Economic & Market Update: February 2, 2009

“It’s Groundhog Day and the Economy Sees its Shadow”

The Fortigent Investment Research Team

Last Week’s Highlights:

Consumer Confidence:            37.7 – record low as confidence continues to evaporate

FOMC:                                      Fed looking to buy longer date Treasuries 

GDP:                                         -3.8% – not as bad as expected on the surface

Stocks:                                       826 – stock close out the worst January on record

Bonds:                                        2.9% – weakness due to a host of economic issues

Oil:                                             $41 – weak economy reducing demand

Dollar/Euro:                             $1.28 – Europe in for an equally difficult ride

Economics This Week:

Date      Item                                    Est.              Comment

2/2        Personal Spending:    -0.9%              Consumers retrenching in a big way

2/5        Factory Orders:            -3.0%              Orders dissipating

2/6        Nonfarm Payrolls:       -500k              Mass layoffs continue

2/6        Unemployment Rate:   7.5%              Economic picture deteriorates

Six More Weeks of Winter (and Probably a Lot More of Recession)

Punxsutawney Phil – the world’s most famous groundhog – saw his shadow this morning, indicating at least six more weeks of winter. Things don’t look so good for the economy, either.

Last Monday brought awful news, as the human toll of the recession became all too apparent – by our count, major corporations announced more than 75k job cuts. For the week, the number was over 100k job cuts and led to a hard realization that the pace and severity of the recession is still accelerating. The consensus opinion is that unemployment will peak sometime this summer at around 9% - 10% – levels we have not seen since the deep recession of 1982.

The other important, yet somewhat deceiving, number of the week was the GDP report released on Friday. On the surface, the decline of 3.8% was better than the expected decline of 5.5%, but the primary contributor to the better than expected number was an excess build up in inventories. Strip out the inventory build up and suddenly we have a decline of 5.1%. Regardless of that fact, the decline was considerable and marked the biggest contraction since – there is that year again – 1982.   

Post Hoc Ergo Propter Hoc (or, the fallacy of “after this therefore because of this”)

The end of the week (and the end of the trading month) also marked this January’s dubious honor of being the worst January on record for stocks. While we do not place much stock (pun intended) in “The January Effect” and so won’t read too much into the data, we will point out that in 26 of the past 30 years, January accurately predicted the trajectory of equities through year-end. Since we are briefly highlighting potentially specious cause-and-effect phenomena, we also glumly note that the AFC won the Super Bowl last night, which supposedly signals a down year for stocks. It was a great game, though, and we send our congratulations to the Steelers.

Politicians on the Warpath

President Obama’s stimulus package wound through the House of Representatives this week, ominously passing on a straight party line vote. Republicans complained of not being consulted on the bill and House Leader Nancy Pelosi famously responded, “Yes, we wrote the bill. Yes, we won the election.” So much for bipartisanship.

The echo of doubt surrounding the effectiveness of the proposed stimulus package grows louder, with the situation feeling eerily similar to the passage of the TARP bill – proponents were eager to push the bill through as long as their pet projects were included, only later stopping to question, “What Just Happened?”

The stimulus bill may face problems in the Senate and/or then back in the joint committee as it becomes increasingly clear that it contains more special interest and congressional pork than anything that might actually stimulate the economy. Even some Democrats (the so-called fiscally conservative “Blue Dogs”) are complaining, and Republicans are firing back by suggesting that, since concern about budget deficits is off the table in the current economic crisis, why not simply cut taxes and give the money directly to consumers and companies, rather than transfer it through the “leaky bucket” of governmental intermediation? We think that is a very good question.

Tastes Great vs. Less Filling (Spending Spree vs. Tax Cuts)

The biggest debate on the stimulus package is the delicate balancing act between tax cuts and infrastructure spending. Republicans are obviously pushing for a larger portion of tax cuts, believing that these will have a more immediate impact on consumer spending.

Unfortunately, what may have worked in the past might not work this time around. Tax cuts are quickly and easily executed, but consumers and businesses alike are shutting off the spending spigot at a much faster pace than we have previously witnessed.  

Source:  Briefing.com

On the flip side, some within Obama’s camp are estimating that the infrastructure component of the stimulus package would create anywhere from 3-4 million new jobs. Assuming that is true, and also assuming that more than a handful of the proposed projects are, indeed, “shovel ready”, the consensus still is that any real stimulation to the economy won’t take effect until 2010 at the earliest.

Voters hate pork in the abstract but love it in the concrete – that is, when they are the beneficiaries. So you can’t really blame politicians for porking up the stimulus bill – it’s what gets them re-elected. In other words, you shouldn’t get mad at a dog for scratching himself – that’s what he does.

But since we all know that to be the case, why does anyone think this time will be any different? We continue to hope that President Obama and his Administration can actually deliver the “change” he promised in his campaign. So far, however (and, admittedly, it’s only been two weeks), it seems to be politics as usual in Washington.   

Getting the “Bad Bank” Off the Ground

Another looming problem for the administration has been the indecision surrounding the creation of a “bad bank” to soak up deteriorating loans from bank balance sheets. Early in the week, financial stocks rallied on news leaks that the administration was going to create an institution under the FDIC to purchase these assets. That excitement subsided quickly as Vice President Biden acknowledged that the idea was “premature”.

It may be remembered that the original TARP concept was to purchase toxic assets from the banks, but this idea quickly floundered on an inability to accurately price the bad assets. The plan then quickly morphed to direct capital infusions into the banks.

Now we are circling back (via the “bad bank” idea) to buying toxic assets – but the original problem of accurate price discovery still exists. Until this issue is resolved the “bad bank” concept remains a promising theory in search of a practical solution.

With All Due Respect, Mr. Swensen, We Disagree

The esteemed investor and Yale Endowment CIO, David Swensen, has become quite vocal in recent weeks and seems rather hell-bent on discrediting the hedge fund industry, notably the fund-of-funds model. More than 20 years ago, Swensen turned the traditional allocation model (50% domestic equity, 40% bonds and cash and 10% alternatives) on its head and almost single-handedly created what we now term the “endowment model” (a broadly diversified mix of traditional, non-traditional, and real assets). The performance of the Yale Endowment has been nothing short of spectacular since Mr. Swensen took the helm (with a noticeable hiccup over the past 6 months). So when Mr. Swensen speaks, we like to listen.

But in recent interviews he has been caustic and dismissive about the “average” investors’ use of hedge funds, and on this point we respectfully disagree.

Here is an excerpt of a January 14th interview with Mr. Swensen, followed by our own thoughts as to why he is…well…just wrong. 

“Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital... You need to be in the top 10% of hedge funds to succeed.”

Hedge funds attract many of the best and brightest investment professionals in the world – nowhere else do they have more freedom to exercise their investment acumen and potentially be handsomely rewarded for success. That statement applies to fund of fund managers as well as single strategy managers. But many of the best hedge funds are either closed to new investors or have investment minimums that put them out of reach to most investors – except through funds of funds.

Without funds of funds, most investors would not have access to these high quality investment professionals (because of high minimums or simply lack of access). Does Mr. Swensen believe that only multi-billion dollar endowments should be able to invest with the very best investment professionals? Or is Mr. Swensen simply suggesting that anyone who doesn’t have assets and professional resources comparable to his are “ignorant”?

To ask these questions is to answer them – of course not.

We also think it worthwhile to point out that one of the important by-products of the recent hedge fund performance downturn is the number of top-tier managers who have re-opened to new capital. As evidenced by the chart below, a number of 5-star rated hedge funds (as determined by Morningstar) witnessed massive redemptions during the months of October and November, and we highly suspect that number increased in December. This was partially due, of course, to poor performance. But another huge factor was the lack of liquidity of many market participants, who correctly surmised that the only place to get cash was from the managers with the most liquid and highest performing portfolios.  

Source:  allaboutalpha.com

This is leading many of the largest and most successful managers to re-open their funds to new investment. If investors can handle the relative illiquidity (compared to more traditional investments) that comes with some of these strategies, this represents – potentially – a wonderful investment opportunity. 

The hedge fund industry has survived previous periods of duress (albeit not necessarily of this magnitude), such as the collapse of the European Exchange Rate Mechanism in 1992, the Asian financial crisis in 1997, the disintegration of Long-Term Capital Management in 1998, and the technology bubble in 2001. A period of inevitable retrenchment will benefit the remaining participants, as it will shake out of the system those many unskilled managers who infiltrated the hedge fund community under the sanguine liquidity, leverage, and market conditions of the past 5 years. We expect to see some serious Economic Darwinism within the hedge fund community, but we believe the end result will be a stronger investment “space” that will present very interesting opportunities to investors.

Source: HFR Research and InsideMoneyTalk

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