsed in the early months of this year, Berkshire also fell and hit a low of $70,050 on March 5th. We backed up the truck again and once again profited as the stock today sits at $97,000.

We have trimmed the position, but not as aggressive as we did last December, for a number of reasons. First, obviously $97,000 isn’t $107,000. Also, the stock has actually underperformed the S&P 500 by a bit more than 10 percentage points since March 5th, so while we’re not complaining, on a relative basis Berkshire is even cheaper than it was a few months ago. More importantly, Berkshire’s intrinsic value has risen smartly – not as much as the stock, but enough so that we still think it’s attractively priced. We think the stock is worth at least $120,000 today.

Finally, we don’t want to sell prior to Berkshire’s second quarter earnings release coming up this Friday because we think the news will be very good in many areas. First, the investment portfolio will show approximately $7 billion in after-tax gains, plus there will likely be another $1 billion in a reversal of losses on the equity index put positions, and the Goldman Sachs warrants will add another $1.5 billion or so in after-tax gains. Thus, Berkshire should report a 10% gain in book value before operating results.

On top of this, investment income will be roughly $1.3 billion, mostly interest from the many preferred stock and debt deals Buffett did with Goldman, GE and many other companies during the worst of the crisis. Lastly, among Berkshire’s operating businesses, the two largest areas, insurance and utilities should report solid earnings, while the other operating businesses will continue to be weak.

Overall, we expect a very strong earnings report that, based on the stock price, we don’t think the market is anticipating, so it’s an added bonus to have this as a catalyst for the stock."

So there you have it, interesting stuff from Tilson and gang. Longer-term readers of Market Folly will recall that we posted up a quick bit back in December of 2008 regarding Tilson's bullishness on BRK.A. It looks like he's played that one well so far (twice).

Monday, August 10, 2009

Seth Klarman's Baupost Group Sells PDL Biopharma (PDLI)

Recently, Seth Klarman's hedge fund filed a flurry of 13G's and we're back again as always to track the latest developments out of Baupost Group. Both documents were filed due to Baupost's activity on July 31st, 2009. Firstly, they've filed an amended 13G on Horizon Lines (HRZ). They are now showing a 7.28% ownership stake in the company with 2,199,129 shares. This is down from their previous 3,641,545 shares that they disclosed owning in their previous 13F filing.

Secondly, they've filed an amended 13G on PDL Biopharma (PDLI). In the filing, we learn that Baupost Group now has a 0% ownership stake in PDLI with 0 shares. In other words, they've completely sold out of this position. Previously, Klarman's fund owned a sizable stake in PDLI as it was their 3rd largest holding when we covered Baupost's portfolio. From their 13F filing that detailed positions as of March 31st, 2009 Baupost owned 15,559,608 shares. New 13F filings are due out this and next week so we'll get an update on the rest of Baupost's positions. They were definitely out selling the two names mentioned above though. Klarman's fund has been pretty busy lately as we also covered them selling their Omnova (OMN) position.

Remember that Baupost's insane long-term track record is a major reason they've landed in our custom Market Folly portfolio that is seeing 25.8% annualized returns. We cloned our portfolio based on multiple hedge fund managers with the help of Alphaclone and Klarman was an easy choice because he is the definition of a value sleuth. And the fact that Baupost has seen annual compounded returns of 20% over the course of 25 years doesn't hurt either.

Klarman started working at Baupost at age 25 after receiving his Harvard MBA. Baupost Group was ranked 13th in the recent 2009 hedge fund rankings. Klarman has been patient through the market turmoil and had nearly half their $14 billion in assets in cash. But, with crisis sprouts opportunity. And as such, Klarman has begun deploying their dry powder, leaving them with around a fourth of assets left in cash. To learn more about his investing ways, check out the now out of print book that Klarman has authored, Margin of Safety.

Taken from Google Finance,

Horizon Lines is "a container shipping and integrated logistics company. The Company's subsidiaries include Horizon Lines, LLC (Horizon Lines), Horizon Logistics Holdings, LLC (Horizon Logistics) and Horizon Lines of Puerto Rico, Inc. (HLPR). The Company owns or leases 21 vessels, 16 of which are qualified Jones Act vessels, and approximately 20,800 cargo containers.The Company ships a spectrum of consumer and industrial items ranging from foodstuffs (refrigerated and non-refrigerated) to household goods and auto parts to building materials and various materials used in manufacturing."

PDL Biopharma is "engaged in the business of management of its antibody humanization patents and royalty assets, which consist of the Company’s Queen et al. patents and license agreements with several biotechnology and pharmaceutical companies."

Sprott Asset Management Market Update: July 2009

Thanks as always to a reader in Toronto for the latest from the Sprott Asset Management camp. Their hedge fund was -7.89% for the month of July and they are now -9.32% for the year. The past 2 months have not been their best and have swung them back to negative for the year. However, we should also quickly point out the long-term track record of Sprott. They are seeing a compound rate of return of 21.37% annualized and a cumulative return of 442.63% since inception. For whatever reason, everyone is so focused on near-term performance these days. "A bad 2 months in a row? Oh, we're pulling our money out." We here at Market Folly are trying to shift the focus back towards outperformance over the long-term. While it is obviously prudent to monitor your investments in the near-term, a long-term focus can generate some serious Alpha and some solid returns.

Included below is the performance breakdown of Sprott's hedge funds, including their LP, LP II, Bull/Bear RSP Fund, Opportunities Fund, Opportunities RSP Fund, and Small Cap Fund. RSS & Email readers will need to come to the blog to view the embedded documents. (Or you can try downloading the .pdf here however long the link lasts).

Sprott-7 09 Hedge Funds

Additionally, we've got the summary of performances drilled down into one convenient document:

Sprott-7 2009 Performance Summary

(Try to download the .pdf here).

We've started to cover Sprott in more detail on the blog now and just a few weeks ago featured their July Market Commentary. Additionally, we've also covered their long and short positions within their Canadian Equity Fund. We're not kidding when we say we've posted a lot of Sprott stuff up recently as we seek to play catch-up in adding them to the list of 40+ prominent hedge funds that we track.

Some other resources worth checking out are some articles featuring members of the Sprott team that are scattered about online. Here is the list below:

Stay tuned as we continue to cover Sprott Asset Management going forward.

PIMCO's Bill Gross Investment Outlook: August 2009

Some of you may have already read the latest from PIMCO's Bill Gross. But if you haven't, then here's the August 2009 commentary from the bond-trooper himself, entitled 'Investment Potions,' which can be found on PIMCO's website.


I took my troubles down to Madame Rue
You know that gypsy with the gold-capped tooth
She’s got a pad down on 34th and Vine
Sellin’ little bottles of – Love Potion #9
– Love Potion #9, Circa 1959

I’ve never known any gold-capped tooth money managers, but without squinting very hard there is undoubtedly a strong resemblance between all of us “managers” and the infamous Madame Rue selling Potion #9. Instead of love, though, we sell “hope,” but very few are able to seal the deal with performance anywhere close to compensating for the generous fees we command. Hope has a legitimate price, of course, even if its promises are never fulfilled. It is the reason we put a five spot into the collection plate on Sunday mornings and why we risk a 25-dollar chip at the blackjack table. In the former case we usually rationalize it as “insurance,” and with the latter as “entertainment.” Whatever – I’ve already alienated all of you with strong faith in the hereafter or the ones who actually believe they’re going to win on their next trip to Las Vegas. But my point is that those who sell investment “potions” must wrap their product with an extra large ribbon because history is not on their side. Common sense would dictate that the industry as a whole cannot outperform the market because they are the market, and long-term statistics revealing negative alpha for the class of active managers confirms it. Yet, what a price investors are willing to pay! A recent Barron’s article pointed out that stock funds extract an average 99 basis points or virtually 1% a year in fees from an investor’s portfolio. Bond managers are more benevolent (or less pretentious) at 75 basis points, and many money market funds manage to subsist at a miserly 38. Still, those 38 basis points are as deceptive as the pea that disappears beneath the shell of a street-side con game. Since money market funds barely earn 38 basis points these days, much of the return winds up in the hands of investment managers. A mighty expensive potion indeed. While some index and ETF proponents avoid this extreme absurdity with lower fees, roughly 90% of the $1.5 trillion in 401(k) and other defined contribution assets in mutual funds are in actively managed offerings with expenses close to 1%. Paying for those potions during an era of asset appreciation with double-digit returns may have been tolerable, but if investment returns gravitate close to 6% as envisaged in PIMCO’s “new normal,” then 15% of your income will be extracted based on the beguiling promise of Madame Rue. The solution, of course, is to compare long-term performance with fees and approach 34th & Vine with informed confidence, as opposed to Pollyannaish hope that you’ll get your money’s worth. Down the hatch and good luck!

Investors looking for love potions or successful investment strategies in this new normal economy dominated by deleveraging and reregulation must focus on some very macro-oriented ingredients as opposed to typical news-dominated minutiae. The latest quarterly earnings report from Goldman Sachs may be an indicator that the financial sector is getting some color in its cheeks, but it doesn’t really let you know what needs to happen in order for the real economy to stabilize as well. My last month’s Investment Outlook commentary on the significance of wage and employment trends remains the key focus. Common sense tells us that consumer spending growth comes from highly employed, well-compensated labor, and we are far-far from even approaching that elemental condition. The fact is that near double-digit unemployment has resulted from numerous business models that are now broken: autos, home construction, commercial real estate development, finance, and retail sales. Construction of a new Humpty Dumpty capitalistic “oeuf” will be a herculean task.

Potion hunters, however, should also understand the following macro concept that will dominate the indefinite future, one which I will humbly try to explain in the next few pages in 500 words or less: Reflating nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers. If they can do that, then employment and economic stability may ultimately follow.

To explain:
A country’s GDP or Gross Domestic Product is really just an annual total of the goods and services that have been produced by its existing stock of investment (capital in the form of plant, equipment, software and certain intangibles) and labor (people working). Over the last 15 years or so in the U.S. that annual production (GDP) has increased in nominal (real growth and inflation) terms of 5-7% as shown in Chart 1. Not every year, certainly not in boom or recessionary years, but pretty steadily over longer timeframes, and consistently enough to signal to capitalists that 5% was the number they could count on to justify employment hiring, investment spending plans, and which would serve as well as a close proxy for the return on capital that they should expect. Nominal GDP is in fact a decent proxy for a national economy’s return on capital. If each and every year we grew by 5%, then that would be sort of like a stock whose earnings grew by the same amount. Companies and investors then would be able to estimate the present value of those cash flows, and price investment and related assets accordingly – a capital asset pricing model or CAPM based on nominal GDP expectations.

While objectively hard to prove, logic dictates that that is exactly what has happened over the past several decades. Businesses expanded with a developing certainty that demand, expenses, and return on the economy’s capital would mimic this 5% consistency. Debt was issued with yields that reflected the ability to service those payments through 5% growth in both real and inflationary terms, and stocks were issued and priced as well with the same foundation. Pension obligations and similar liabilities were legitimized on comparable logic, as were government spending programs forecasting tax revenues and benefits. Both real economy and financial markets then, were geared to and, in fact, mesmerized by this 5%, GDP/CAPM, “model.”

Now, however, things have changed, and it is apparent that there is massive overcapacity in the U.S. and indeed the global economy. As reflexive delevering has unveiled the ugly stepsister of the “great 5% moderation,” nominal GDP has not only sunk below 5%, but turned at least temporarily negative. If allowed to continue – and this is my critical point – a portion of the U.S. production capacity and labor market will have to be permanently laid off. Nominal GDP has to grow close to 5% in order for the economy’s long-term balance to be maintained. Otherwise, employment levels become unsustainable, retail shopping centers unserviceable, automobile production facilities unprofitable, and the economy itself heads towards a new normal where unemployment averages 8 instead of 5%, housing starts total 1.5 instead of 2 million, and domestic auto sales 12, instead of 16 million annual units. Critically in the readjustment process, debts are haircutted via corporate defaults and home foreclosures, and equity P/Es are cut based upon increased risk and substantially lower growth expectations. A virtuous circle of expansion turns into a vicious cycle of recession or low-growth stagnation. Label it what you will, but a modern capitalistic economy based on levered financing and asset appreciation cannot thrive if its “return on capital” or nominal GDP suffers such a significant shock.

Policymakers/government to the rescue –we hope. 0% interest rates, quantitative easing, $1.5 trillion deficits, trillions more in FDIC or explicit government guarantees, a trillion plus in MBS and Treasury bond purchases, TALF, TARP – I could, but I need not go on. Can they do it? In other words, can they successfully reflate to 5% nominal GDP and recreate an “old” normal economy? Not likely. The substitution of government-backed vs. private-leverage is one strong argument against the possibility. Despite the attractive financing rates incorporated with the TALF, TLGP and other government-subsidized financing programs, they come with quality constraints (larger collateral haircuts and mortgage down payments, to name a few) that inhibit the “new normal” lenders from approaching the standards of the 5% nominal-based shadow banking system. Just last week, President Obama proposed new “transaction fees” for “far out transactions” undertaken by financial companies. “If you guys want to do them,” he said, “put something into the kitty.” In turn, there are internal Washington Beltway/external Main Street USA, politically imposed limits which will thwart policy expansion beyond the current stasis. Most of the politicos and even ordinary citizens are screaming for limits on monetary/fiscal expansion: “No TARP II! 1.5 trillion dollar deficits are enough! The Fed must have an exit plan!” etc. If there are such future political constraints or caps (both domestically and from abroad), then one should recognize that most of the ammunition has been spent stabilizing the financial system, and very little directed towards the real economy in terms of job loss prevention. Where is the political will or wallet now to grant corporate tax breaks for private sector job creation or to even hire new government workers, aside from a minor positive push with military enlistment? In brief, the “new normal” nominal GDP, the future return on our stock of labor and capital investment, will likely be centered closer to 3%, for at least a few years once a recovery is in place beginning in this year’s second half. Diminished capitalistic risk taking and constrained policymaker releveraging will lead to that likely conclusion.

Investment conclusions? A 3% nominal GDP “new normal” means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope. An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end. There is no investment potion for this new environment other than steady income-producing bond and equity investments in companies with strong balance sheets and high dividend yields, as well as selectively chosen emerging market commitments where nominal GDP growth prospects are tilted upward as opposed to gravitating to new lower norms. Madame Rue has met her match.

William H. Gross
Managing Director


Alternatively, you can try downloading the .pdf here while the link lasts. And if you missed his July Investment Outlook, we touched on that in one of our recent hedge fund/market guru news summaries.