Why Hasn't Gold Skyrocketed After Clearing Resistance?

This is indeed a prudent question that needs addressing. We've been covering the move in gold on the blog with our technical analysis updates and paid special attention to when gold crossed the important psychological and technical resistance level of $1000. But since this big achievement, it hasn't done a whole lot. Why hasn't it skyrocketed yet?

The guys at MarketClub have identified an interesting pattern in the gold market that could possibly highlight why gold hasn't taken off yet given the fact that it broke out above longstanding resistance levels. Check out their technical analysis video here to see a possible explanation. They've noticed a pattern that gold trades in cycles where it will make a higher low every 84-90 days or so. Looking back to October of 2008, this cycle plays out for another potential higher low soon. This could potentially be a reason as to why gold isn't skyrocketing higher as near-term pressure could be weighing on the precious metal. It hit a tradable low in November 2008, January 2009, April 2009, and July 2009. That cyclical pattern points to this coming October next.

The long-term uptrend seems to still be intact, but there could be a trading range or pullback on a shorter timeframe. They also go on to highlight a similar cyclical pattern where gold could potentially be topping out every few months too, so make sure to check out the video for the full graphical representation and explanation.

Hedge Fund D.E. Shaw's Market Insight: Tracking Asset Class Returns Through the Crisis

In keeping with our theme of interesting hedge fund reports, here's an excellent 15 page report from hedge fund D.E. Shaw & Co entitled "Is It Better Yet? Charting the Course of Various Asset Classes Through a Global Financial Crisis." Just yesterday, we also posted up a theoretical and applicational piece from D.E. Shaw that focused on common trading mistakes and the consequences associated with them.

This time around, we're posting up a piece specific to this financial crisis as the 15 page document examines how various asset classes have performed in these hectic times. While the report was released back in July, it is obviously still timely given that we're not out of the woods yet. You can download D.E. Shaw's Market Insights here (.pdf).

Philip Falcone's Harbinger Sells Shares of New York Times (NYT), Leap Wireless (LEAP); Adds Mercer (MERC)

We've got a flurry of SEC filings from Philip Falcone's hedge fund Harbinger Capital Partners. While the update below covers their US equity positions, we just this morning updated their UK holdings for those interested. That aside, let's dive right into the US equity filings:

Firstly, Harbinger has filed an amended 13D on Leap Wireless (LEAP) and is now showing a 5.7% ownership stake with 4,451,100 shares. The filing was made due to activity on September 16th, 2009. It shows them selling shares on the 29th and 30th of July, as well as the 16th and 17th of September. The transactions occurred in their Master Fund and Special Situations Fund and here is a screenshot of their sales:

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Harbinger continues to sell shares of LEAP as we detailed their previous sales back in August. They had previously owned over a 9% ownership stake, so they have nearly cut their ownership stake in half since then.

Secondly, Philip Falcone's hedge fund also sold shares of The New York Times (NYT). Due to activity on September 17th, Harbinger filed an amended 13D on NYT and now show a 16.38% ownership stake with 23,538,434 shares. They sold 5,000,000 shares at a price of $8.25 on the 17th of September according to an SEC Form 4 filing, having previously owned a 20% stake. A spokesman for Harbinger addressed the sale by saying, "The New York Times is still a core holding, and the sale was done to take advantage of the strength in the market, to adjust the portfolio accordingly." They have sold these shares at a loss as they initially acquired their shares between $15-20 per share almost two years ago when they invested over $500 million.

In the past, we've covered the fact that Harbinger were open to hearing suitors for their NYT stake. As always, we'll continue to track developments in this regard. In addition to Harbinger, Mexican billionaire Carlos Slim has a hefty position in NYT. Taking a step back and looking at the macro picture, we've questioned whether newspapers are a dying industry. It's definitely a prudent question to ponder and the debate has been cataloged through various mediums. Shares of The New York Times traded way down to as low as $3.51 earlier this year.

Thirdly, in a 13G filed with the SEC, Harbinger is also showing a 5.5% ownership stake in Mercer (MERC). They hold 1,995,100 shares and the filing was made due to activity on September 9th, 2009. This is a new position for them as they did not hold it as of their latest 13F filing which discloses positions as of June 30th, 2009. So they have added these shares over the course of the past 3 months. And with that, we wrap up this portfolio update on Philip Falcone's fund. They've been quite busy recently as we also detailed their position in Spectrum Brands (SPEB) late last week. We also covered their 13D on SkyTerra for those interested as well.

Philip Falcone runs $6 billion Harbinger Capital Partners and while he has numerous equity positions, his background is in the distressed arena. When we saw Harbinger's portfolio, we noted that they had been out adding to natural resource plays amongst a slew of other activity. For more background on them and their portfolio holdings, check out our post on Harbinger here.

Taken from Google Finance,

Leap Wireless is "a wireless communications carrier that offers digital wireless service in the United States under the Cricket brand. Cricket service is offered by Cricket, a wholly owned subsidiary of Leap, and is also offered in Oregon by LCW Wireless Operations, LLC (LCW Operations), and in the upper Midwest by Denali Spectrum Operations, LLC (Denali Operations). Cricket owns an indirect 73.3% non-controlling interest in LCW Operations through a 73.3% non-controlling interest in LCW Wireless, LLC (LCW Wireless), and owns an indirect 82.5% non-controlling interest in Denali Operations through an 82.5% non-controlling interest in Denali Spectrum, LLC (Denali). At December 31, 2008, Cricket service was offered in 30 states and had approximately 3.8 million customers."

New York Times is "a diversified media company, including newspapers, Internet businesses, a radio station, investments in paper mills and other investments. The Company is organized in two segments: News Media Group and the About Group. Additionally, the Company owns equity interests in a Canadian newsprint company, a supercalendered paper manufacturing partnership in Maine, and Metro Boston LLC, which publishes a free daily newspaper in the greater Boston area. In February 2008, it acquired a 25% ownership interest in quadrantONE LLC, an online advertising network that sells bundled premium, targeted display advertising onto local newspaper and other Websites."

Mercer "operates in the pulp business and is a producer of market northern bleached softwood kraft (NBSK) pulp. The Company’s operations are located in Eastern Germany and Western Canada. It operates three NBSK pulp mills with a consolidated annual production capacity of approximately 1.5 million million air-dried metric tons (ADMTs): Rosenthal mill, Stendal mill and Celgar mill."

Hedge Fund Harbinger Capital's Activist Positions In UK Markets

Philip Falcone: Slow Moving Activism in the UK

This is yet another edition of our extended hedge fund portfolio tracking series where we are now tracking UK positions. Coinciding with another update later this morning, we're today focused on the holdings of Harbinger Capital Partners. Philip Falcone’s hedge fund has had two activist positions in UK companies for quite some time, owning Tate and Lyle as well as Inmarsat. In both cases, Harbinger’s efforts to unlock value are ongoing and are probably progressing more slowly than they would like. Both cases demonstrate that contrary to popular opinion, hedge fund activism often does not produce a quick buck. Instead, it often takes time and patience before paying off, as hedge fund activists either enter the position with a long-term focus or acquire one once assessing the situation.

Harbinger Capital Partners is an activist hedge fund that was founded in 2001 by Philip Falcone. Harbinger’s website says their strategy is to seek alpha-generating ideas that are uncorrelated to investment cycles. Harbinger looks for investments that fall into four categories:

1. Event – investments in companies where the Harbinger team identifies a significant opportunity to actively engage with a company to unlock value (activism).

2. Distressed/Bankruptcy – investments in companies that are already in default, in bankruptcy, or in some other stage of financial failure or distress.

3. Value – passive investments in securities where Harbinger believes a positive catalyst for value realization is already present.

4. Corporate Shorts – passive investments where Harbinger views the security to be overvalued or believes weakening fundamental trends or identifiable negative catalysts are apparent.

While Harbinger deals in equity markets, Falcone's roots are in distressed investing and he is opening a new fund to return to these roots. His investment style focuses on bankruptcies, proxy fights, and intensive credit research. We've been tracking their US equity positions for quite some time now and you can see their latest movements in this regard here. Additionally, we've just today updated some of their portfolio holdings too.

Now, let’s take a look at their UK holdings. Tate & Lyle is a manufacturer of food ingredients that are mainly made from corn and sugar cane.

The table below shows that Harbinger started accumulating shares of Tate and Lyle as long ago as January 2008. It is believed that Harbinger are seeking to push for a link with Bunge, a US food group in which Harbinger also has an interest. In June 2008, Bunge agreed a $4.8bn takeover of Corn Products International, the US corn sweeteners group. That fueled speculation that Bunge might be interested in buying Tate as well as it has a large corn-based food ingredients business in the US.

During 2008, Tate and Lyle’s then CEO, Iain Feguson, met with Philip Falcone several times and also talked with him on the phone fairly regularly. Ferguson has said that Falcone’s investment in Tate lies behind his habit of focusing on scarce assets that are hard to replicate. Ferguson noted that in the case of Tate & Lyle, the scarce assets are the US plants - including the new Fort Dodge plant in Iowa which is the first corn wet mill built for 12 years - and the company's access to valuable slots on the US rail system.

Tate and Lyle Plc	Symbol	Date	No. shares	% issued stock	Estimated price paid
	TATE	09/01/2008	25945000	5.6	na
		31/01/2008	46055909	10	482p
		06/02/2008	51505909	11.23	491p
		08/02/2008	55389320	12.01	489p
		13/02/2008	59489320	13	513p
		19/02/2008	65239320	14.3	502p
		21/02/2008	69811234	15.3	507p
		06/06/2008	74160669	16.2	440p
		19/06/2008	78138514	17.1	374p
		26/06/2008	83435025	18.2	395p
		01/07/2009	88297800	19.3	394p
		18/11/2008	85761931	18.7	367p
		26/11/2008	81649497	17.8	367p
		05/12/2008	77667106	16.9	395p
		12/12/2008	73384822	16	403p
		15/12/2008	72713213	15.86	412p
		19/12/2008	64602775	14.09	412p
		22/12/2008	63877775	13.9	400p
		04/03/2009	60037554	13.09	236p

As we have reported before, after an extremely successful 2007 in which they shorted subprime mortgage debt, Harbinger had a bad 2008 and were, like many hedge funds, inundated with redemption requests. Harbinger appear to have been forced to reduce some holdings, including the Tate and Lyle stake. The table shows that from a high of a 19% ownership stake in July 2008, Harbinger reduced their holding down to a 13% stake in March 2009, where it still stands today. Despite some press speculation that Harbinger would sell out of Tate and Lyle altogether, they appear for the time being to be continuing their efforts to bring Bunge and Tate & Lyle together. From the outside at least, not a lot appears to have changed since March of this year. The CEO, Iain Freguson, is in the process of being replaced by Javed Ahmed. It's difficult to attribute this management shift to Harbinger as one of Tate & Lyle’s other large shareholders, Invesco, has been campaigning for a change at the top for sometime.

Secondly, let's turn our focus to Harbinger's position in Immarsat:

Immarsat Plc	Symbol	03/01/2008	125142961	27.4	na
	ISAT	31/01/2008	129068751	28.2	464p
		04/03/2009	132041000	28.8	431p

Inmarsat was founded in1979 to ensure that ships could stay in contact by telephone. In 1999, they became the first intergovernmental organization to be transformed into a private company and in 2005 they were floated on the London Stock Exchange. Inmarsat offer a Broadband Global Area Network (BGAN) service that enables, among other things, TV broadcasters to beam breaking news live via videophone. In future they hope to offer a new service allowing mobile phone calls or text messages from aircraft transmitted via Inmarsat satellites to the ground.

Harbinger, in partnership with SkyTerra Communications (a US satellite company that they have a 48.5% stake in) has been interested in Inmarsat for some time. It is thought that Harbinger are looking to merge the spectrum holdings - the radio bands used for mobile communications - of Inmarsat and SkyTerra. SkyTerra has said that the spectrum owned by Inmarsat could be used by SkyTerra to provide "ubiquitous wireless coverage" in the US and Canada. Inmarsat’s view is that it is confident of its stand-alone prospects, but it intends to maintain a constructive relationship with Harbinger and SkyTerra.

Harbinger has not made a formal offer for Inmarsat because it needs to gain regulatory clearance for a deal first. Their intentions became clearer in July 2008 when the board of SkyTerra and Harbinger announced that they were seeking to make an offer to acquire the entire issued share capital of Inmarsat. Harbinger has given a so-called "reference price" for the possible bid of 535p, although it has stressed that this does not constitute a conditional bid price.

The approval process for the Inmarsat Change of Control Application is ongoing. Harbinger's expectations remain as stated in the July 2008 announcement and they think that approval is likely to take approximately 12-18 months from the date of that announcement. The regulatory process requires:

• approval from the U.S. Federal Communications Commission (FCC) for the transfer of control of the FCC licences held by subsidiaries of Inmarsat
• FCC approval for the transfer of control of the FCC licences held by SkyTerra Subsidiary LLC, an indirect subsidiary of SkyTerra
• approval under the FCC's foreign ownership limits for Harbinger to own up to 100% of SkyTerra.

So it looks to definitely be an ongoing situation that we'll keep track of as it unfolds. In addition to the two activist holdings, Harbinger also has what appears to be a passive, value orientated stake in Northern Petroleum.

Northern Petroleum	NOP	31/01/2008	7056014	10
		14/05/2008	3338006	4.71

Taken from Google Finance - Northern Petroleum Plc is an oil and gas production, development, exploration and asset trading company focused on areas in Europe. The Company is recognized as an Operator of both onshore and offshore projects. Its activity is mainly carried out in The Netherlands, Italy, United Kingdom and Guyane.

This is a part of our continued expansion of our hedge fund portfolio tracking series. For a brief primer on tracking positions that various funds hold in UK markets, head to our article here. For further coverage of UK positions that prominent hedge funds hold, make sure to check out our following coverage: Coatue Management's UK holdings, as well as Moore Capital Management's positions, Stephen Mandel's Lone Pine Capital UK holdings (and their recent movements as well), Sprott Asset Management's defensive UK portfolio, as well as Citadel's positions. Check back daily as we continue to cover some of the most prominent hedge funds in the game.

Market Insights From Hedge Fund D.E. Shaw & Co: Common Trading Mistakes

This is a first for Market Folly in that we've been able to track down some market insight from none other than hedge fund firm D.E. Shaw & Co. While the commentary is from July of this year, it is theoretical and applicational in nature so it's still very relevant. Not to mention, it's probably worth your time regardless, considering it is coming from a firm who has their hand in all different types of markets. After all, they are a hedge fund, a private equity firm, and technology development shop all rolled up into one.

This particular research report focuses on intuition versus reason. Additionally, it deals with analyzing trades and what they call the "time-portal" fallacy. It makes for interesting reading so definitely check it out as they delve into the topic of common trading mistakes and the consequences that follow. You can download the .pdf here. For more on DE Shaw, check out our recent portfolio coverage on them.

Where's the S&P 500 Headed? Here's What Two Technical Indicators Say

Here's a current S&P 500 technical analysis video that takes a look at two technical indicators colliding in the chart of the S&P 500. While the market was clearly downtrending throughout 2008, it is undeniably in an uptrend from March of this year until present. However, if you draw a trendline connecting the sequential lower highs from late 2007 until now, you'll find that the market is approaching a resistance level as determined by this downtrending resistance line. You can watch the video here to see this illustrated.

Additionally, if you setup a fibonacci retracement tool from the last highs of October 2007 to the lows in March of this year, you'll see something very interesting. The 50% retracement ends up at S&P 1,122 and could very well also serve as resistance. So, you essentially have areas overhead to worry about. And, we're dangerously close to those areas already. Again, here's the S&P 500 video. And if you're unfamiliar with fibonacci retracements, watch this educational video.

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Possible Current Long & Short Hedge Fund Strategies

There has been some interesting work coming out of Goldman Sachs as of late and we wanted to take a moment to highlight the latest piece we've stumbled across. If you missed it, make sure you check out their hedge fund trend monitor where they identify portfolio holdings across the hedge fund universe as well. Turning now to another recent report, we examine their piece entitled 'State of the Markets.' Members of Goldman Sachs' sales/trading desk have compiled possible current long & short strategies they are seeing in the markets. They touch on tradable themes and various other market opportunities. In particular, they focus on the topics of commercial real estate, balance sheets of public companies, Japan, the consumer and retail, as well as commodity and event-driven opportunities. Keep in mind that these thoughts do not reflect an official view of Goldman Sachs and are solely those of the sales/trading authors.

Drilling down those talking points, the main trading and hedging opportunities they see are derived from a notion that the combination of the housing bubble and equity market decline have essentially destroyed wealth (we touched on this theme way back in December). This leads to consumer debt repayment and a higher savings rate. Due to the economic malaise, elevated and prolonged unemployment becomes a real source of problems. In turn, you then see lower consumer spending. They've also identified a second theme to take advantage of: risk shifting to public balance sheets. Based on all of these notions, various members of Goldman Sachs' sales/trading desks have highlighted the following strategies as opportunistic within the context of the current market landscape:

- Short REIT Equities
- Buy AAA CMBS
- Buy FX Options on commodity linked currencies
- Buy Equities of non-US commodity producers
- Sell Caps on the US Tax Index
- Short JPY
- Buy Yen CMS Caps
- Short US consumer and retail companies (via equities or CDS)
- Sell Aluminum Caps
- Long crude oil vs short heating oil (short the crack spread)
- Engage in market neutral strategies (event-driven, etc)

As you can see, some of these strategies are obviously not executable by your average retail investor and that is why the piece is deemed possible hedge fund strategies. As such, we insert the necessary note of caution here: Don't trade anything you aren't familiar with. Nothing herein is a recommendation and we won't be responsible for your acts of stupidity when you decide to go leverage-happy trading FX options when you've barely even traded equities. Use your head with this stuff. More so than anything, we found their report to be intriguing and figured it was good food for thought. Acting like a lemming and just following whatever you read on the internet is not a smart investment strategy (in fact, it's not one at all). Just keep all this in mind when reading and do note our disclaimer at the bottom of the site.

Overall, this is definitely an interesting mix of possible hedge fund strategies being pursued in the current markets. (These strategies were compiled in August 2009). Since we typically focus on equity holdings of various hedge funds, we'll leave all the macro trades for another day and will instead focus on the equity strategies presented.

Firstly, we'll turn our attention to the proposed strategy of shorting REIT equities. This has already been widely discussed before as the collapse in commercial real estate intensifies by the day. Yet through equity dilutions-a-plenty, REIT equities have managed to stay afloat. The fundamental problems and macro picture duly noted, members of Goldman's team have identified an opportunity to capitalize on the divergence in commercial real estate price estimates between REIT equity and CMBS markets. They identify possible trade ideas as follows: short REIT equity, long CMBS through buying AAA CMBS or selling protection on AAA CMBX.

According to S&P's rating stress for CMBS, CRE values have apparently dropped 26% from their peak and could potentially drop another 20-30%. A few recent transactions have sold around 60-65% below the peak in 2007 prices. Not to mention, you have the awesome problem of store closings that could shut down numerous regional malls over an extended timeframe. It is all a domino effect as the consumer has been wounded from the economy. As the consumer goes, so does the retail sector. As retail slowly ceases to bask in their former profitable glory, commercial real estate property owners start to suffer from lost tenants, amongst other problems.

While US REITs have raised almost $13 billion in capital year to date (mainly courtesy of the equity dilutions we referenced earlier), they still might need $40-60 billion more to stay afloat and meet impending debt maturities. Despite property values falling and equity dilution, REIT share prices have continued to ramp up. REIT indices are up well over 50% since the lows in March, yet the problems in commercial real estate seem to be accelerating to the downside.

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If there is indeed a 25% mis-pricing in loss expectations for CRE, there could be further trouble ahead.

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An example of putting on the short portion of the trade would be to buy puts or put spreads on a REIT equity index or a basket of various REITs (they highlight retail and office REITs). You can either buy the put outright or sell a further out of the money put to create a put spread (and cheapen your cost). With put options, you define the amount you are willing to lose as opposed to shorting common where a stock can rally > 100%, compounding your losses. While this could potentially be an effective short strategy, you also have to keep in mind that they have also presented a long strategy that retail investors can't pursue. But, for those of you interested, the idea as referenced earlier is a long of AAA CMBS. Obviously the risk there is that if the loans cease to pay their mortgage payments, the value of the bond price could be impaired. In the past, we've covered how various hedge funds have been short REITs as this theme definitely looks to be in play. That about sums up the CRE play for now, and you can bet we aren't done hearing about the problems in this industry.


Secondly, we'll shift the focus to public balance sheet conditions. Goldman's team has identified strength in emerging market balance sheets as developed countries increase their public debt. As such, they have proposed shorting developed countries overloaded with debt and going long select emerging market economies. They also highlight the possibility to buy equities of non-US commodity producers or inflation proxy commodity indices.

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And another idea:

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While we don't typically cover currencies here, you could implement a makeshift version of this trade using currency baskets created with ETFs such as the Australian Dollar (FXA) and the Canadian Dollar (FXC). We've seen this theme (longing commodity producers) mentioned numerous times and we would venture a guess that hedge funds like John Burbank's Passport Capital have executed some form of this trade (we've also covered their curve steepener play in the past too). Commodities definitely have piqued the interest of many this year (especially Jim Rogers) so we'll continue to keep track of that trend.


Lastly, we want to cover the theme of lower consumer spending as it pertains to the retail sector. This theme is relatively straightforward as a weaker economic outlook will impact the consumer. This obviously hurts participants in the retail sector and Goldman's team highlights a possibility of buying 6 month or 1 year put spreads on the S&P Retail Select Index (you could also sell a Call to cheapen the option). Buying protection on an individual retailer or basket of names would make sense should consumer spending drop off due to continued weakness in the economy.

They postulate that we could be seeing a structural ( rather than cyclical) change as it relates to consumer spending. While many will argue that the American consumer is the engine that somehow miraculously keeps on chugging, it's tough to argue with the fact that the US household has lost 23% in net wealth over the past 18 months (totaling over $14 trillion).

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Yet, similar to REIT equities, retail equities are up massively from their lows.

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Unemployment continues to rise and the economy is by no means 'in the clear' yet. Many macro hedge funds (Clarium Capital, Tudor Investment Corp) will be quick to highlight unemployment as a main contributor to continued pain. Can consumer spending go back to normal at the drop of a hat? We'll have to wait and see if the giant American consumption machine will be fettered by the continued effects of the recession.


Overall, very relevant propositions as it pertains to possible hedge fund strategies in the current markets. Keep in mind that these are not recommendations and do not represent the views of Goldman Sachs (or Market Folly either for that matter). If you missed the previous hedge fund report out of Goldman, it is definitely worth reading. Their hedge fund trend monitor surveys the hedge fund portfolio landscape much as we do here at Market Folly. For more on hedge fund holdings, make sure to check out our hedge fund portfolio tracking series as well.

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.

****

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.

Band of Analysts: Learn From Hedge Fund Analysts

Given the fact that many of our readers are hedge fund managers, analysts, traders and the like, we're always looking to share resources that are specific to this industry niche. At the same time, we also recognize that we have a large amount of readers who are passionate investors, employed in some other branch of finance, or are simply looking to break into the hedge fund industry. This resource is aimed directly at those readers. Here's your chance to learn from hedge fund analysts themselves in order to hone your understanding of fundamentals. It serves to bridge the gap between retail investing and the type of methodologies employed at many of the hedge funds we track here at Market Folly. Upon discovering this resource, we made it a priority to arrange a discount exclusively for our readers as the Band of Analysts team are Market Folly readers themselves. So, we are proud to offer you an exclusive 30% recurring discount to Band of Analysts with the code: MFolly.

Band of Analysts is a community of hedge fund analysts committed to sharing experience, knowledge, and most importantly, ideas. They give you access to the actual Excel financial models, Powerpoint presentations, and various other related materials regarding an actionable investment idea. Regardless of whether you're working in the hedgie world or not, this is an excellent resource. You can see an example of one of the Powerpoint presentations here. That lesson discusses event-driven investing with a particular focus on binary outcomes using CIT Group as an example. This is just one type of the many analytical resources that get posted on the site.

Undoubtedly, many of you are familiar with sites like SumZero or the Value Investor's Club. These communities are great tools to share your investment ideas, read others' picks and interact with each other. Given their exclusivity though, those sites are often reserved for industry professionals. Band of Analysts looks to break down that barrier by letting you learn from hedge fund analysts themselves. Their videos are literally as if you're looking over the shoulder of a hedge fund analyst as they explain their work. These serve as a great starting place to jump right into in-depth fundamental research. Secondly, they also offer many educational videos analyzing current situations. This is all on top of the discussion forums where community members can interact and really discuss what they're seeing in the markets. Their focus is on those of you looking to bridge the gap from retail to professional investor or from an associate in the financial world to an analyst at a hedge fund or major financial firm. We think their resource is an ideal fit for that portion of our reading audience and so that's why we wanted to share it with you.

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Hedge Fund Harbinger Capital Files 13D on Spectrum Brands (SPEB)

In an SEC filing made due to activity on August 28th, 2009, Philip Falcone's hedge fund firm Harbinger Capital Partners has disclosed a 42% ownership stake in Spectrum Brands (SPEB). Their 13D shows that they now own 12,604,216 shares.

This filing is interesting because it details how SPEB filed for reorganization relief under Chapter 11 bankruptcy back in February. Then just recently back in late August the plan became active. When this occurred, SPEB's old common stock and their various notes (some of which Harbinger owned) were deemed surrendered and exchanged for an aggregate of 11,405,281 shares to Harbinger. SPEB then issued an additional 2,970,000 shares to participants in a supplemental loan to the issuer in consideration for their participation. Due to their participation, Harbinger received a total of 1,198,395 additional shares. This brings you to the grand total of shares listed at the beginning of this article. This 13D is unique in that it gives us a glimpse as to how Phil Falcone has gone back to his distressed roots and invested Harbinger's capital in such a transaction. Check out the rest of Falcone's holdings in an article where we recently covered Harbinger's portfolio.

We also want to highlight that fellow hedge fund D.E. Shaw & Co recently filed a 13G on Spectrum Brands as well. In their filing, David Shaw's firm disclosed they now have a 14% ownership stake. So while D.E. Shaw has opted for a passive stake with their 13G, Harbinger's filing is a 13D and has represented an activist stake where they can press for change at the company.

Harbinger Capital Partners is a $6 billion hedge fund ran by Philip Falcone. While Harbinger deals in equity markets, Falcone's roots are in distressed investing and he is opening a new fund to return to these roots. His investment style focuses on bankruptcies (as evidenced above), proxy fights, and intensive research on credit. Since their equity positions are easily tracked via SEC filing, we've kept tabs on their moves in this regard for some time now. In terms of recent activity, Harbinger has been decreasing their position in Cliffs Natural Resources (CLF), dumping some of their Calpine (CPN), and most recently amended their 13D on SkyTerra. Last, but certainly not least, they've also been selling shares of Solutia (SOA) as if it were going out of style.

Taken from their company website, Spectrum Brands includes brands such as 8 in 1, Cutter, Jungle Labs, Rayovac, Remington, Schultz, and more.

Don Coxe's Basic Points - September 2009 Market Commentary

Market strategist Don Coxe is back with his 'Basic Points' for September 2009 and we have embedded them below. Alternatively, you can download the .pdf here. We've typically covered Coxe's commentary in months prior but after a brief hiatus on our part, we're back with his latest edition. If you're interested in his past work as well, you can view his June commentary here and an excellent question and answer session with Coxe himself.

If you're not familiar with Coxe, he's a market strategist and has quite a large following due to his opinions and forecasting. He currently likes commodities, precious metals and the like. He is an agriculture bull and actually shares a lot of views with that of legendary investor Jim Rogers (we've covered Rogers' market thoughts in the past as well).

RSS& Email readers: come to the blog to view the embedded document.

Don Coxe Basic Points Sept 2009

What We're Reading 9/18/09

Why the Natural Gas Fund (UNG) is issuing new units [FT Alphaville]

Evaluating S&P fair value target [Peridot Capitalist]

How the giants of finance shrunk, then grew, under the financial crisis - animated graphic [NY Times]

The nightmare portfolio of 2009 [Money & Co] ~ Alternatively, you could have just been net short with leverage... that'd be pretty abysmal as well.

Rail traffic continues to show weakness [My Investing Notebook]

A new era of hedge fund transparency? [zero hedge]

Value Investing Congress (VIC) Discount: MF Readers Save $800

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Clear your schedules and get your firm to pay for your admission so that you can hear the likes of Julian Robertson, David Einhorn, Bill Ackman, Eric Sprott, Whitney Tilson and many more speak. We cover these managers every single month on the blog and here's your chance to gain insight directly from them at the conference. Not to mention, this is an awesome event to network at as you'll meet plenty of great people to connect with. The schedule of the event is as follows: On Sunday (Oct 18th) there is an optional workshop from 8 AM to 5 PM: An Advanced Seminar on Value Investing. Then on Monday (Oct 19th) the main event begins as the Congress runs from 8:45 AM to 5 PM, followed by a networking cocktail reception. Then on Tuesday (Oct 20th) the Congress picks up again from 8:45 AM til 4 PM.

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Hedge Fund Coatue Management Files 13G on Silicon Motion Technology (SIMO)

In keeping with the theme of tracking Coatue Management's portfolio, we wanted to also post up their most recent portfolio activity as indicated by SEC filings. Since we hadn't been tracking them in-depth, we need to play a little bit for catch-up here. Philippe Laffont's hedge fund filed a 13G on Silicon Motion Technology (SIMO). They disclosed a 7.4% ownership stake in the company with 2,067,014 shares. This is an increase from their previous 795,514 shares reported on their most recent 13F filing (which shows holdings as of June 30th, 2009). As such, in the past 3 months Coatue has significantly boosted their SIMO stake. Just yesterday, we disclosed some of Coatue's positions in UK markets.

Coatue is a long/short equity hedge fund in the true sense of the definition. They specialize in technology, media and telecom. Fund manager Philippe Laffont is a 'Tiger Cub' and worked for Julian Robertson at Tiger Management. Now running his own fund, Laffont focuses on in-depth proprietary research of individual companies and sectors. Head over to our background post on Laffont and Coatue for more information on them.

Taken from Google Finance, Silicon Motion Technology is "a fabless semiconductor company that designs, develops and markets, high-performance, low-power semiconductor solutions for the multimedia consumer electronics market. It has three product lines: mobile storage business, multimedia systems-on-a-chip (SoC) business, and mobile communications business."

S&P500: Highest Level Above Its 200-Day Moving Average In 25+ Years

Pardon the terse posts that only include a single chart lately, but they really speak for themselves. Hat tip again to the great folks over at Bespoke for generating this great research as always. They've highlighted the fact that the S&P 500 is now more than 20% above its 200 day moving average on the chart. Now, this would be all fine and dandy except for one thing: this hasn't happened in 25 years! The last time this happened? May 1983. What's even more interesting is that back then the market still continued to rally after breaching that threshold.

(click to enlarge)

This is yet another awesome fact to add to our statistics-that-make-us-cautious list (which by the way just keeps growing). After all, just a few days ago we highlighted that short interest is at the lowest level in over 2 years. Not to mention, many of the smart hedge fund minds we track on the blog have become skeptical of the rally as well, as legendary trader Paul Tudor Jones has called this a bear market rally. Additionally, other global macro firms like Clarium Capital are skeptical of the recovery.

Nevermind the fact that we are also seeing a multi-day rally of strange proportions. If the S&P were to close up 9 days in a row, that would be quite a rare occurrence. Pull up a chart of the S&P and you'll be a bit amazed. This feat has occurred a handful of times, with the most recent being in 2004 (thanks to tendollartommy for the data correction). Nothing goes up in a straight line. Well, nothing that isn't on LSD, ecstasy, bionic, turbo or whatever the kids are calling drugs these days. Then look at the rally on the chart below that preceded the current one. After going near vertical from S&P 880to 980, it still slowly chugged along up to 1010. While we don't think anyone would argue with the fact that the market is due for a pullback, it continues to defy odds and rationality. After all, the market can remain irrational longer than you can remain solvent. At the very least, we've become more cautious.

(click to enlarge)

Back on March 8th, 2009, we penned a piece entitled 'Ranting, Raving & Contrarian Signals' highlighting the ubiquitous negativity in the markets and noted that it might be a prudent time to take a contrarian viewpoint. Little did we know that our article would be published merely a few days after the market bottomed (for now at least). Now, with all the data we've been seeing, we are slowly starting to get the contrarian itch again. Maybe it's time to pen another piece, this time in the opposite direction. After all, the economy has completely recovered because Dennis Kneale said so, right?