2010 Outlook: A Tale Of Two Economies

The following is a guest post from Phil's Stock World:

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way–in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.” – Charles Dickens, 1859

Dickens famous novel (which was originally written as a weekly series in 31 installments) depicts life in the time of the French revolution but was also a parable, meant to warn the British aristocracy that they should not ignore the parallels to the social inequities that existed at the time in England. Dickens warned the nobles that the seeds of revolution were planted through unjust acts and surely there would be a time of reaping yet to come.

It is said that the French Revolution was sparked by outrage over a statement by the Queen Mary Antoinette who, when told that the peasants had no bread to eat, supposedly replied (she never actually said this) “Qu’ils mangent de la brioche” or “Then let them eat cake.” It’s hard for us to imagine the impact of this statement in modern times but “peasants” were 90% of the population at the time and bread was 90% of what they ate, consuming 50% of the average family’s income (people weren’t silly enough to pay for housing back then – they just found a bit of land, bought some wood and nails and built their own homes). Brioche was a luxury combination of bread enriched with flour and butter so the statement ”Qu’ils mangent de la brioche” implies both lack of caring and cluelessness on the part of the Queen.

The United States had what passes for a revolution between 2006 and 2008 as we threw out the Republicans and went with a Democrat-controlled government. While the Bush administration, the Republican Congress and Fox News may have been as clueless as a French Queen to the plight of the people – the fact of the matter is that the base pay of top management rose 78% from 2002-2007 while the pay for workers went up just 24%. The top 10% of executives and professional workers drew 33% of all income paid in the US ($2.1Tn) and that does not take into account stock options and bonuses that more than doubled that figure.

At the same time as the income gap was widening to historic levels, commodity prices doubled, taking the cost of food and fuel from 12% to 20% of household income. Add in skyrocketing health care costs and you can see where the seeds of revolution had been sown long before the 2008 election. Disposable income has fallen from 8% in 2000 to actual negative numbers in 2009 (families must borrow just to survive). Is it any wonder that people in America were hungry for change as the decade, and their incomes, wound down?

Despite the change in leadership, 2009 has not been kind to the American proletariat. There has been a $539Bn decrease in real income and, since 2006, Americans have lost $3.7Tn housing value (15%). Homes represent 42% of the average family’s total net worth but it’s worse than that because home mortgage debt is at $10.4Tn, which is 57% of total home worth. US home equity has dropped from 58% in 2003 to 43% this year, a loss of over 25% in 6 years. This is reality for American peasants, the 300M people who aren’t in the top 10% and don’t read the Wall Street Journal (as they have nothing to invest) and don’t shop at WSM or TIF or SKS or JWN – all stocks that have been off to the races in the second half of 2009 as the rich grow far, far richer.

How much richer, you may ask? Well the chart on the right says it all. In the past quarter century, the inflation-adjusted household income for the top 3% of Americans has tripled while the other 97% have gained about 50%, roughly 2% per year over inflation. Since 1979, 80% of the vast GDP growth in the United States has been diverted to less than 10M of its citizens, while the other 295M people struggle to maintain their lifestyles. Forcing the vast majority of Americans into a life of wage slavery has, of course, been an economic renaissance for those of us fortunate enough to be at the top of the economic pyramid.

Since 1979, the hourly earnings for 80% of American workers (those in private-sector, nonsupervisory jobs) have risen by just 1 percent, after inflation. The average hourly wage was $17.71 at the end of 2007. For male workers, the average wage has actually slid by 5 percent since 1979. Worker productivity, meanwhile, has climbed 60 percent. If wages had kept pace with productivity, the average full-time worker would be earning $58,000 a year; $36,000 was the average in 2007. The nation’s economic pie is growing, but corporations by and large have not given their workers a bigger piece but have instead, kept that 60% gain almost entirely for themselves.

The typical American worker toils 1,804 hours a year, 135 hours more per year than the typical British worker (3.5 weeks), 240 hours more than the average French worker (6 weeks), and 370 hours (or nine full-time weeks) more than the average German worker. No one in the world’s advanced economies works more for less. A 2007 report by the Congressional Budget Office found that the top 1 percent of households had pre-tax income in 2005 that was 140% larger than that of the bottom 40 percent so let’s not kid ourselves, America, we have effectively re-created a slave-driven economy but we’ve wrapped it in the flag and keep the slaves in line by providing them with cheap beer, happy meals and 200 channels of corporate entertainment while drumming into their heads that all they need is a dollar and a dream and they too can step right over the fallen bodies of their fellow workers to join us at the top of the pyramid.

With the fall of Communism, the global economy has become more and more like us. One of the great accomplishments of capitalism is that we have made the rich into heroic figures while the working man or the soldier is just the anonymous cog in the great machine. 2,000 years ago, the masses were kept in line with tales of Hector an Achilles as any man with a sword that was strong enough could gain immortality. A thousand years later ordinary men could aspire to be knights or saints but, after the dark ages, that mythos was lost as the noble class tightened their grip and denied upward mobility to the masses which, of course, led to revolution. America, France, Russia, China – all went through revolutions and England even had one in the mid 1600s and many small revolutions swept through Europe in the mid 1800s (around the time of Dicken’s writings).

The cure for all this revolutionary nonsense in the Western World was Capitalism, which was embodied by another writer in the late 1800s called Horatio Alger, who became famous for writing over 100 books along the lines of “rags to riches” stories. By leading exemplary lives, struggling valiantly against poverty and adversity, Alger’s protagonists gain both wealth and honor, ultimately realizing the American Dream. The characters in his formulaic stories sometimes improved their social position through auspicious accidents instead of hard work and denial but the bottom line is the myth of upward mobility that lets us all aspire to be modern economic heroes like Rockefeller, Hughes, Buffett, Gates, Oprah, Soros and Pickens – sure there’s only 1,000 of those guys on the planet but we all like to believe it could be us too, right?

Capitalism is so good at keeping the masses in line that even China and Russia have now adopted our model as it turns out you can effectively squeeze much more out of your workers with carrots than with sticks. The dream of modern capitalism also has the added benefit of relieving the wealthy of the burden of guilt by envisioning a level playing field in which they have triumphed through their own hard work and perseverance making it poor people’s own damn fault if they can’t be motivated enough to improve their lot in life. It is necessary to engender this feeling amongst the rich lest the conscience of some may lead them to “overpay” their workers, which makes their fellow entrepreneurs look bad so we have devised a system (the stock market) in which only the most ruthless practices of capitalism are rewarded over time.

OK, liberal rant over now – I feel better having indulged my Dickensian side and identifying with the plight of the workers but workers don’t buy stock market newsletters so f*ck them, right? We are investors and we shouldn’t be worried about if it’s FAIR or RIGHT that we have established an economic engine that funnels the wealth of the nation to the top – if you are reading this article, then chances are you are on or near the top and our job is to figure out how to maintain or improve our position and my biggest failing of 2009 has probably been worrying about the long-term repercussions of impoverishing 295M people when really it’s just us (me and my 9,999,9999 economically close friends) that we need to worry about and we have jobs and money and assets and stocks so, once again – F*ck those people!

Now that we have Russia and China on board with this Capitalism thing, we are more efficient at exploiting the global labor force than ever. Corporate profits, other than 2008, have climbed an average of 13% a year without increasing wages a single cent over that same time period. Corporate profits have climbed to their highest share of national income in sixty-four years, while the share going to wages has sunk to its lowest level since 1929 – Perhaps there has never been a better time to invest in Corporate America than right now. Our global GDP has climbed to about $55Tn, up 100% in 20 years and, the best news of all is that we’ve made sure that over $21.5Tn (71%) of that growth went to the top 10% of the population. By keeping the money amongst ourselves, we can be sure that it goes where we WANT it to.

What does it matter if the capital allocation to the great, unwashed masses barely keeps up with their population growth when our cut grows by leaps and bounds? We only need them to have just enough to eat and to be able to dress and transport themselves to a place where we can get that 1,800 hours of highly-productive work out of them. This makes good, economic sense. If we give money to the world’s 6Bn poor people, they’re only going to go and buy bread (or dare I say cake) and maybe shoes or clean shirt and mostly they will buy them at Wal-Mart or, even worse, make it themselves and there’s little profit for us in that. By keeping the vast global wealth “in the family,” so to speak, we can sell IPods and Hummers and luxury homes and diamonds and gold and other high-margin, unnecessary items to each other that allow the corporations we invest in to make obscene profits which, in turn, makes us EVEN RICHER! Isn’t that fantastic?

So let’s not kid ourselves that anything in this country is being done for the benefit of the 90% who serve us. We provide the basics and there are even many fine companies who can make money selling those basics like KO, MCD, JNJ, WMT… that we can invest in. One of the big issues we had been facing the past few years is that the damned poor people kept dying because they didn’t have adequate health care as they squandered their meager wages on cheap Chinese treats from the dollar store or whatever it is poor people do when you let them have money. Now we have taken a great step towards mandating that a portion of their meager wages goes towards health care and, in doing so, we have created 40M new patients for our wonderful medical industry to exploit.

Back on August 10th, we had discussed IHI (medical equipment) as a great growth ETF to play in this space and they have done well[...] GE is also big on medical devices and also infrastructure plays that should do well next year. Big Pharma (MRK, PFE) should do well with 40M new patients coming on line and we always like Biotech like CELG and AMGN and let’s not forget the actual hospitals like UHS and THC, who have millions of new patients to take care of. It’s hard to get a grip on how big the impact of national health care without understanding that the bottom 90% of this country have no disposable income at all and now, through a government mandate, we have now enabled them to buy hundreds of Billions of dollars in medical care – what a country!

We’ll be doing a lot of these articles in the coming year as health care looks to be the most exciting sector for long-term growth, especially with the aging baby boomers lining up to join the poor to be diagnosed and medicated in the 2nd decade of the century.

The 295,000,000 that share 28% of this nation’s wealth in 95M households are normally supported by about 140M non-farm jobs but that was down to just 120M jobs as of Nov 17th so, as a group, we’re sure not going to be counting on the poor to be splurging next year as even record job growth (6M) would only replace about 1/3 of all jobs lost. What do the poor do when times are hard? Mainly they shift their spending so we can expect more money spent at MCD and BKC with less money spent on “casual dining.“ We can expect pasta and bread to do well and meat to do worse because those items depend on large numbers of buyers.

The disposable income of the poor this year will depend very much on the price of oil and other commodities and that’s going to be one of the year’s trickier issues. To some extent, the price of oil is based on consumption but, since speculators took over the market, it’s been fairly disconnected from reality and speculation is a rich man’s game so it’s really a question of how much pain can be inflicted on the working classes before they change their habits so much that it spurs actual price competition among the oil producers - something that is also avoided through the formation of cartels. Consumption of oil fell 5% this year yet the price of oil is up nearly 100% from last winter – go figure.

While the commodity pushers can charge us (the top 10%) whatever they wish for oil, gold, copper, food and lumber – it seems they have already squeezed the bottom 90% to the breaking point. The $3.5Tn that was overcharged for commodities in the last few years was withdrawn from household wealth and without an expansion of household values, increases in lending or (gasp) higher wages – I just don’t see that they have any room to push the commodity train. Even inflation and dollar devaluation doesn’t work until you get those dollars into the hands of the bottom 90% so they can trade them for gas or bread. That’s the great joke about the inflation pundits – they seem to think it can magically appear just because the banks are hoarding our increased money supply. Unless the banks start buying a few million barrels of oil per week, we’re going to have to wait for the citizens to catch up.

And keep in mind that our poor people are the richest poor people in the world. Over 4Bn people in this world get by on less than $2,000 a year while our welfare recipients get a whopping $12,000 a year – enough to be considered upper class in many of the World’s nations. So our nation’s poor can actually afford to eat cake, as well as many other foods loaded with delicious and relatively inexpensive polyunsaturated fats (that are leading to those health problems that are killing them). Keep in mind that, in the above chart, you are looking at the percentage of the AVERAGE US household but imagine how that changes for households on the bottom half of that $48,000 average income, especially for the 34M homes that make less than $20,000 a year yet still need to eat as much as the average family of 4 and probably still want things like heat, clothing and maybe a bed to sleep in – it simply doesn’t leave a lot of room for “other.”

So forget those people – they are simply not going to be customers of much next year. Let’s concentrate on the people who have money – us! With 71% of the nation’s net worth and 66% of it’s annual income, the top 10% are the real customers for US business. Unfortunately, it’s just 10M households with 30M people so we need to focus on things that can be sold to relatively few people at high margins. That’s going to rule out cars (other than Porsche or BMW), mid-priced homes (but look for luxury home sales to come back) and mid-priced merchandise as the middle class is a vanishing myth, which is going to leave the merchants who try to service them out in the cold.

Financial services will do well as we shuffle our money around through various investments but don’t look for banks who rely on lending to the masses as they are all tied too tightly together to separate the good from the bad and that makes the whole sector a bit too dodgy although we continue to like XLF and UYG as the sector in general should recover over time.

Another problem with the banking sector is the probable end to the free money train that’s been supporting them since last November. While there are 30M of us who are ready, willing and able to borrow money for our various endeavors, banks need volume and it’s not very likely the other 275M Americans will be filling out successful loan applications in 2010. That limits the amounts of homes that can be bought and the total volume of credit that can be extended and also runs up the risk of default as we are now spreading our risk over a smaller borrowing pool.

With global debt piling up at a rate of over $10Bn a day, we are rapidly reaching the end of the game where we pretend interest rates can stay this low (especially if the economy really does heat up and creates a demand for money) and that brings us back to our favorite ETF: TBT, the ultra-short on the value of a 20-year treasury note. The higher rates go, the lower the value of the fixed-rate notes that suckers have been buying for less than 3% interest this past year. We’ve been in TBT since the low 40s but we are very confident rates have only one way to go in 2010, good for another 20% from the current 50 at least.

Travel should do well next year as many of us put off vacations while waiting to see how the economy shakes out. As we get more confident the world is not ending in 2010. PCLN is out of control but I still like OWW as a value play and CCL should perform well long-term as high fuel prices are not likely to return as fast as passengers. CAL is still an airline stock I like and MAR is the place to stay as business travelers once again venture out of the office. IHG is also a good pick in the luxury travel area.

GE should do well on infrastructure building. My big concern with them remains Commercial Real Estate but no one else seems worried about that sector. GE is also big on solar projects, which should do well and my favorite pure play on Solar remains SPWRA, who are the quality leader but I also like STP and, of course, WFR on the chip side. Also in the chip space is AMAT and INTC while GLW should have a great year supplying glass for all the new electronic devices us top 10%’ers love to buy.

I wouldn’t go so far as to stick my neck out on luxury retail as some of that is affected by aspirational buyers, of which there are far fewer these days as aspirations have been crushed into dust by the latest downturn. My main concern for the US and the global economy is that rising rates and other credit risks, reflected in various CDS rates, will begin to bring down some of the marginal global economies like Spain, Greece and anything ending in “stan” or “ia.” Also, 20M unemployed in the US and 400M globally is nothing to sneeze at. Will we, the top 10%, bear the cost of taking care of them or shall we, like old Scrooge, wish them to die quickly and help decrease the surplus population?

2010 is going to be an interesting year and it seems the majority of investors believe that we can keep living on this harshly divided planet and keep squeezing productivity gains out of the working masses even as we continue to hold wages down and drive the cost of their basic necessities higher. Even the slave owners had to provide food, clothing, shelter and medical care to their workers although I suppose we can feel good about the fact that slave owners outlawed education while we simply provide a very poor quality one – not enough for true upward mobility but certainly enough to hammer home the message that all they need is a dollar and that great American dream.

As long as we can keep the peasants from revolting we can keep partying like it’s 1999 but I do have reservations (obviously) and we will continue to exercise a degree of caution in our investing but history has taught us that the rich can indeed get richer and we have plenty of good places to focus our bullish attention as we begin this centrury’s second decade.

For more posts on the 2010 outlook as it pertains to markets and the economy, check out the top 10 investment themes for 2010, Jeff Saut's 2010 outlook, and Doug Kass' 2010 predictions.

Hedge Fund Tontine's Rebirth? (Guest Post Over On Zero Hedge)

Hey everyone, just wanted to let you know that we had a guest post published over at ZeroHedge.com yesterday regarding the latest out of Jeffrey Gendell's hedge fund Tontine Associates. In it, we cover their latest SEC filings and investor letter so click here to check it out.

Interview With The Mad Hedge Fund Trader

Here's a recent interview Ilene from Phil's Stock World recently did with the Mad Hedge Fund Trader. Enjoy:

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Mad Hedge Fund Trader began his career in finance by moving to Japan and working at Dai Nana Securities as a research analyst in 1974. In 1976 he was named the Tokyo correspondent for The Economist magazine and the Financial Times, which then shared an office. He traveled the world interviewing famous people, such as Ronald Reagan and Margaret Thatcher. In 1982, he was named the US editor of Euromoney magazine, and in 1983 he built a new division in international equities for Morgan Stanley. After moving to London in 1985, Mad Hedge supervised sales and trading in Japanese equity derivatives. In 1989, he became a director of the Swiss Bank Corp, responsible for Japanese equity derivatives. A year later, he set up an international hedge fund which he sold in 1999.

I haven’t even covered all of Mad Hedge’s adventures, such as his latent movie star career (as an extra in the 1979 epic war film, Apocalypse Now), and who knows what else. But now, missing the adrenaline-surging excitement of active trading, Mad Hedge has returned to the hedge fund business, set up an educational website, and is busy keeping up with the demands of newsletter writing.. So let’s begin our interview with Mad Hedge by exploring his current thoughts on the markets.

Interview

Ilene: Hi Mad Hedge. You’ve had a fascinating career having little to do with your major in biochemistry. A brief review of your newsletter shows that your recommendations early in 2009 have appreciated by an average of around 400%. You’ve been writing your daily market thoughts and investment strategies at your website - www.madhedgefundtrader.com - which it’s terrific, by the way. What are your goals with this site?

Mad Hedge: This whole thing started out as a letter to investors in my hedge fund, to tell them my thinking behind my positions. Then I thought, why not post this on the web and see what happens? Six months later it is now going out to 50,000 readers a day, mostly to portfolio managers, financial advisors, and traders. The growth has been explosive.

Ilene: Who are your readers?

I seemed to have stumbled on a market that I describe as “semi-professionals.” If you are a big hedge fund, with a staff of 600 and a huge in-house research department, I’m not going to tell you anything you don’t already know. But there appear to be a few million people out there who trade their own accounts, or invest their own IRA’s. They have never worked on Wall Street, but have taught themselves a lot about markets and investing. My letter gives them the 30,000 foot view on global stock, bond, currency, commodity, and real estate markets which they can’t find at their online broker. About half of them are from abroad. When I get up in the morning now, there are five e-mails waiting for me from China and India asking what to do about natural gas. I also try to make the letter funny and entertaining. Not all financial publications have to be dreary reading. It’s not always about the next stock to buy.

Ilene: In a recent letter you wrote that one of your favorite ETF’s is the Proshares Ultra Short Treasury Trust (TBT). Why is that?

Mad Hedge: TBT is a 200% leveraged bet that long Treasury bonds will go down. While the Fed keeps short rates low, it doesn’t directly control long rates. As the supply of government bonds increases exponentially, their eventual collapse is inevitable. All Ponzi schemes must come to an end, and the US government is no exception. We currently have the greatest liquidity driven market of all time, and the ten year is eking out a mere 3.30% yield, pricing in near zero inflationary expectations. The average yield on this paper for the last ten years is 6.20%. If the yield goes back to 5%, that will take the TBT from $45 to $70. The TBT could perform even better if Treasuries lose their triple “A” rating, which I think is a real possibility.

Historically, bonds are not a good buy in a low interest rate, deflationary environment. If long rates move from 3% back to the 12% we saw in the early eighties, bond holders will get slaughtered, and the TBT could exceed $200. Even if inflation stays low, the sheer weight of supply and credit concerns will crater government bond prices.

Ilene: What’s the worst case scenario for the bond market?

Mad Hedge: Debt service is currently 11% of the budget. If interest rates rise sharply, that could double to 22%. Then you get a downward spiral like you saw in Latin America in the eighties, when higher debt service creates more borrowing, and more borrowing creates a higher debt service, until the whole thing blows up. At some point China, Japan, the Middle Eastern countries may stop buying our debt. There are only so many “greater fools” out there.

The only way out of this is for the economy to return to a long term 3%-4% growth rate. That’s obviously what Obama is hoping for with his programs. He’s taking big risks, but he doesn’t have much choice. He really did inherit a bad hand. If he did nothing, we’d be in a depression by now, with 25% unemployment. He understands what he’s doing and understands the risks. He has great economic advisors.

Obama couldn’t have allowed the banking system to collapse. We need banks as the economy’s lynchpin. A year ago we could have lost the entire financial system over a weekend. Ships were being turned around at sea and going back home because their letters of credit were failing. The freeze up in credit could have gone on for years.

The stock market is up 50% since Obama took office, so it likes the uneasy stability that we have now. Credit markets have recovered tremendously, and IPOs are coming to the market again. Junk bond funds are up, confidence is returning. There’s greater willingness to lend, though only at high interest rates. But it’s a big improvement over last year.

Ilene: What do you expect for mortgage rates in the next few months? Years?

Mad Hedge: You shouldn’t touch real estate, as I think it will be dead money for another decade. Rent, don’t buy. If you have to buy, then get a 30 year fixed rate mortgage now at 5%, because rates are going up a lot in the future. When I bought my first home in New York in the early eighties, I got nailed with a 17% interest rate on my mortgage. We may revisit those levels.

Houses will continue to move lower, maybe another 10% or so. We have another wave of foreclosures hitting the system soon, triggered by the option arm readjustments. I see support for prices when the cost of owning and the cost of renting are more in line. Home ownership may have to become cheaper than renting, because of perceived risk to the principle, for the real estate market sell-off to finish. However, expecting houses to drop a lot from here is like shorting Citibank at $3. We’ve basically had the big move already. Due to poor demographic factors, the demand for houses is going to take a long time to come back. While 80 million baby boomers are trying to sell their houses to 65 million gen Xer’s, don’t expect a recovery in prices, especially when the gen Xer’s are still living in your basement.

Ilene: You mentioned you missed the rally in financials, but still have concerns about the financial sector.

Mad Hedge: With financials, I knew they would rebound, but didn’t imagine the extensive move we’ve seen. It was the greatest dead cat bounce and short covering rally of all time. But the financial sector will have troubles for years. If I had to buy U.S. stocks, I’d buy big tech stocks like Microsoft (MSFT), Oracle (ORCL), Intel, (INTC) and Cisco (CSCO), because for the most part they have tons of cash and little debt. Tech stocks didn’t have the problems that were plaguing the other sectors. For example, they have no troubled assets, and no regulatory clamp down on their business. The credit crisis didn’t affect them directly because they finance their operations through cash flow and tend not to borrow. Of course, they’re hurt indirectly when the customers have credit problems.

Credit markets are now seeing a huge differentiation in terms. Lenders are much more discriminating about who they lend to. American consumers are very constrained, but foreign consumers are not as constrained. They are not returning to frugality as we are because they didn’t share our excesses in the first place. You don’t see many black Cadillac Escalades with chrome wheels in China. If I had to buy stocks, I would buy equity in foreign companies where the growth will be in the coming years. In March, you could have bought anything and had a great trade, as the rising tide lifted all boats. But stocks in emerging markets outperformed US stocks by over a two to one margin.

Ilene: Would you be buying stocks now?

Mad Hedge: No, I sold most of my positions in June. The risk was low in March, but not so low in June, and it’s even greater now. The PE multiple on the S&P 500 has just jumped from 10 to 20 in six months. Historically, a 20 multiple is a terrible time to enter the market. Markets are discounting a “V”-shaped recovery, which we are not going to get. I think we’ll get more of a “square root” shaped recovery, a “V” followed by sideways to a gradually upward sloping grind. We’ve already had the “V”. Markets are overpriced. I don’t see how we can have huge economic growth with capital-constrained banks, catatonic consumers, and commercial real estate troubles up the wazoo. One of the only positives is the weak dollar, which makes everything we sell to the rest of the world cheaper. This is good for our multi-national companies, good for our exporters. So far, the dollar is on a grinding, controlled move down, which is good. But if the dollar’s fall accelerates, it would not be good. A real dollar panic would lead to the widespread dumping of dollar assets, and commodity prices would explode. Then we’ll get to $2,000 for gold and $40 for silver very quickly.

Ilene: You spent several years wildcatting for natural gas in Texas and Colorado, which has given you a unique insight into the energy space. What are your current thoughts on natural gas and oil?

Mad Hedge: Stay away from natural gas. The volatility will kill you. If you are a masochist, then buy it only when it’s cheap, on big dips, in the $3/MBTU range. In the last three years, thanks to the new “fracting” technology used in oil shales, we have discovered a 100 year supply of natural gas sitting under the US, and the producers have not been able to cut back fast enough. So now we have a supply glut, and we are almost out of storage. This is what took us down from $13 to $2.40 in 18 months. The lack of hurricanes has not helped demand either. Producers have been cutting back like crazy, trying to balance supply and demand, with a breakeven point of $2. They need a cold winter to help bring things back into balance. If the industry gets organized, then gas can become the 20 year bridge we need, until energy alternatives kick in. That makes me a big supporter of the “Pickens Plan.”

Oil is much more interesting. It overshot to downside in January to $32. Crude is now at $70 climbing out of the recession. Imagine how high it will get when all economies are functioning again. The financial crisis hurt the ability of big oil companies to get financing for large development projects in oil. These projects can take five to ten years to bring online. That means we will get higher oil prices sooner. We may get a pull back to the $50s, but the $30’s would be a stretch. The $32 low was an artificial one caused by a complete absence of liquidity in all markets. I don’t think we’ll see those lows again.

Ilene: Where do you see the price of oil going in the distant future?

Mad Hedge: I think it may dip into the 50s, then up, perhaps skyrocketing to $300 before dropping back down to $3 after alternatives take over and demand vanishes. But that’s at best 20 years out. If we can wean ourselves off oil in 20 years, it would be a huge accomplishment.

Ilene: I noticed you speak a little about politics in your essays; do you have a leaning one way or another?

Mad Hedge: I’m politically neutral. I’m getting bashed by the right these days because I’ve said that the Republicans have no ability to affect the legislative process now. But we need to adjust our portfolios to reflect the current political realities. No matter how much you love Obama, you can’t dispute the fact that the massive issuance of government bonds he is proposing is terrible for the bond market and the dollar, but great for precious metals and commodities. Obama won by a big margin, so the Democrats will be around for a while. Of course, if my “square root” scenario doesn’t pan out, and we get a serious “W” recession instead, all bets are off. People will only give him the benefit of the doubt for so long.

Ilene: Where do you think the stock market’s going to go over the next few years?

Mad Hedge: I think there’s a 1 in 3 chance for new lows. That’s the “W” scenario. But with Lehman, Bear Stearns, Merrill Lynch, and Washington Mutual gone, we have run out of companies that can suddenly go under and trigger a new financial crisis. The big survivors are partially government owned, and of course zero interest rates help a lot. More banks are going under, but they will be smaller, regional banks with excessive exposure to commercial real estate.

Ilene: How does this affect your actions in the markets?

Mad Hedge: The best and least risky trades were in the early part of the year. Now, there’s a lot more risk in all markets. I’m neutral right now. If stocks dropped from here, I might be a buyer, but only in energy, commodities, and technology, and of course in emerging markets like Brazil, India, China, Korea, and Vietnam. Gold, silver and commodities have all had huge runs. My inner wimp has me in cash, waiting for better opportunities. I haven’t been playing the short side, because it’s a nightmare trying to short a liquidity driven market with interest rates at zero. There is no return on low risk investments now. Capital always moves to risky assets when interest rates are zero. Just look at Japan in the 1980s. There PE multiples soared from 10 to 100 purely driven by liquidity. For the last three years of that run the fundamental analysts were left twisting slowly in the wind. Artificially low interest rates boost asset prices to artificially high prices. It always ends in tears, but can play out for a while. You want to have an asymmetric risk reward metric in your favor, as we did in March of this year. Now, we don’t have that.

The next downward move in the markets will more likely be due to disappointing economic data, earning misses, etc., not due to a total collapse of the system. We may sell off, but I don’t think it will be to new lows. It’s hard to see new lows with interest rates at zero. Instead, I see the “square root” recovery scenario mentioned earlier. The market may start drifting lower as people start seeing this possibility. That might set up a trading range for the S&P 500 which could last for years, something like 800-1,200. During the nineties, Japan peaked at ¥39,000, then traded in a ¥20,000-¥25,000 range for five years, before the final collapse to ¥7,000. That’s one scenario for the US.

Ilene: You’ve had an amazing career. Let me ask you about some of the people you’ve interviewed. What was Ronald Reagan like?

Mad Hedge: Although I never agreed with him politically, you couldn’t help but like the guy. He always had a joke ready. He was a lot smarter than he let on.

Ilene: And Margaret Thatcher, the prime minister of Britain?

Mad Hedge: Her nickname as “The Iron Lady” was well deserved. She could stare holes right through you. She treated journalists like a disapproving school teacher, which of course, she was.

Ilene: How about the terrorist leader, Yassir Arafat, of the PLO?

Mad Hedge: His body guards almost shot me when I reached to turn over a cassette in my tape recorder. I always thought he was a terrible leader. That is why the Palestinians never got anywhere, and why the Israelis left him alone.

Ilene: Meeting China’s Deng Xiaoping must have been amazing.

Mad Hedge: I am 6’4” and he was only 4’9”, so of course there were plenty of opportunities for humor. I could never envision this guy going on the Long March. He had a tremendous wit. Someone asked him why China kept its borders closed, and wasn’t this an imposition on human rights. He said if he opened the borders, the surrounding countries would get flooded with people. He asked “How many Chinese do you want? 20 million? 30 million?” I also met Zhou Enlai during the Cultural Revolution. He was a brilliant man, the last man on a bell shaped curve of 500 million.

Ilene: I read somewhere that you interviewed four US Secretaries of the Treasury.

Yes, Miller Reagan, Schultz, and Brady. And I visited the French chateau of a fifth, C. Douglas Dillon. I keep a collection of dollar bills they signed.

My goal in life was always to get in the way of history, and let it run me over. It’s been an amazing life. I wouldn’t trade it for anything.

Ilene: What about Apocalypse Now?

Mad Hedge: I happened to be in town to interview Ferdinand Marcos, the president of the Philippines. If you look hard, I’m in the USO scene. Most of the other “GI’s” in that scene were European and Australian hippies rounded up from the Youth Hostels of Manila by Francis Ford Coppola’s agents. Good luck, though. I was a lot younger and thinner then.

Ilene: Thanks a lot. It’s been great talking to you.

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The above was an interview with the Mad Hedge Fund Trader, courtesy of Ilene with Phil's Stock World.

Two Reasons It's Time To Short Stocks

The following is a guest post by Martin Hutchinson, Contributing Editor of Money Morning.

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The stock market is up 51% from its March 9 lows. The leading economic indicators have turned sharply positive, showing gains for each of the last four months. Manufacturing is on the rebound. And banks are promising to pay record bonuses, as their earnings have rebounded.

With this recent rush of upbeat economic news, it’s no wonder commentators are trumpeting the rebound of the U.S. economy.

But I think it’s time to short U.S. stocks.

Shocked?

Don’t be.

What most experts see as a strengthening U.S. rebound, I see as an increasingly dangerous “false dawn” – for these two key reasons:

• An overly expansive monetary policy that’s almost certain to spawn inflation.
• And a record-level budget deficit that will cause interest rates to spike, crimping economic growth.

A Foundation for Trouble

U.S. policies that were intended to combat the financial crisis that broke last year – as well as the recession that’s been plaguing us since December 2007 – have actually inflicted a lot of weakness upon our economic system.

For instance, the federal government has made $11.6 trillion in financing commitments, many of which will saddle us with debt for generations – some of it forever. Outlays of that magnitude in a $14 trillion economy are bound to have lasting implications: Think of the consumer who has a series of maxxed-out credit cards – he’ll make the minimum payments, but the actual balance will never get paid down.

And the foundation for this financial fiasco was actually constructed several years ago.

After the bursting of the 1996-2000 “dot-com” bubble, the U.S. Federal Reserve re-inflated the money supply. That caused stocks to resume their upward march, and as we now know, also inflated a housing bubble of such enormous size that it caused a general financial-system crash when that real estate bubble burst in 2007-08.

This time around, the Fed has been even more expansive. The benchmark Federal Funds Rate was 1.0% in 2002-04. This time it is 0.25%. What’s more, this time around we’ve had a $2 trillion expansion of the Fed balance sheet, a doubling of the monetary base and $300 billion worth of direct central bank purchases of government debt. Given this orgy of Fed expansionism, it’s likely that the onset of inflation – whether it’s in consumer prices or asset prices – will be correspondingly worse. In fact, we’re already seeing that gold prices are once again making a run at their all-time high. And crude oil hovers at about $70 per barrel, a level that would have been unimaginable before 2004.

Now that he’s been nominated for reappointment, U.S. Federal Reserve Chairman Ben S. Bernanke says he will tighten monetary policy in good time. But why should we believe him? If he tries to tighten significantly, he will incur the wrath of the Obama administration and the Democrats in Congress.

Even back during the 2001-04 time frame – when there was an administration in place that claimed to believe in monetary stringency – the Fed didn’t tighten. Bernanke himself was among the most aggressive opponents of tightening. Back in 2002, in fact, when inflation was running at a perfectly respectable 2%, Bernanke actually spun myths about the imminent onset of “deflation.”

Given what we know, it seems that if the current economic bounce shows even the slightest signs of faltering, Bernanke won’t tighten – he’ll pump even more money into the U.S. financial system. Rest assured that the administration, Congress, and much of the media will be cheering his move.

Borrow Now, Hurt Later

If an overly expansive monetary policy was the only problem we faced, it might not be so bad. Unfortunately, there’s more.

Lots more.

Unlike in 2002 – in fact, unlike any other time in U.S. history – this country now has a budget deficit in excess of 10% of gross domestic product (GDP). For fiscal 2009, that was forgivable: We’ve had a major recession, and a shattering financial crisis, which the federal government has tried to battle with aggressive bailout programs.

Here’s the problem, however: The projected deficit remains above 10% of GDP for fiscal 2010, even though no additional bailouts are contemplated and the Obama administration is projecting a modest-but-steady economic recovery.

The result is harder to predict – this country hasn’t travelled down this particular path before. This strategy bears some resemblance to the position Japan found itself in during its so-called “Lost Decade” of the 1990s. But even Japan’s deficit never reached this 10% threshold.

In Japan, the effect seems to have been the gradual abandonment of small business finance, and the resulting starvation of the most critical factor in economic growth – entrepreneurship.

The small-business sector creates most of the new jobs in the U.S. economy. But in a challenging environment, it’s easy to see why this sector gets overlooked. Without political connections or large contracts to hand out, the small-business sector ends up being last in line in the financing queue when the economy faces strong headwinds. Why should banks or other people lend to small businesses when the U.S. government bond market stands as such as huge, safe parking place for their cash?

Interest rates will also become an issue. With the inflationary pressures we expect to see from the overly expansive monetary policy we’ve described, long-term interest rates are likely going to rise anyway. As was the case in Japan’s decade-long malaise, these forces will combine to spark high default rates in the banking system, low or zero economic growth, and a general downward trend in the stock market.

All of this will make it tough for small businesses to obtain the cash they need to grow, meaning this key job-creation engine will have to sputter along.

It’s still early in the game, and there are many factors to consider, so the future economic picture remains a bit murky right now. But my guess is that the bubble in asset prices will be largely confined to commodities, that economic growth after this current initial burst will relapse, and that U.S. stocks will prove to be the same generally unattractive investment that they were in 1970s – the era of the so-called “Nifty Fifty.” If the stock market bubble gets even more exuberant from here, the relapse will be correspondingly more painful.

Profitable Pockets

Despite this dour backdrop, three things are worth remembering:

• First, all U.S. stocks are not created equal. Although I’m saying it’s time to short U.S. stocks, and I see tough times ahead for the key indices, there will always be individual stocks worth consideration, such as the “Alpha Bulldog” stocks I highlight in the Permanent Wealth Investor service.
• Second, the best way to play this looming downdraft – either as a direct profit opportunity or as a way of hedging your current portfolio – is through the use of what I like to call “Stage 3″ investments. An example of one such investment is long-dated “put” options on the Standard & Poor’s 500 Index, which trade on the Chicago Board Options Exchange. If you buy these options when they are way “out of the money” with a strike price far below the current price, in a real bear market (like that of 2007-09), you will see them really zoom up in value as the S&P drops down closer to the strike price, or possibly even falls below it.
• And third, understand that my pessimism about the U.S. market doesn’t apply to every other market around the world. While the monetary problems are more or less global, the budget-deficit problems are not. For instance, you might want to consider investments in Japan, where a recent election should spawn the kind of economic changes that will benefit savvy investors. Germany, too, looks to have avoided the contagion of “stimulitus,” which is why its economy is now viewed as one of the healthiest in Europe. Consider the iShares exchange-traded fund (ETF) entry for each of those two markets: The iShares MSCI Japan Index Fund (NYSE: EWJ) and the iShares MSCI Germany Index Fund (NYSE: EWG). They each warrant a look.

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The above was a guest post by Martin Hutchinson, Contributing Editor of Money Morning.

Intellectual Property In Hedge Fund Land

The following is a guest post from Ilene over at Phil's Stock World.

The Limits of Intellectual Property
Are There Any in the Hedge Fund World?

By Ilene at Phil's Stock World

So who is Eric Falkenstein and how did he become an ex-portfolio manager with no portfolio to manage?

Eric graduated from Northwestern with a PhD in economics and wrote his dissertation on cross sectional stock returns and volatility. Prior to joining Telluride as a hedge fund manager in 2004, he had been using strategies that drew upon his education, previous work running his own fund and a fund, Deephaven.

Eric resigned his position at Telluride in September, 2006. Several months later, Telluride initiated a lawsuit claiming that strategies used by Eric belonged to Telluride. The claims in the lawsuit would require a court to determine the nature of the components of the strategy Eric had been using and decide who owned them. This is more complicated than it may appear.

Consider this analogy. Baker E goes to work baking sugar cookies for Bakery B. E, who’s been a baker for ten years, has a favorite recipe calling for flour, butter, sugar, eggs and baking soda. During the next few years, E tinkers with the ratios of ingredients and experiments with chocolate frosting and colorful sprinkles, but never deviates significantly from the basic recipe.

Then one day, Baker E decides to leave Bakery B and open a Cookie Shoppe C in another town. Bakery B initiates legal action to prevent E from operating C, arguing that E’s cookie recipe will inevitably be derived from privileged information gained while working for B.

In response, Baker E argues that his recipe is a standard sugar cookie recipe, using common ingredients. He argues that B cannot own the sugar cookie constituents (sugar, flour, butter, etc.), and that B needs to define the specific recipe in its complaint. Bakery B argues they will provide that, after full discovery has been completed (which could be a few years).

And so began Eric’s adventure into IP law.

In a hedge fund “trade secret” case, the “ingredients” are variables used to construct a fund manager’s strategy, and the use of these variables may vary. In contrast to cookie baking, the manner in which the variables may be used are not obvious. Because the analysis is not intuitively understood by lay persons, any assertion by the complaining party may appear tenable.

Broad financial concepts of profitability, volatility, and mean-variance optimization and virtually any financial ratio or indicator may be particularly troublesome. While lawyers and courts are generally familiar with cookies, they are not familiar with hedge fund strategies. They must differentiate whether certain variables and their use are in the public domain or within the definition of a trade secret, and what kinds of ‘ideas’ fall under the confidential agreement. They might also need to decide whether the variables were used by the ex-employee prior to his work with the complaining party.

In Telluride Asset Management LLC v. Eric Falkenstein, Telluride claimed that Eric was violating his confidentiality agreement, which included trade secrets, but also ‘all inventions, discoveries, computer software programs, trade concepts, designs, patents, ideas … conceived or developed by Employee’ during his employment. Eric claimed his only planned overlap with his former work pertained to common tools, ones he used for a decade prior to his work at Telluride.

Eric’s story received some media attention from Megan Barnett in May of 2008. She wrote in “Cudgel Over the Quants,” Portfolio.com:

“Eric Falkenstein isn’t your typical 42-year-old hedge fund manager. Instead of trading stocks all day or courting new investors, he spends his time updating his blog, researching equity strategies, and talking to his lawyer. He’s a hedge fund portfolio manager who is legally restrained from managing hedge fund portfolios.

But Falkenstein didn’t embezzle funds, swindle unsuspecting investors, or violate insider-trading laws. Rather, he quit his job one September day in 2006 and he hasn’t been able to work since…

Welcome to the murky world of hedge fund trade secrets, where your likelihood of getting a new job may be directly related to your employer’s inclination toward litigation. These types of trade-secret suits are generating a controversy in the hedge fund industry. Is the litigation little more than a bullying tactic to keep valuable employees from heading to a competitor, as the blogger Equity Private suggests? Is the specific knowledge of trading strategies one gains at a hedge fund legitimately unusable in any future endeavor? Or are traders stealing secrets with the hopes of making more money from them someplace else?”

Trade secret suits are especially difficult to defend in many states because the trade secret does not have to be defined and can be changed after discovery ensues.

As anonymous blogger Private Equity commented on Eric’s case in “IP Litigation Arbitrage Tactics,” April, 2008:

Work for a hedge fund, perhaps as a quant, depart and try to work in the field again. Instead of attempting to directly enforce a non-compete agreement, the hedge fund might bring an intellectual property case based on trade secrets. Now the non-compete provisions, which on their own are not likely to work well, merely become further evidence of the former employee’s bad faith.

If you are a clever hedge fund, you will then seal your complaint, after all, it contains sensitive trade secrets. What sort of secrets? Let’s take an example, perhaps from a temporary restraining order [TRO] granted to Telluride Asset Management against their former employee, Eric Falkenstein….

And how might you, as a hedge fund in this position, respond to the suggestion that these factors and mean-variance optimization might be rather obviously in the "public domain" and therefore beyond enforcement as a "trade secret"? First, in your complaint, indicate that your trade secret is "a specific application of mean-variance optimization that will be defined after discovery." That will delay the argument until a fishing expedition can be conducted and a connection made. Then, insist that your former employee disclose the entire model to prove it doesn’t infringe…

Here’s the great part: As a hedge fund, you don’t even need to be granted the TRO. You merely file it and get discovery going. The effect is the same…

Discovery is key in the tactic. The hedge fund can insist on a core dump of, for example, every email the former employee has written since employment, including material from personal email accounts.

Well, sure, that’s painful, but no big deal. The former employee can just go back to work and make money to pay the defense lawyers. Sure, if you can find an employer willing to retain you and your methods when it might mean unlimited liability for every dollar you make for them thereafter…

For Eric, the experience was emotionally exhausting and extremely expensive. Telluride’s lawyers examined 10 years worth of data from his hard drives, including personal computers, emails, every aspect of Eric’s life as recorded on his computer and in trails of online activity. Because the specific ‘ideas/designs/trade secrets’ were not defined at the outset, lawyers searching for evidence of stolen IP could identify it after seeing all his data. Again, the search, productive or not, could take years.

"The nasty thing about intellectual property cases is that one can use it to start discovery on a broad scope of information, and then generate a post hoc definition of what is covered. The key is that overbreadth in technical matters is not obvious. For example, one can say, "he took the secret of mean-variance optimization", and by the time the court figures out such a claim is absurdly overbroad, a more tenable claim can be made, such as ‘a specific application of mean-variance optimization that will be defined after discovery’. To the defendant, both claims place all his activities as potentially poisoned, so the effect on the defendant’s ability to work is unabated. But to the court, the latter works as long as he has some deleted files on his home computer related to his work, and ‘related’ can be rather boring stuff that the court does not recognize as well-known, such as a spreadsheet with S&P returns and Excel formulae." Eric, Goldman Quant Case Continues, Falkenblog, August, 2009.

In addition, Eric was unemployable as a hedge fund manager while living and paying for his legal fees out of savings. These factors ultimately led to Eric filing a counter-claim and the suit being settled. Eric notes, "The settlement gives me complete freedom, but there’s a stain there. I could have burnt more money litigating, but my chances of receiving damages that would cover legal expenses and opportunity costs were small, and a final judgment would have given me no greater ability to ply my wares than the settlement.”

Interview: Present and Future.

Ilene: Thank you for filling in all the background information regarding your case. How was the claim against you eventually resolved?

Eric: At our final hearing where I got three counterclaims inserted into the case, the judge strongly suggested mediation. So, with the judge’s encouragement, we entered mediation and settled our dispute in a few hours. We agreed not to re-file our claims, and that I can use anything I used at Telluride going forward.

Ilene: They seemed willing to settle after you made certain counter-claims, what were they?

Eric: The main one was tortuous interference, i.e. that Telluride asserted its IP and contractual rights in bad faith and in a knowingly overbroad manner that directly affected a specific business deal.

Ilene: What were the components of your model–the variables you looked at which Telluride claimed constituted trade secrets, and which you claimed were variables you previously used and variables in the public domain?

Eric: In response to an inquiry by Telluride as to my proposed venture, I mentioned that the only similarities were common tools that I thought I had full right to use, factors like profitability, changes in equity, volatility, accruals, and the process of mean-variance optimization. I thought being explicit would make it clear I merely wanted to do what I had done previously, using factors I used before, factors that are well-known in the academic literature. This was incredibly naïve on my part. My disclosure was used as a prime exhibit in their complaint against me as ‘proof’ I was violating the confidentiality agreement. That is, I admitted using factors used at Telluride, and supposedly after they showed me how these factors work, my future use could not help but be derived from this privileged knowledge. To someone who has read the literature on these common factors, and how they were applied, this seemed insane, but to a judge it was not obvious, and once IP litigation starts, as a defendant you’re in the penalty box.

Ilene: Are you permitted to explain how your strategy worked?

Eric: There’s a sealed list of concepts they assert are their confidential information in our settlement. If I work with you I can explain in detail the specific concepts in dispute, as defined by Telluride, but not otherwise. It’s been several years, and I’m always working on new ideas, making these specifics totally uninteresting to me, so it’s really a moot point. The key is, I’m no longer a liability, because I bought a ‘perpetual license’ to these concepts (I paid secret amount ‘x’ for this license). I have a right to use anything Telluride could claim via my license.

Ilene: One aspect of this that is probably not generally appreciated is that after the settlement, it was difficult for you to find work. In fact, up until today, you’ve been unemployed and looking for work. Why was it so hard?

Eric: I cannot discuss my track record at Telluride. Thus, my largest datapoint as a portfolio manager was a black hole. Furthermore, larger institutions are especially wary of managers with ‘hair’ on them via working at large firms, or having engaged in litigation.

Ilene: If you could go back and do things differently, what would you change? What would you suggest to other hedge fund managers in a similar position to the position you were in?

Eric: Well, you can insulate yourself in various ways—negotiating ex ante that you can use your track record going forward, actually throw away any computers used contemporaneous to your employment, examine a potential employer for previous litigation tactics–but ultimately, it’s about judging people’s reasonableness. Like judging a date on how they treat the waiter, be aware of unreasonable behavior, and then ratchet your precautions accordingly. You don’t want to start every relationship assuming the worst but you need to be careful. The key to having good relationships is picking reasonable partners, as opposed to constructing a bunch of formal legal agreements. Good faith goes a long way.

Ilene: Yes, I agree – that’s certainly true in all relationships. If you could change the way the law deals with trade secret litigation, what changes would you recommend?

Eric: First, I would make firms define their trade secrets or specific concepts subject to any confidentiality agreement prior to discovery. I would also like a ‘loser pays’ rule, because you can win your lawsuit and still lose, because you cannot count on getting damages from a counter-claim. This happening is probably unlikely.

But here is a novel item worth noting. You can see the model I proposed when I came to Telluride, it is in the Hennepin County documents (unsealed). It presents a rather straightforward model based on several exclusionary rules, or sequence of sorts. For example, to simplify, say I arrived at Telluride with a strategy in which I construct a long portfolio by first targeting only firms with market caps greater than $500MM, then take those top 200 companies with the highest cash-flow, and then take the top 100 within that which had the best momentum. Now, Telluride basically argued I could not use these factors because they were inevitably derived from special knowledge acquired while at Telluride. The court eventually ruled they could not own these factors (profitability, accruals, capital issuance, and volatility) or processes (mean variance optimization) in general. So Telluride then merely said, we own them in a particular usage to be defined after discovery, and the court let them proceed on that path.

Implicitly, the court anticipated some set of applications of this logic would be forbidden by me, but it was never clear to me what they could then own in practice. That is, if I took the model above, and say changed it while I worked at Telluride so that I only used companies with market caps greater than $600MM, and the top 220 highest profitability, and then top 100 by momentum, how does that modification affect what I cannot do outside the firm given our confidentiality agreement? What about using $700MM as a cutoff, and 300 top cash flow firms? What if I used a new algorithm that, say, transformed cash flow and momentum into percentiles, then added those numbers together, and chose the top 100 for my longs? How is the line drawn in these cases for parameters and other algorithms use these same factors? It was never clear to me what the end game would look like, because if I enter a firm with an algorithm which uses a set of inputs, I clearly can use that, but then I make modest changes. If they own a family of things extrapolated from those changes, how is this determined? In an algorithm, you often can’t simply ‘split the difference’.

Or to take another example, I planned on using mean variance optimization going forward, and Telluride objected. After some months, the court agreed with me that they did not own this concept in general, but they could own it in some way they could define after looking through all my hard drives. Mean-variance optimization is very well known, and basically a way to generate portfolio weights. I could not imagine the provenance of the parameters could affect whether I use this very well known technique. It’s a well defined problem, so the solution is trivial. You can even buy software that does it.

I wonder how often people are constrained in this way, prevented from using common tools because these were used while working at a firm where they had signed a confidentiality agreement. You don’t hear about it much, but litigation databases are hard to search, and people don’t like to talk about it.

Ilene: I understand you wrote your book, Finding Alpha, during this period of time. Would you tell us a bit about your book?

Eric: Finding Alpha is about the search for ‘risk adjusted outperformance’, or alpha. My main argument is that the ‘risk adjustment’ is trivial because risk and return are not correlated, so the expected return on most assets should be the same. The absence of a risk premium in so many domains is not an anomaly, but an empirical fact, and I present a novel scope of information relevant to this. Further, this pattern is a consequence of a modification about how people internalize their wealth, which is relative to others, as opposed to comparing to having absolutely nothing. So it’s mainly an argument against the conventional theory that risk generates a positive return premium, and it gets into technical issues about utility functions. The practical application is you should only expect to make a return above, say, the BBB libor rate, by being smart, not merely taking some measure of risk.

This is a pretty profound difference from the standard theory. Some rather straightforward investment strategies are implied as having higher returns for the same level of volatility or beta if this is true. Also, as alpha is a risk adjusted return, and ‘risk’ is not unambiguously defined, there’s a lot of room for shenanigans.

Ilene: Speaking of shenanigans, do you have any thoughts about the Goldman Quant Case?

Eric: The fact this is considered a criminal, not a civil matter, highlights the political muscle of Goldman. From what I have read this ex-Goldman employee seems guilty, in that he came to Goldman with no trading experience, left with lots of code explicitly mentioned in various agreements, and suddenly was worth $1.2MM to a new employer. It seems rather incredible to believe be this programmer developed $1.2MM worth of alpha without appropriating Goldman’s IP.

Ilene: Did the financial meltdown of last year surprise you? Did your models (if you were still applying them) predict any kind of sudden market decline?

Eric: I did not see it coming, but the collapse tended to hurt firms that statistically underperform over the long run, and in that way is consistent with my models. However, the rebound this year did just the opposite, where the longer run losers have done especially well this year. That’s not inconsistent with my models, but in bear markets, the bad stocks (high volatility, low profitability, high capital issuance, negative momentum) do really, really badly, and the good stocks relatively better. In the snap back, however, the performance is strongly anomalous, though temporarily.

Ilene: Where do you think the market is headed now?

Eric: Up for stocks, down for Treasuries, up for corporate debt. I don’t like a lot of longer term signals, as I think government is ascendant in all sorts of bad ways that will hurt productivity growth in the long run. But that’s a long run effect. In the short run, people were expecting another Great Depression and that’s not going to happen, so banks and REITs have a lot of room for recovery.

Ilene: What are your plans next?

Eric: I just took a job with a local trading company, working on various quantitative projects. It’s a local option market making firm.

Ilene: Excited?

Eric: Sure, new opportunities are always exciting. When I stop getting excited, I’ll retire, or become a risk manager :-)

Ilene: Well, thank you Eric. I’ve certainly learned a lot and hope you’ve enjoyed sharing your experiences and thoughts with us.

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Note: For further reading, public documents filed on the case are online at http://www.efalken.com/papers/legaldocs.html.

Thanks again to Ilene for the guest post. You can check out other intriguing market articles over at Phil's Stock World.

Overcoming Madoff In Fund Management

A few weeks back, we bought you a guest post entitled, 'The Future of Hedge Funds.' Dwelling somewhat along the same lines of that topic, we have another guest post today for you examining how funds will overcome the sour taste Bernie Madoff and his ponzi scheme has left in investors mouths.

Below is a guest post by Elizabeth Harrin of TheGlassHammer.com, an "award-winning blog and online community created for women executives in finance, law, technology and big business."

“We have definitely seen a deterioration in potential investors because of Mr. Madoff’s activities,” says Tonya Powell, Principal at ELP Capital, Inc, investment company which specializes in real estate-secured assets. “The biggest issue is trust, and the almost automatic assumption created by the media that all fund managers may have participated in the same kind of activities.”

Judi Snyder, Partner at JP Snyder, Inc, a boutique financial planning firm, agrees. “Previously, people blindly trusted advisors and didn’t do their own research. This blind trust led to much of the current economic and investor climate.”

Both women’s firms are using multi-pronged approaches to win back consumer confidence. “There’s a fundamental shift – clients are demanding more education,” says Snyder. “I believe, however, Wall Street doesn’t necessarily want people to be educated.” This is a problem that Snyder’s firm is tackling head-on. “We give our clients homework,” she says. “We want them to do research, become educated and ask questions. We want them to take as long as they need to be comfortable with the investment options that we recommend.”

Communication is Key

To educate your clients you have to talk to them. “Even if the news is bad news, investors appreciate hearing from you,” says Nevada-based Powell. “We have done and will continue to conduct a series of webinars on our portfolio and consistent updates via mail and email so that everyone feels included. In addition, our CEO has literally been going through each and every investor with a personal call. Just hearing his voice has helped calm and reassure nearly every person.”

Powell advises that fund managers need to work out in the open. “Don’t hide,” she says. “Even though it may be easier to not want to take calls, answer emails, etc, if investors feel you are avoiding them, they will become even more nervous and potentially angry. Take their calls, answer their questions, pass along all news to them as best you can. By stepping up, assuming responsibility for that which you can, but also making sure boundaries are understood where you cannot fix the situation; it helps to create a much more friendly and smoother relationship between your company and your clients.” She also suggests that if investors want to meet face to face at the office and look through files for example, that this option – and anything else you can think of – is made available to them.

On the other side of the United States, in Florida, the story is the same. “Education and communication are the keys to helping the public better understand free market capitalism,” says Snyder, whose company is based out of Tampa.

Investors Must Do Their Homework

Snyder also believes that due diligence for investors is the way forward. “As an investor, if you don’t conduct due diligence, you are putting your life decisions into the hands of other people,” she says. “It takes time and work. We’ve seen the public adopt a victim mentality when they are let down by their advisors or when their investments perform poorly.” Snyder uses the example of someone buying a car to illustrate her point: “Most people do internet research to find the best car to buy,” she says. “A number of ‘consumer reports’ are likely to pop up. Most of the time, however, these studies are not independent, but are sponsored by an organization with a vested interest in the outcome – such as a particular auto manufacturer. The same holds true for financial instruments and strategies.” If potential clients don’t turn to the internet they might look to well-known media sources for information. “It is essential to take an objective look at who the advertisers and sponsors are behind these media giants,” adds Snyder, “and determine if there is an underlying slant or bias toward particular types of investments.”

With confidence in the financial markets at a low, now might not be the time to point out that investors who didn’t do their homework partly have themselves to blame. Powell believes that fund managers are also facing a challenge convincing clients that the firms are entitled to stay in the black when investors themselves may find themselves in financial difficulties. “It is both acceptable and right that a fund management company can and should continue to make money,” she says, “even if the clients have lost a portion of their portfolio.”

“Corporations are not the Godzilla-like monsters people often portray them as,” says Snyder. “They exist to provide goods and services to the world while making a profit. That is capitalism 101. The bottom-line is businesses keep people employed. If you vilify corporate profit – companies will be forced to shut down or move off-shore.”

Snyder advises that corporations should remind the public that they are made up of individual people: the CEO at ELP Capital calling every investor is a good example of this – it’s the human touch. “These people have names, faces and families,” says Snyder. “They are no different than anyone else. Each and every person has the right to make a living. Just as each corporation has the right to make a profit. Profits keep companies going during tough times, pay for research, help launch new products and services and keep the economy humming.” She recalls Citgo’s recent ad campaign. “It successfully focused on locally-owned retailers,” she explains. “By featuring these entrepreneurs in the campaign, it effectively tells the Citgo story by linking the corporation to every day people. These workers have a family, are supporting grandparents and putting kids through college.”

It’s a difficult message, but getting it across to the investor on the street is key to undoing some of the damage done since Madoff. “If there is no company to oversee their investments, then how do they expect to make any of their principal back?” asks Powell. “Hurting the company only hurts themselves, especially if it is small firm such as ours.”

The above was a guest post by Elizabeth Harrin of TheGlassHammer.com, an "award-winning blog and online community created for women executives in finance, law, technology and big business." Thanks to Elizabeth and the Glass Hammer team for a great piece and head's up on their blossoming community. Make sure to check out the earlier piece, The Future of Hedge Funds and to check out their community as well.

Doug Kass Calls Market Top For the Year

Noted shortseller and Seabreeze Partners hedge fund manager Doug Kass has had impeccable timing recently. Market timing is a b*tch, but Kass has flipped that statement upside-down and made the market his b*tch. Back on the March lows, Kass was calling 'the bottom' and buying when everyone else was calling for the end of the world. This time around, he's calling for a top in the market for the year and has been assembling a short position. His contrarianism is the polar opposite this time around as he writes, "To most investors, today the fear of being in has now been eclipsed by the fear of being out as the animal spirits are in full force. Bears are now scarce to nonexistent in the face of steady price gains in equity and credit prices. As if the movie is now being shown in reverse, the bull is persistent, stock corrections are remarkably shallow, cash reserves at mutual funds have been depleted, and hedge funds hold their highest net long positions in many moons."

We first noted Kass' bearishness a few weeks ago and he has since deepened his stance. He brings up great points and it really has all the elements of another great contrarian call. Time will tell and we'll wait and see. Back in the beginning of March, we penned a piece entitled, Ranting, Raving & Contrarian Signals to highlight the extreme bearish sentiment as if the world was imploding. We have been considering penning a piece again on this topic, only in reverse. Looks as if Kass has beat us to it and we'll gladly let him take that honor.

His point about mutual fund inflows is exactly what we were recently looking at as well and we tweeted about these inflows. Many a contrarian will say that when the retail/'dumb' money rushes in, it is time to get out. Another interesting statistic was the fact that hedge funds have had high net long exposures for the first time in forever. And, as we also tweeted about, hedge funds were *buying* financials hand over fist the past few quarters. Today, we also saw a unicorn and bigfoot; that's how crazy things have been getting.

In order for the market to truly recover, many fundamental problems must be addressed. Kass outlines his signs needed for a market recovery and it's a great reference to have. But in the mean time, he lists 10 things that will weigh on the economy:

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 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.

He ends this list by stating that he is looking, "over the visible green shoots of recovery toward a hostile assault of nonconventional factors that few business/credit cycles and even fewer investors have ever witnessed."

Now that you've seen the rationale for Kass' shift in sentiment, we now want to turn our focus to a timeline of Kass' sentiment as compiled by our friend FirstAdopter. We've mentioned our 'tweets' a few times in this article and we further want to highlight the utility of Twitter as it pertains to financial markets. The rest of this article is a guest post by FirstAdopter, whose blog and twitter we've been following for some time now.

Doug Kass is widely regarded as the guy that called the exact bottom in March by Barrons, New York Times, and CNBC anchors. Here are some tweets from his Twitter Feed. I will let them speak for themselves:

SP500 August 26th 12:17PM: 1027

SP500 August 10th: 1007

SP500 August 5th: 1003

SP500 July 28th: 980

SP500 July 22nd: 954

SP500 July 2nd: 896

SP500 June 19th: 921

SP500 May 8th: 929

SP500 April 29th: 874

SP500 April 16th: 865

SP500 March 26th: 833

SP500 March 18th: 794

Actual Low Close of SP500 March 9th: 677

SP500 February 26th: 753

SP500 February 18th: 788

SP500 February 12th: 835

So there you have it, Kass calls the top and is bearish for now. We'll wait and see if he has made not one, but two amazing market calls within the span of a year. Thanks again to FirstAdopter for the guest post. You can follow his blog here and his twitter here. Make sure to also follow @marketfolly on twitter and to follow @DougKass on twitter as well.

Hopefully this highlights the great quick insight you can gain in 140 characters or less via the Twitter platform. There's an entire finance focused group of posters on there (including yours truly) that has assembled via the great community at Stocktwits, so definitely check it out and join in (Also see our post on Stocktwits & Twitter here).

Last, but certainly not least, make sure you read Kass' latest piece where he elaborates on his 'top' call.