Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

Hedge Fund Greats Disappearing

Montreal, Canada

News that Stanley Druckenmiller was calling it quits after thirty years in the hedge fund business came as a big surprise to investors. His departure accelerates the list of legendary hedge fund managers closing shop and heading for less stressful pastures in the post-2008 credit crisis environment whereby macro trades have grown difficult to execute profitably.

Druckenmiller joins other legendary macro traders heading into retirement, including Julian Robertson (2001), Tim Barakett (2009) and recently, Richard Grubman.

Druckenmiller, who worked for hedge fund titan, George Soros, claims he's paid a "high emotional toll" recently for trailing benchmarks and certainly falling behind his blistering track record of generating 30% annually since 1990. In 2010, Druckenmiller's Duquesne Fund, closed to new investors since 2000, is down about 5%.

To be sure, Druckemiller has already made billions of dollars. The 57-year-old doesn't need the market. But it seems more hedge fund managers are leaving the ranks as the thrill to produce profits fades in an age of rising global dislocations, institutional counter-party risks, violent and choppy trading and tough calls on macro trades.

Fifteen years ago, I poured everything I managed into hedge funds – mostly guys like Soros, Druckemiller, Zweig, Bacon and, especially, Julian Robertson. I also invested in distressed debt, bankruptcy reorganization and event-driven strategies. Those strategies largely worked well producing compound returns of about 8% to 10% per annum after all fees.

But over the past several years I've grown extremely disenchanted with hedge fund investing because, for the most part, these guys really don't beat the market. The sector crashed almost 20% in 2008 as most managers were caught long or simply didn't know how to effectively short the market – unlike the legends listed above. Worse, many funds imposed gates or lock-ups on capital starting in late 2008 and extended advance redemption notices to 90 days ahead of each quarter – making it almost forever to get your money back once the redemption notice was delivered to the hedge fund.

Also, too many entrepreneurs were launching hedge funds after 2000 and that alone meant trouble. How many smart MBAs are really out there?

These days, I'm bullish on managed futures, or Commodity Trading Advisors. The asset class manages about $275 billion dollars (much smaller than hedge funds at about $2 trillion dollars) but, unlike hedge funds, trade mostly on a systematic basis employing market-based trend-following strategies. No hunches or guru stubbornness here; CTAs use trend-following systems to ride markets long or short. They also trade in over 100 world markets 24-hours per day.

Managed futures are coming off a bad year in 2009 and continue to show only modest gains this year. But, when volatility breaks loose, these guys rally hard. In 2008, CTAs gained about 17% as world markets crashed 40%.

Hedge funds still belong in a diversified portfolio. Some strategies remain compelling, especially bankruptcy reorganization amid a struggling economic recovery. Yet, I think the glory days for this sector at the macro level is about over. Once Soros finally retires, that'll mark the end of what was once a glorious period for hedge fund macro strategies in the 1980s and 1990s.

Who’s Buying TIPS?

Montreal, Canada

Who's buying Treasury Inflation-Protected Securities or TIPS? Rates are at rock bottom and inflation is falling, not rising.

For the first time since their introduction in 1997, TIPS now harbor the lowest yields.

Yesterday, the five-year TIPS closed the session yielding nothing – that's right, absolutely zero. At this morning's opening, the note has dropped a bit to yield a mind-blowing 0.06% or six basis points! That's not exactly the Field of Dreams when it comes to yield.

The break-even rate, calculated by subtracting the nominal Treasury bond rate less TIPS' yield, is just 1.36%. Nominal five-year Treasury bonds yield 1.42%.

In 2010, the total return of the Vanguard Inflation-Protected Fund is 5.6%; that's an enigma because inflation expectations have literally crashed since May when benchmark ten-year Treasury bonds yielded about 4%. Investors buy TIPS because they seek inflation protection – not a deflation hedge. Or perhaps this is not the case…

Benchmark ten-year TIPS yield 0.94% and, adjusted for the break-even compared to nominal Treasury bonds, which yield 2.61%, pay just 1.67%. That means the market expects an average ten-year inflation rate of just 1.67% from now until 2020.

Who is buying TIPS in this accelerated environment of disinflation?

TIPS provide an absolute floor even amid deflation. TIPS can't yield less than zero whereas nominal bonds can -- if demand is strong enough to drive rates into negative territory. This occurred in the 1930s. But TIPS are attractive for this reason: Yields can't go into minus territory. That would explain why investors continue to bid TIPS prices higher even though deflation fears have mounted since May.

From my end, I would not buy TIPS now. I wouldn't lunge after non-TIPS fixed-income securities, either.

We've had an explosive rally in bonds since May and prices right across the curve are really expensive. TIPS aren't cheap and offer a raw deal. Ultimately, higher inflation down the road might draw interest from bond investors into these securities; but what's the point if interest rates are rapidly rising? Who'll want to buy TIPS? If anything, Treasury bills will draw the bulk of fund-flows, not bonds or TIPS as rates eventually rise.

TIPS are not forecasting an inflation problem any time soon. Recent price action, however, might be a deflationary strategy now in-play among bond investors as they seek to hedge not against inflation, but deflation.

Germany Comes out Swinging in Q2

Montreal, Canada

Among the major industrialized economies, Germany ranks as one of the best performing economies this year in the G-7. A plunging EUR in 2010 has been a boon to exports, which grew 29% in June compared to 12 months earlier.

German GDP in the second quarter expanded by 2.2%, almost 9% on an annualized basis – the best performance since reunification 20 years ago. Germany had a trade surplus of $77 billion dollars for the first five months of the year, according to latest statistics.

German stocks, as measured by the Frankfurt DAX Index, have also been among the best performers in Europe this year and have over the last 12 months shown a 17.5% total return in EUR. On most days when European stocks rise, German blue-chips usually fare better and also have managed to decline less on days when equities are hammered.

German stocks sell at 16 times trailing earnings and yield 2.7%. The DAX remains about 27% below its all-time high.

Major German exporters like Siemens, BASF, Daimler, Hochtief and Volkswagen have witnessed a surge in sales – mainly to the emerging markets.

More than any other eurozone exporter, Germany is home to the largest concentration of manufacturing powerhouses; China was primarily responsible for the big rise in industrial orders during the first half as infrastructure projects boost demand for high-end German engineering.

A sharply lower EUR has propped up German exports and should continue to support the broader economy even as spending cuts curtail government outlays. Stocks are vulnerable to more selling pressure this summer as credit and banking fears dominate global markets. A correction will provide a better entry point this fall for value investors coupled with a weaker EUR. Germany looks brightest among the G-7 along with Canada. Wait for cheaper prices.

Growing Liquidity Trap Forces Fed’s Hand

Zurich, Switzerland

The odds were always high that one or more central banks would eventually bungle monetary or fiscal policy in the post-2009 credit crisis recovery environment. In the context of the most formidable and extensive unorthodox monetary operations since the 1930s, the Federal Reserve has seemingly pulled almost every rabbit out of its hat since August 2007.

Did investors really believe we'd get through this mess without a hiccup?

Another liquidity trap might be at the cusp of testing the Fed this summer as Treasury bond prices surge and risk assets commence another leg south.

Two-year notes are approaching record lows and suggest the Fed needs to act. Long-term rates, as measured by the benchmark ten-year T-bond, have seen yields crash from 4% in April to 2.72% this morning. This action is a warning shot for the Fed as the economy continues to cool since May, compounded by credit stress in bank lending and a deep bear market in the housing sector.

It's been a rough year for most investors outside the confines of fixed-income securities as wild gyrations in equities, commodities and currencies challenge even the best hedge funds in the business.

After a strong bounce in July most indexes are now down again in 2010 following a sobering Wednesday whereby the averages fell about 2.5%. As Dugald pointed out yesterday, the U.S. broader market looks like it's rolling over again; but we've already seen two similar breakdowns since May with neither bulls nor bears really making any serious money amid a volatile trading range.

The Fed, acting as the printing machine of only resort, announced QE2, another round of quantitative easing, this week as the central bank takes the interest from its vast pool of mortgage-backed securities and begins buying the long-end of the Treasury market. The Fed wants to keep long-term interest rates down. By throwing another few hundred billion dollars at the curve, the Fed is expanding its bloated balance sheet again in its effort to grow liquidity in areas of the economy that need it most.

Banks in the United States don't seem bullish on lending. And the best customers don't seem too bullish about borrowing. Companies outside of the financial sector are sitting on roughly $1.8 trillion dollars of cash and, outside of technology spending, aren't doing very much with that cash. Some have boosted buybacks and raised dividends; overall, the flow of cash is stuck in Treasury coffers at most businesses, including the biggest banks, which continue to purchase Treasury bonds.

The bond market is now entering the gates of its "last hurrah." The grand 1981 to 2010 bond market super-cycle is nearing an end. Yields are likely to take out the December 2008 low of 2.2% on this rally and, possibly, break 2%. I would not buy bonds at these overbought levels. I'm pretty confident the Fed will pour more money into the financial system and, at some point, will get its wish – higher inflation that'll be difficult to cork once it's out of the bottle. Helicopter Ben is coming back in 2010.

I'll be in-transit tomorrow from Europe and will be back on Monday. Have a nice weekend.

Another Whipsaw?

A whipsaw is characterized by a quick reversal in price movement from one direction to the other by a security or index. In July we witnessed a textbook example of a whipsaw, as the S&P 500 gained 6.9% on the heels of a 5.4% loss for the previous month. These dizzying market movement can be quite frustrating for investors who are left desperately trying to keep pace with the direction of the market.

While the July rally was impressive, the S&P 500 seemed to stall in August as it hovered just a few points above the 200 day moving average. This formidable level of resistance was responsible for putting an end to a late June rally, where the S&P 500 managed to breach the 200 day moving average for a few trading sessions only to plunge to new lows thereafter. If today's market movement to the downside is any indication, we could be seeing a similar scenario play out. The two percent market dip today taking us back below the 200 day moving average is not the only foreboding signal on the chart today: the MACD and stochastic have rolled over with the MACD just turning negative as I type. If this results in any significant pullback, I will be keeping a close eye on the levels of support around the neckline of the Head-and-Shoulders Top formation that is still in play.

I had originally drawn the neckline of the Head-and-Shoulder Top formation at the 1,040 level on the S&P. In watch watching for a breaking of the neckline one must a have a 3% close below it for it to be truly violated. A quick trip below in early July did not succeed in achieving the 3% goal. As a result, I have redrawn the neckline to include November 2009 lows as well as the recent lows put in during July. The result is a slightly tilting neckline at around the 1,020 level. If this level is retested, it would also result in the formation of yet another right shoulder, a common in feature of complex Head-and-Shoulder formations.

If the 1,020 level is breached, however, the S&P 500 could be in serious jeopardy. Keep in mind that the last time we saw a Head-and-Shoulders Top formation fail was in early 2008 - and we all know what happened next. Conversely, should the market rally again, we would want to see resistance levels of 1,130 be taken out for confirmation of the move.

Austrian Real Estate Survives Credit Vice

Vienna, Austria

I'm in beautiful Vienna this week for a few days visiting our good friends at Valartis Bank located on the Rathaustrasse in the university district. The architecture this time of year is especially mind-blowing. I urge anyone who has never been to Vienna to make a visit. Despite this being my 35th trip since the late 1990s, I'm continuously in awe of this magnificent capital.

At lunch yesterday, my colleague and old friend, Patrick Doherty, reminded me that some markets in Europe are selling at all-time highs. "Stocks might be struggling but that's certainly not the case for real estate in Eastern Austria. I just purchased my first dwelling a few months ago. Real estate is at an all-time high in many parts of Vienna and not only survived the credit crisis but, in some cases, actually thrived."

Real estate prices soared in Eastern Austria in 2009 as investors scrambled for safe investments amid a meltdown in equities and credit markets.

Real estate firm Raiffeisen Immobilien Vermittlung (RIV) said: "Record prices were paid for high-quality, privately-owned apartments and houses with good locations, especially in Vienna." RIV added that price increases for single family houses in Stockerau and Korneuburg, Lower Austria, rose 55% and 40%, respectively.

RIV manager Peter Weinberger said areas north of Vienna had seen the largest price increases. "Korneuburg, Stockerau and Tulln districts have profited enormously from this trend," he added.

Weinberger said that some areas had not experienced price increases, such as Lower Austria's Amstetten district. "In that industrial area, demand for housing has decreased owing to the recession, more part-time work and higher unemployment," he said.

Innsbruck is the most expensive provincial capital for apartment rentals, commanding a monthly rental price of €10.70 EUR per square meter with Salzburg in second place at €9.00 EUR, according to the Austrian Times.

Can real estate in Europe defy the trend in rising deflation? I wonder. It seems to me the European Central Bank (ECB) has set a course to slow the economy vis-à-vis encouraging harsh spending cuts in the Club Med countries and other deficit-plagued EU nations. I highly doubt Austria or any other EU country will escape the wrath of deflation if central banks lose the war against falling prices.

For now, bond markets in Europe are telling investors that central banks are losing control of the economy as several bond markets hit new highs, including France on Friday as short-term yields crashed.

I'm off to Café Landtmann where I will feast on wiener schnitzel and perhaps treat myself to an Austrian pastry. Dugald will comment on the technical direction of the markets tomorrow. See you Thursday from Zurich.

Why Bonds are in Bubble-Trouble

Barcelona, Spain

Can the stock market peak in this cycle without the individual investor? If history is any guide, the odds are pretty low that equities will tank because investors remain net sellers of stocks funds. From a contrarian perspective, the individual investor is a useful barometer; but based on historical evidence, retail fund-flows really don't boost the market. Hedge fund trading boosts the market because they command swaths of cash.

Bond funds, however, remain the asset class of choice since 2009 with investors lunging after yield despite near-record low bond rates. Since the credit crisis, investors have shoved more than $430 billion dollars into bond funds.

Through June 30th, U.S. domestic mutual fund stock flows have seen a negative $17 billion dollars of outflows compared to a net $119.6 billion dollars of bond fund inflows. During the first half, bonds gained about 6% and stock declined 7.5%.

The table above, courtesy of Morningstar, is outdated since it's only through January 2010. But the reason why I've included it is because we've got a full picture of mutual fund flows in 2009 and 2008.

Despite a net $25.7 billion dollars of redemptions in 2009, the U.S. broader market gained more than 22%. Indeed, these and other dollar amounts are small compared to the size of hedge funds and other large institutions trading stocks daily. Yet from a sentiment gauge, rising net outflows of domestic stock funds this year can be viewed as a contrarian indicator because investors usually get their timing wrong.

The one variable bothering me the most as a bear on the economy is the fact that individual investors are not participating in the post-March 2009 rally. They're still unloading equities. In the late 1990s, individual investors purchased almost 75% of their total stock fund contributions in the last 24 months of the bull market, which ended in March 2000. In other words, stock fund sales came largely towards the end of the party.

The same phenomenon is probably going to happen to bond funds. The ongoing avalanche of net inflows since late 2008 will draw to a violent end eventually, just like the previous bubble in technology stocks did in the late 1990s.

The massive and seemingly never-ending tidal wave of bond fund inflows is indicative of a bubble in fixed income securities for no other reason, except the trends underway in bond mutual fund flows. The individual investor is a good leading indicator of trends, which always become overbought and, ultimately, violently discredited. If this is the case, then stocks are not about to crash again but, at some point in the future, bond prices will.

Iberian Real Estate Deflation Continues

Barcelona, Spain

When I first started coming to Barcelona more than 40 years ago, the airport consisted of one terminal and no gates. Buses picked up passengers and then whisked you to the terminal. My late grandfather was always waiting for us at customs; we never waited in line because he knew customs officials by their first name. That was a long time ago.

Today, BCN, or Barcelona International airport, has grown into a first-class airport with three terminals, including the latest goliath located across the original structure. A few years ago when the project began construction, I had a feeling a top was being formed in the real estate market. Amazing, but other "bubble" real estate markets in the country also constructed new terminals, signifying a top in real estate. When buildings are sprouting like weeds in any market, you know you've got trouble brewing – eventually.

My mother's side of the family has been in this Catalan capital since the 1950s and I remember the city well as a child. I love Barcelona, mostly the weather, food and Rioja. I've never met anyone who doesn't like Spain. The only thing I don't like is bull fighting – a cruel sport by any measure. Bull fighting was recently banned in Cataluña.

Five years ago, I vacationed with my Swiss friends in Costa del Sol, the Spanish Riviera, located to the south and about 45 minutes south of Malaga. The region was on fire; real estate projects going up all over the place as cranes littered the landscape. Prices were high, the British and northern Europeans were flocking to the region bidding prices even higher and the cost of living had soared. I remember a Scandinavian next door to me where I was renting a villa with friends asking over €1.5 million EUR for a shack. Unreal.

Spain is now in the third year of a major property bust. Construction represents about 35% of GDP and at the peak of the real estate cycle was almost 50% of output. You don't see building activity anymore; construction has stopped, the cranes are gone and prices have crashed across many parts of the country. My uncle's high-end condominium in one of the best Barcelona neighborhoods is now worth about 50% less compared to three years ago.

The banking sector here is still in trouble. The big problem lies with the cajas, or mortgage savings banks, that, for all intents and purposes, are largely bust. I'm not sure the government can deal with the situation because I suspect current property values are not entirely reflected in bank balance sheets, especially the cajas.

Spain is now entering a deflationary abyss as new austerity measures introduced by the Zapatero government force frugality and massive spending cuts. These policies will likely act as a continued drag on domestic consumption and force property values lower over the short-term. What Spain needs is inflation – something that remains in short supply since the emergence of the credit crisis two years ago.

The bottom line for investors is that Spanish real estate is a "buy."

Prices are down significantly over the past few years, including big bargains to be had not only in Barcelona but also in Costa del Sol. Last summer, while vacationing in Puerto Banus or in the Costa del Sol region, I met a local broker who presented a laundry list of real estate bargains. I suspect those values are even greater now.

Real estate prices along the coast might get cheaper. But as an investor looking to buy a distressed asset that's 25% to 50% below its all-time high, now is the time to be bargain-hunting. Interest rates are super low, the EUR is well off its highs and I have no doubt whatsoever that high-end Spanish property will rebound one day.

Viva Espańa…

Vanguard has the Edge on Emerging Market Fees

Montreal, Canada

There’s no doubt that over the longer term, fees make a world of difference and can impact your bottom line. Nobody likes forking over a big fee for an investment and passive investment management companies have capitalized on this trend since 2000. When it comes to investing, lower fees can make or break your performance in a tough year for the markets.

Mutual fund fees have compressed over the last decade but are still no match for ETFs and index funds. Canadians have the worst deal of all, paying the highest expenses for mutual funds than any other major industrialized economy. And investors are tired of high fees.

Yesterday, I commented on the emerging markets and how this asset class has dominated the performance tables over the last decade. Though I’m bearish on most things with a risk-bias, I still like emerging market stocks because that’s where the earnings growth resides coupled with strong balance sheets in many countries that represent the benchmark.

I like emerging market stocks (not the debt) because most currencies are undervalued and over the next decade they’ll rally against the major currencies like the dollar and the EUR. I also think growth rates will remain superior to sluggish and debt-plagued Western countries.

I recently purchased a small 3% position in my managed accounts in VWO or the Vanguard Emerging Markets ETF. Like all stock-based products, I apply a 20% stop-loss just in case markets violently collide – something that’s become extremely regular since mid-2007.

ETFs, unlike open-end mutual funds, are also generally more tax-efficient because they don’t pass on those potentially fat distributions to investors following a redemption or sale. They’re also much cheaper than actively-managed open-end funds, which tend to turnover portfolios much more as opposed to passive indexing. Higher turnover means higher expenses.

Vanguard Group, the low-cost giant based in the United States, currently has the most inexpensive emerging markets ETF.

Traded under the symbol VWO, the ETF tracks the benchmark MSCI Emerging Markets Index and sports a 0.27% total expense ratio; that’s pretty darn cheap compared to the iShares Emerging Markets Index or EEM, which levies 0.72% for the same portfolio.

VWO also offers a high degree of daily trading volume – usually implying a better bid/ask spread than those ETFs with less trading volume.

Over the last five years, through July 31, 2010, VWO has earned 12.4% per annum compared to 11.8% per year for EEM. That performance differential lies strictly in fees. Both portfolios hold the same benchmark weightings. Meanwhile, according to Lipper, emerging market stock mutual funds gained 11.1% per annum over the last five years – lagging ETFs and index funds because of higher fees.

I still believe active portfolio management deserves a place in a diversified portfolio because indexing won’t beat the market – it’s designed to replicate the market. Sure, most mutual funds have trailed the benchmark and there’s no questioning the results over time; indexing wins. But some stock and bond fund managers have trounced their respective benchmarks over the years and can add alpha or excess returns in up and down markets.

Bill Gross, Dan Fuss, Don Yacktman and Bruce Berkowitz are just a few of those five-star managers that belong in your portfolio.

Indexing is great but it’s not great all the time; adding successful risk-adjusted, actively-managed products to your portfolio mix will reduce volatility and over time, boost your total return.

I’m off to Barcelona tonight for holidays. I’ll blog from Spain on Thursday.

Emerging Markets Dominate again in Volatile 2010

Montreal, Canada

Since October 2002 when stocks hit a low in the first of two bear markets in the 2000s, emerging market equities have dominated global investing. That trend continues in a rough 2010 for most investors as major benchmarks struggle since April.

Since 2000, the MSCI Emerging Markets Index has gained 8.9% per annum compared to a loss of 1.7% per annum for the MSCI World Index of mature economies.

Emerging market bonds, unlike most stocks, have not suffered a decline this year as buoyant inflows continue to drive bond yields lower; in fact, no other investable bond index in the world since 1992 has outpaced emerging market debt. Only U.S. zero-coupon bonds (strips) come close.

The MSCI Emerging Markets Index is once again on top this year following big rallies last month in the BRICs (Brazil, Russia, India and China) and has surpassed the MSCI World Index in the total return column. In 2010, emerging markets are up a modest 0.20% versus a loss of 3.7% for major markets.

Emerging market stocks have beat major market equities every year world markets have posted a gain since 1999. In bad years, including major dislocations in 2002 and in 2008, emerging markets sank deeper than major markets but also bounced back much faster on subsequent recoveries.

Valuations, however, are not as compelling for emerging market stocks as compared to two years ago. Some “bubbles” are forming in China and Brazil.

According to Montreal-based Bank Credit Analyst (BCA), emerging markets now trade at about a 40% discount to major markets compared to almost 90% twelve years ago when the Asian currency crisis pummeled the sector. Still, a 40% discount is pretty attractive, especially when combined with superior growth rates, far lower net debt-to-GDP ratios and for the most, trade and budget balances in surplus, unlike the West.

Emerging market bonds remain expensive and should be avoided. The biggest bond markets in this sector – dominated by Brazil and Mexico – are overheating as spreads have crashed over the last several years. With several emerging market central banks now in the process of tightening the best strategy is to avoid domestic bond markets and over-weight equities. Inflation, not deflation, is a primary concern in these markets with the significant exception of China.

The primary trend for emerging markets remains bullish. In up markets, the asset class tends to provide greater alpha or excess return while in down markets they do fall harder than the major economies. The Fed has been a good friend to this exciting sector as the dollar has remained cheap and interest rates the lowest since the 1950s. Some “bubbles” are forming and others are in the process of being liquidated – mainly in Chinese real estate. Overall, the trend is bullish.