Long Beach Island

I just returned from a week long family reunion on Long Beach Island in New Jersey. It was a much needed break and in order to truly appreciate it I abstained from all internet usage during the week (okay I may have cheated once or twice on my blackberry, but who can resist that?). So after a week of not posting I am itching to get at it again. Expect regular posting to resume this week.

Blackstone Up, Fortress Down

Blackstone IPO'd today under the ticker symbol BX and was rewarded with a 13% gain on its first day in the market in spite of market forces heading the opposite direction. Investors seemed to shrug off the new tax proposal announced by Congressional leaders that could double the tax on carried interest. All in all the IPO was a success and Stephen Schwarzmann and Pete Peterson both made out handsomely.


An interesting sidenote to today's action was that Fortress Investment Group (FIG) had a terrible day. After opening 2.5% above yesterday's close the stock sagged in mid-morning trading before closing down 6.3% on the day. FIG is now trading close to the level it was at last week when I recommended it. In my mind nothing has really changed, this might just represent a second buying opportunity for FIG at a great price.

Worst Friday Since Mid-March

Friday's over the last few months have been spectacular days for the market. In fact since March 16th we haven't had a single down day in th Dow to end the week. That all came to an end today with the Dow off 185 points to close the week down more than 2%. (Hat Tip: Bespoke Investment Group) While too much shouldn't be read into the fall, it shouldn't surprise people that the market was off this week with all of the bad news surrounding Bear Stearns' hedge fund blow-up and the bloody subprime debt market. Unless we have a flurry of deals over the weekend next week could be a repeat affair. Click the graph below to enlarge:

Goodbye Terry, Welcome Back Jerry

In a widely anticipated move, Yahoo CEO Terry Semel stepped down today and will be replaced as CEO by Yahoo founder Jerry Yang. Why was Semel shown the door? Quite simply Semel hasn't been able to do much with Yahoo's stock in the almost 3 years since rival Google's IPO. In fact on August 18th 2004, the day before Google's IPO, Yahoo closed at $28.48. Today Yahoo opened at $27.72 still under its value from nearly 3 years ago. In the meantime Google has risen over 600% from $85 to $515. Needless to say many Yahoo investors have become quite frustrated. Recently there have been rumors swirling about the possibility of a Microsoft takeover as well as discussions with Time Warner and eBay. But, to date nothing has come of it. Maybe now with Semel out of the way Yahoo will make a move. After opening the day trading at $27.72 the stock will likely open tomorrow around $30. Where it goes from there is anyone's guess.

Here is Yahoo versus Google over the past 3 years. I think it was time for Semel to leave:

The Private Equity Tax Battle Rages On

On the eve of Blackstone's planned IPO a proposed private equity tax law could throw a wrench in CEO Stephen Schwarzman's plans. Private equity firms make their money via an asset based fee and a performance fee. This is typically* expressed as "2-and-20": the 2% fee is on all assets under management and is taxed at ordinary income rates up to 35% and the 20% is a cut of the firm's profits and is taxed at the 15% capital gains rate.

Under pressure to combat increased income inequality and increase tax revenue, Federal lawmakers had been tossing around the idea of raising taxes on private equity firms by re-characterizing "carried interest" as ordinary income. It appears that they have curbed that discussion for now.

However, since Fortress and Blackstone would both be publicly traded partnerships, Congress, led by Charles Grassley and Max Baucus (pictured above), could overturn a 20 year old tax law that taxes publicly traded partnerships at 15%. Instead these publicly traded private equity firms would be taxed at corporate rates of up to 35%. This won't effect private equity firms who stay private but it will certainly influence whether or not they choose to go public.

If such a bill were to pass Congress and avoid a presidential veto it would certainly dampen the valuations private equity firms have been receiving and create massive disincentives to going public. The law, were it to pass, would grandfather in Fortress and Blackstone for a period of 5 years.

Fortress Investment Group (FIG) was off 6.5% today on the news and is off nearly 30% since late March. I think investors may be overly pessimistic on FIG because of this bill. FIG's effective tax rate today is already somewhere near 25% and much of their income is not tax-advantaged. If, as I expect, this bill doesn't pass this might be a great time to pick up a few shares of FIG on sale. Heck even if the bill does pass, FIG is safe for 5 years and even with conservative growth projections and higher taxes, buying FIG at $23.50 with a PE of 21.5 is a steal.


* Some firms charge more, some less.

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Is Fred Thompson Our Next President?

Actor and former Tennessee Senator Fred Thompson hasn't yet announced his campaign for President, but that hasn't stopped him from quickly becoming the early Republican leader in the InTrade prediction markets. In just three months of trading he has passed McCain, Romney and Guiliani in rapid succession:


You can see his rise has been fairly steady and received quite a boost after asking to be released from Law & Order in May and forming an "exploratory committee" in June:


To be perfectly honest I don't know much about Fred's economic policies, though from a quick glance at his blog it looks like he is strong fiscal conservative. All I knew about him before that little bit of research was his stellar performance as Jim Robinson in the "Barbarians at the Gate" made for TV movie . . . but I digress . . .

Subprime Isn't Done Yet Folks

Yesterday a hedge fund managed by Bear Stearns announced their intention to sell $4 billion of mortgage backed bonds. The fund -- the High-Grade Structured Credit Strategies Enhanced Leverage Fund -- has been hurt by their exposure to the subprime sector and is allegedly down almost 25% this year. One way to track the damage in the subprime sector is to monitor the ABX Home Equity BBB Index. Here is some quick background on the ABX index courtesy of Nouriel Roubini's Blog:

“One way to measure the effects of problems in the sub-prime mortgage sector is to look at Credit Default Swaps (CDS). Remember that these CDS contracts effectively work as a kind of insurance policy for banks or other holders of bad mortgages. If the mortgage goes bad, then the seller of the CDS must pay the bank for the lost mortgage payments (alternatively ... if the mortgage stays good then the seller makes a lot of money).

The index that measures the CDS market for home equity is called the ABX.HE index. The sub-variation of this index that refers to risky sub-prime loans is called the ABX.HE BBB index.

I just checked the ABX.HE BBB index. It has dropped by about 5-7% since July of 2006. This is a substantial drop! Notably, there was a major plummet of the index starting in Dec 2006 when some of the dealers in risky mortgages started going belly up.

So what does this mean? It means that someone out there is now having to cough up the losses in the bad loans. It could be hedge funds, or maybe overseas lenders. But someone is starting to see some losses happening on their balance sheets, and the problem is going to grow significantly in 2007.”

Keep in mind Roubini had this on his blog back on January 11th, 2007. Back then the ABX Home Equity Index had fallen from 101 to 93 in 6 months, which at the time surely seemed like a "substantial drop." Since then the index has fallen precipitously. It now trades in the low 60's and looks ready to re-test its February lows. See graph below courtesy of Markit:


So who is paying for these bad loans? Well in this case its the investors in Bear's fund and perhaps the banks who helped Bear lever up 10 to 1 . . . it makes you wonder who is next.

Benchmark 10-Yr Note Yield Approaching 5.25%

The dramatic 20% rise in the 10-Yr Treasury Note yield over the past month didn't let up today. It currently sits just under 5.25%. If the note passes through that level it will mark the second psychological level the yield has climbed past in the past two weeks.


There are two main areas where rising yields can hurt the economy. The first is housing, as yields are positively correlated with mortgage rates. The second is stocks, where the buyout boom and stock buybacks have in large part been financed with cheap debt and both practices will slow as borrowing becomes more expensive. We are still holding our 10 Year Treasury Note target steady at 5.5% by the end of the year.

Eddie Lampert Wants Your Money

I have blogged many times about Eddie Lampert. First bragging about his income and again showing off his beautiful Connecticut home. Today I have news of a different variety; I learned that Eddie Lampert's ESL Investments is hoping to raise $3 - 5 billion USD in new investment capital. Due to Lampert's concentrated investment style in which he takes large stakes in a few companies he has placed a long holding period on the capital. There will be two successive 5 year lock-ups with one opportunity to withdraw. The minimum investment is set at $25 million. I would encourage any of my readers who have $25 million investable lying around to take Eddie up on the opportunity. Very rarely is there an opportunity to invest with a top notch manager with such a long track record of 25%+ returns. Frankly though I am a little surprised he set the investment minimum so low, if he truly wanted patient capital he could easily have set a floor of $100 million, making the investment off-limits to all but institutions, endowments, central banks and the wealthiest of families.

Interestingly Eddie has hired Goldman Sachs to help raise the money. Seeing as he probably wants nothing to do with marketing I think that this is a smart move, though probably unneccesary. I understand why Eddie turned to Goldman; they just raised $20 billion for their buyout fund and have no problem raising large sums of money fast. But, I really don't think the problem will be raising the money I think the problem will be stemming the flow of investors who want in.

I can think of two big investors who may want in right off the top: China and Goldman itself. It was back in mid-May that I heard China was buying a pre-IPO stake in Blackstone worth some $3 billion. An investment of a few billion in ESL would seem like a logical second big move for China to diversify their foreign currency reserves and invest with one of the top hedge fund managers. After all what is $2 billion to China, a couple of days of currency reserves? It also makes sense that Goldman itself will probably take a stake. Trading and principal investments make up a full two thirds of their revenue and they are always looking for additional ways to put their capital to work. After all if they are willing to dump millions into RadioShack even after its stellar Q1 performance. Perhaps they are just caught up in the success of Radio Shack CEO Julian Day, an Eddie Lampert hire who helped bring Kmart/Sears out of bankruptcy.

The most exciting part of this development for me is that I think that Lampert probably has a couple of ideas in the works and is looking for a little bit (cough) more capital so that he can complete them on his own. I am a huge fan of ESL and am intrigued to see what his next move is. For those of us who don't have $25 million to invest you can always pony up the $176 for a share of Sears Holdings. It isn't ESL, but its as close as you are going to get. With over $2 billion of cash on their balance sheet I'm sure Eddie will find a way to make some money with Sears.

Time To Trim Apple?

A handful of pundits and bloggers have mentioned this as a good time to trim positions in Apple. Until today though the stock didn't give any support to those arguments. However now the stock is up 43% on the year, trades at a P/E nearing 40 and is perhaps overdue for a pullback. In its first major move to the downside today the stock is off 2.5% in afternoon trading in spite of strength in the broader indexes. Look for Apple to pull back further particularly if the market struggles with weak data this week. With the iPhone release approaching there is enough downside risk to warrant traders trimming their positions. On the other hand Steve Jobs and Apple are on a roll and the near term momentum they are experiencing could very likely continue. Decisions like this are never easy, but anytime a stock is up 40%+ on the year I think taking some gains is intelligent.

Housing Weakness To Continue

On an intuitive level, does the San Diego home price chart to the right look like a buying opportunity or a selling opportunity? Many economists are finally starting to agree with those of us who foresaw a multi-year, agonizing fall in real estate prices. In a weekend Journal article entitled "Economists See Housing Slump Enduring Longer", many economists admitted that there is very little good data out there to support an argument that the housing slump will end this year. Many originally were calling for a Fed rate cut or two and another dip down in mortgage rates to help stave off further declines. However in all likelihood the Fed will hold rates at 5.25% for the rest of the year. In fact at this point I think that it is slightly more likely that the Fed's next move will be to raise rates, not lower them. Without a drop in rates, and with continued weakness in Treasury prices I think the housing market has very little to support it. Current 30-year fixed mortgage rates are around 6.7% up considerably from a year ago and inventories continue to rise across the country.

In San Diego foreclosures are hitting record levels. In March, April and May there were 1727 homes that went to trustee's sale, which is 37% of all foreclosed homes. That 3 month total is more than ALL the homes that went to trustee's sale in San Diego in 2003, 2004 and 2005 combined. As all of these homes get dumped on the market, price declines are inevitable. I expect these numbers to continue to increase and for the % of foreclosure's going to trustee's sale to reach 50%.

The other major risk is the huge volume of subprime loans that are set to recast over the next 6 months. If subprime borrowers can't afford a 15-25% increase in their mortgage payments and can't qualify for a prime loan product things could get ugly. Many of these borrowers were banking on home prices to increase in order to help them keep their homes. Unfortunately since most of these borrowers used 100% financing and home prices are down in San Diego over the past 2 years it is likely that many subprime borrowers here are underwater. This does not bode well for home prices for the foreseeable future. Remember this graph? Many of the monoline subprime lenders aren't around anymore but the loans still are!

Gross on Endowment Style Investing

Buried in Gross' secular analysis was an important observation I felt echoed what Harvard's $30 billion endowment manager Mohamed El-Erian mentioned in an interview last week with Fortune magazine:

"In effect, and we put this in the secular outlook, most investors these days are trying to be like Yale and Harvard now, which is fine I suppose, although it brings with it risks of its own in terms of leverage and ultimately compressing risk spreads to levels that are unattractive.

But the race is on to be like Yale and Harvard now. And that to us suggests that purchases of safe, low-yielding assets—U.S. Treasuries, German bunds and other bonds—are likely to decline and flows into commodities and companies and equity-like types of investments will likely increase. We’re not talking about a major overnight shift but at the margin."

In a single week two of the most respected voices in asset management pointed out the same trend; more and more investors are seeking to mimic the high return, low volatility returns of the Harvard and Yale endowments. (Come to think of it these two guys were both bond managers at PIMCO before El-Erian made the jump to Harvard Management Company, so it makes sense they share similar viewpoints.) These Harvard and Yale imitators aren't just other endowments, but also include foreign central banks (like China) with trillions of dollars of investable assets, large family offices with hundreds of millions of investable assets and even retail investors. For many David Swensen's books on endowment style investing have become bedside reading and the Yale and Harvard annual endowment reports are pored over for hints of future moves. As Gross points out this isn't necessarily a bad thing, but as more and more of these investors seek to diversify into commodities, absolute return vehicles, commercial real estate and other assets classes flows into U.S. treasuries will decrease putting downward pressure on treasury prices.

Bill Gross: A "Bear Market Manager"

As I have written before Bill Gross is a man capable of moving markets. Gross spoke at PIMCO's annual secular forum about his view of market trends over the next 3-5 years. The main theme that the markets (and the media) picked up on was that Gross -- a longtime treasury bull -- has now donned a new cap and is calling himself a "bear market manager." This shift is largely due to his expectation of continued rapid 4-5% global growth and increased inflationary pressures from commodity prices and rising wage costs in emerging markets. He has raised his 10-year treasury yield target to 4-6.5% from 4-5.5% which is a significant change for a firm who's total return strategy profited greatly from over 20 years of price appreciation and yield.

Where does Gross see opportunity in a secular bear market for bonds? Well maybe we should start with where he doesn't see opportunity:

"Credit markets, high yield markets, and volatility itself, all are compressed to near historic lows and suggest that at this point, taking major risk positions in order to be like Yale or a Harvard certainly wouldn’t be justified.

It does not make sense for PIMCO to be buying even investment-grade corporates at 30 to 35 basis points over LIBOR. The spreads are too narrow and the risk of a cyclical correction is too great."

Okay, we get it, we've been saying for years that the global liquidity boom has compressed risk spreads. So if risk isn't where to capture return where can return be obtained? Gross' answer: shorten duration, get emerging market currency exposure and heighten commodity exposure. This makes sense! The large US trade deficit, a declining appetite for treasuries and years of global 5% growth are putting downward pressure on the dollar. As demand increases on everything from oil to corn to soybeans to copper, commodity exposure will be crucial. Investors who hold too many assets denominated in US dollars and have failed to allocate a portion of their portfolio to commodities and TIPS will suffer if inflation ticks up and the dollar weakens further.

DXKSX: An ETF to Play Falling Treasury Prices

I have been tracking the Direxion 10 Year Note Bear 2.5X Inverse ETF (DXKSX) to monitor how well it does at tracking the upward yield pressure we have been predicting in the 10 Year Treasury note. So far the strategy appears to be playing out fairly well. The ETF is up over 11% since early March when I first started tracking it:


If the 10 Year Treasury yields continue their push towards 5.5% as we have predicted it is safe to expect that this ETF will continue to capture much of that return.

The Endowment Model is Getting Crowded Says El-Erian

I'm sure David Swensen realized when he wrote "Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment" that he would inevitably attract a few followers to his diversification philosophy. His current counterpart at Harvard, Mohamed El-Erian, confirmed in an interview last week that Swensen's book has played a role in convincing endowment managers to diversify more fully, crowding some of the markets that Yale and Harvard have been in for years. In El-Erian's own words:

"More people are replicating what we do. The endowment model is very much in vogue. There have been many articles in the press trumpeting how well endowments like Harvard's and Yale's have performed. And David Swensen, who brilliantly heads up Yale's endowment with impressive long-term performance, has written a great book showing how endowment management is done. So now lots of central banks and pension funds are trying to become more like endowments. The space is becoming more crowded.

Accordingly, we are spending a lot of time thinking about the related challenges and how we would be able and willing to differentiate ourselves. We have to play the smarter game. And that's always complex, never easy."

As always we will be tracking significant changes in Harvard and Yale's endowment portfolios looking for clues on how El-Erian plans on differentiating himself.

Also in the article were 4 key themes that El-Erian think effect long-term investors:

1. International Diversification and Commodity Exposure are increasingly important.
2. Large Caps will outperform small and mid-cap companies in part because of the boom in private equity.
3. Inflation is picking up, using TIPS is a good hedge against that rise.
4. Foreign Central Banks will look to diversify their reserves to other parts of the world.

To read the article in full go here.

Time to Short the Shanghai Composite?

I'm not a big fan of calling the direction of entire markets, but this one seems like a no-brainer. The Shanghai Composite index is way up from its lows in 2005. It rose from its valley near $1110 back in December of 2005 to its peak over $4330 in May of this year. Over the same time period average weekly trade volume on the exchange increased from 8 billion shares to nearly 55 billion. More and more speculative investors are jumping into the Chinese markets with the hope of making a quick buck.

Meanwhile the index has retreated from its peak and has dipped below virtually all of its moving averages to rest at $3776. Why do I think that the index has very little upside at these levels? Well first and foremost the P/E ratio for the index is 39.82, which is clearly in bubble territory. But, the main reason I believe the Shanghai index is overextended is that the Chinese government has shown its willingness to step in when needed to protect investors from themselves. Just last week the Chinese finance ministry tripled the tax on trading to $0.03. The markets did not take the news well, tumbling 6.5% in the first day of trading after the increase. Since then the market is off another 7% as speculators adjust to the new tax and investors gauge whether that relatively minor change is enough to trip up the bull market. Many probably realize that the finance ministry has more tools in their toolbox to curb speculation and if the market tries to test its highs they will be forced to use them.

Remember it was just a year ago that Shanghai real estate was all the rage. However with a series of tax and administrative measures the government effectively chased speculation out of that market. Unfortunately much of that money has landed in the stock market and the government will in all likelihood be just as diligent in controlling speculation as they were in real estate.

Key thing to notice in the chart below: Yahoo! only tracks volume up to 4 billion. You can see that has been inadequate for quite some time.

Will Banks Cool Private Equity Boom?

Just a week ago I wrote about how many key private equity players were worried about a bubble. The New York Times reported this morning that several banks were cooling on lending to private equity firms to fund buyouts. RBS admitted there are signs that the market is "quite toppish." Mezzanine lender Intermediate Capital also warned that deals were becoming more risky. The warning from Intermediate Capital is not good news considering the fact that they may well be the largest lender to private equity firms. Of course when you are talking about billion dollar deals, banks don't work alone. Usually banks form large syndicates in order to spread the risk around. Be that as it may, as more and more banks become more careful with the risk they take on, they may well pull the punch bowl from the party. I have a feeling that until their is a dramatic default the boom still has some legs.

In the past week investors have punished Merrill Lynch for its role in providing bridge loans for large private equity deals, like the $32 billion deal for First Data. While I am prone to worry about the potential for a deal to blow-up an leave banks and investors up a creek, some, including Dana Cimilluca at the WSJ think that all the words of caution from private equity players and banks alike may actually be a good sign for the M&A boom to continue:

"As we see it, the Merrill scare is a brick in the wall of worry the private-equity industry seems to be facing these days. One executive after another — many of them participants in the buyout boom — is sounding alarm bells about a bubble. The latest is Royal Bank of Scotland CEO Fred Goodwin, who says the private equity market is getting "quite toppish". His comments echo remarks recently from Bank of America chief Ken Lewis. Moody’s Investors Service in a note today questions whether a march upward in long term interest rates could slow the debt issuance behind the buyout and stock repurchase booms. (It doesn’t think so.)

What does this all mean for the big question everyone is asking — how much longer the good times in the deal world will last? Investment types often refer to a chorus of caution as a bullish sign, in part because it keeps investor behavior from becoming too irresponsible. If that’s the case, it could perversely mean the M&A frenzy still has some legs."

While Dana thinks the caution is a good sign, I disagree. As private equity firms and lenders start to wise up to the risks, the cost of debt rises and many of these deals start to crumble. If one major deal falls through it could send an ice cold tremor through the market putting in peril all the other deals that are in the pipeline and crushing the holders of bridge loans that were hoping that their debt would quickly be replaced with junk.

There is one concrete graph to look at that may point to why banks are starting to sour on the deals presented to them. I wrote about this last week as well. That is the rise in the yield of the 10-year treasury. Just last week the yield curve normalized and the 10-year yield is now moving aggressively towards 5% (see graph below/ click to enlarge).


**One last note. Insofar as the rise in the markets this year has been fueled by all the M&A activity, if lending tightens up and the deals slow down the market may well correct sharply. In fact a major credit event could finally restore the volatility to markets that many have been calling for.

How Long Will the Real Estate Downturn Last?

Well if this downturn is of the exact same length as the last downturn we would have about 3 years before we hit a trough in home prices. However, many expect the current housing downturn to be worse than the previous one because the run up in prices was longer and more dramatic. Also, the experience will be different in different markets. Incredibly overheated markets -- like San Diego for instance -- could be in for a longer and more painful downturn than say Fort Collins, Colorado. (click the graph to enlarge).


Courtesy of the New York Times.