The "Bailout and Justify" Fed

I can't think of a Halloween in recent memory that fell on a day with such a heavy dose of economic news. Not only are we getting some of the standard fare -- ADP private payrolls, construction expenditures, the employment cost index etc. -- we are also getting some real substance with the FOMC meeting and the third quarter advance GDP figures. The end result, if this year carries on as it has thus far will probably be bad economic news followed by a great rally. Allow me to explain.


As you can see above, the market has priced in a 25 bip rate cut heading into FOMC day. I personally think the Fed could, and may try to "justify" another 50 bip cut. How would they do that? Well for starters they could point out that market conditions haven't stabilized enough to cushion the blow from an accelerating housing market decline. After all that resilient American consumer is only as resilient as the credit officer who signs off on his/her HELOC's and credit card applications.

The Fed's second "justification" option is to just point at the graph above and use dramatic works like "crisis" and "carnage" to describe the credit spreads. Surely there is something in that chart to scare the weak-hearted and spin a 50 bip cut!

The reason I emphasize the Fed's need for justification is to point out how closely Bernanke's Fed seems to be following Greenspan's basic policy, as summed up in the following Greenspan quote from September of 2004 (and pulled from Jeremy Grantham's most recent newsletter): "For the Fed to interfere in security speculation is neither desirable nor feasible," but "if a sudden correction in asset prices did occur the Fed's first responsibility is to protect . . . to provide ample liquidity until the crisis is past." In plain English, Greenspan's stance is that you can't stop speculation, but you must bail out the speculators before they hurt everybody else. The real key of course is to bail out the speculators, but justify your bailout to market participants in such a way that they don't increase their inflation expectations. While this "bailout and justify" policy seems to be the preferred option for Greenspan and Bernanke, it does have a fatal flaw; it is quite simply not the type of policy that will force market participants to accurately price risk and thus prevent future speculation (moral hazard).

Now I want to make it clear that I don't think these moral hazard problems are necessarily Greenspan or Bernanke's fault. I think that the Fed Chairman's incentives, at least during this little slice of history, are just not in line with staying hawkish on inflation during market corrections. Indulge me on this for a moment. Back in early September Martin Feldstein suggested at the Fed's Jackson Hole Symposium that a 100-bip cut in the Fed Funds rate could be rationally justified. When reading the quote below from Feldstein's speech try to imagine yourself as the Fed Chairman listening to this speech and slowly letting your scholarly inclination to "stay hawkish on inflation and tough on speculators" slowly drift away and start thinking more about how posterity will view you if you precipitated a painful recession:

The Fed could adopt the risk-based "decision theory" approach in responding to the current economic environment. If the triple threat from the housing sector materializes with full force, the economy could suffer a very serious downturn. A sharp reduction in the interest rate – in addition to a vigorous lender of last resort policy – would attenuate that very bad outcome.

But what if the outcome in the absence of a substantial rate cut would be more benign and yet the Fed nevertheless cuts the federal funds rate? The result would be a stronger economy with higher inflation than the Fed desires, an unwelcome outcome but the lesser of two evils. If that happens, the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it would succeed in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability.

Wait a minute, hold the presses, since when did "Decision Theory" replace the Taylor Rule as the key factor in the Fed's decision making? While I don't think Marty was trying to illustrate the amazing power incentives have in encouraging moral hazard in Central Banking, he did a fairly good job of it. The acute pain of a recession is a far bigger and more salient pock mark on the track record of a central banker than that of a "longer period of slower growth." Just think, if you were Bernanke looking at the current state of the economy, and I was God and I offered you stability today followed by a "longer period of slower growth" or a 50% chance of a sharp recession that would likely be blamed on you, which option would you take? That's what I thought.

Following this line of thinking to its natural conclusion, it would also behoove an incentive-led central banker to underestimate the true inflation rate in the economy in order to provide more flexibility to cut rates in times of distress. And now we are at the truly scary part of all of this discussion. More and more scholars are starting to question whether the Fed's preferred inflation measures are truly capturing all the inflation out there in the economy. Jeremy Grantham -- a man who seems perenially worries about the market -- has not once been concerned about inflation for the past 20 years, that is until now:

For the first time in 20 years I am slightly worried about inflation. . . By the way, like many others I have an increasing distrust in the official inflation numbers.
For example, we have rising commodity prices and a very large deficit combined with a very weak currency, yet we have a decreasing inflation rate and one that is lower than that of many European countries with strong currencies. Very odd indeed.

Makes you wonder what exactly goes into the inflation calculation doesn't it? I'll tell you what. With what little I know about incentives it just seems to me that the Fed is more likely to cut big now and seek to justify than it is to rediscover its distate of inflation. I just hope all of you who have made it this far in this post have moved out of the dollar into commodities and emerging market stocks.

Sidenote: Just the other day Jim Rogers was quoted as saying: "It's the official policy of the central bank and the U.S. to debase the currency." While I think he was being a bit dramatic, I think he may have a very good point. China dropped its 'official' dollar peg 26 months ago and has allowed its currency to appreciate just 10% over that stretch. Now China is facing a serious problem: they are raising rates to fight rising inflation (6.2% in September, October numbers due in 2 weeks) and they are watching as the US lower rates (today) to fend off a recession. If the US is at 4.5% and China sees rates rise closer to 3.5 or 4% it won't be long before China's Central bank will actually be losing money if it continues to sterilize capital inflows. With the Fed in "decision theory" mode I might just follow Jim Rogers advice and start moving all of my assets into Renminbi . . .

Bill Gross Predicts a 3.5% Fed Funds Rate

Bill Gross' November market commentary is up on the PIMCO website. In it he pokes fun at Citigroup CEO Chuck Prince for his colorful commentary back in July regarding potential exposure to bad private equity-related debt: "As long as the music is playing you've got to get up and dance. We're still dancing." Turns out Prince probably should have stopped dancing, or at least kept his mouth shut. Investors probably won't look to kindly upon Prince dancing his way to a $6.5 billion writedown.

More important than Chuck Prince however is Gross' outlook on the US economy going forward and particularly his outlook on what Bernanke must do to bail us out:

So both old-fashioned banks and their derivative, conduit-fed shadow counterparts will be growing their balance sheets a lot more slowly in future months and quarters. That rather immediately translates into a slower economy and the need for government assistance in the form of lower interest rates or liquidity pushes like Treasury Secretary Paulson’s “Super SIV.” Whether Paulson’s “Committee to Save the World – Part II” will succeed like Bob Rubin’s original during the Long Term Capital crisis is debatable. The idea, first of all, is counterproductive because it continues to hide subprime asset prices in the “shadows.” Secondly, Rubin confronted no regulatory headwinds back in 1998, nor did he have to deal with today’s behemoth shadow banking system in the process of losing its brave face. Rubin in fact, along with his all-star committee featuring Alan Greenspan and Larry Summers, had a near hurricane force tailwind with 24 months more of dotcom IPOs yet to come. No wonder that Chairman Greenspan needed to cut short rates by only 75 basis points before stabilizing the economy nearly a decade ago.

Ben Bernanke has no such luxury. While he does have the backstop of a global economy powering on at a 4-5% annual clip, today’s U.S. IPOs were more a creation of leverage and the shadow banking system’s ability to create productivity gains through finance, as opposed to technological innovation. With banks and their shadows in retreat and modern day “world saving committees” relatively impotent, Bernanke must do some heavy lifting as opposed to the light housework required of Alan Greenspan in 1998. An increasingly recessionary looking U.S. economy will likely require 1% real short rates and 3½% Fed Funds in order to stabilize a potential growth contraction in lending not witnessed since the early 1970s or, to be honest, Roosevelt’s depressionary 1930s.

So here at the beginning of another Fed week we should look for another 50 basis point cut in the Fed Funds rate as Bernanke seeks to preempt further weakness. This would still leave another full percent for Bernanke to cut before approaching the 3.25% that Gross is predicting. While the smart money is on a 25 basis point cut, I'm going to break from the mold and predict a larger move. Look for this cut to further weaken the dollar and lead to another commodity rally. It is now within the realm of possibility that oil could reach $100 before a cyclical slowdown in the winter. While $100 a barrel oil seems amazing, this isn't the first time we have seen it before. Below is a graph courtesy of James Hamilton at Econbrowser:

Dollar price per barrel of West Texas Intermediate divided by ratio of CPI for the indicated month to the present value.

The other thing to look for is for a major announcement from a foreign central bank that they are officially removing their dollar peg. There is already a great degree of consensus among Gulf executives that removing the dollar peg would help their economies. Of the six major economies in the Gulf region, five -- Saudi Arabia, Oman, Qatar, Bahrain and UAE -- maintain a dollar peg. The sixth, Kuwait, removed their peg in May. All are dealing with serious inflation issues, and are unable to fight against the inflation because of the devaluing dollar.

The Fall of the Dollar (and Rise of the Amero?)

Harvard professor Larry Summers frames the issue of the weak US dollar simply enough:

The falling dollar generates anxiety almost everywhere. Americans and those dependent on American growth worry about the proverbial “hard landing” as inflation and interest rates rise with a weakening dollar, causing asset prices and output to fall. Europeans and others with currencies that float freely against the dollar worry that their currencies will bear a disproportionate share of the dollar’s decline and appreciate too far, leading to competitiveness problems. The falling dollar risks rising inflation, asset bubbles and the loss of macroeconomic control in countries that have tied their currencies to the dollar’s sagging mast.

The dollar’s decline may provoke anxiety but it should not be a surprise to anyone who has followed the global economy in recent years. History suggests that periods when a country’s economy turns down, short-term interest rates are declining and financial strains are increasing are likely to be periods when a nation’s currency depreciates. Moreover the US current account has for years now been financing consumption rather than investment, with the financing coming increasingly from debt rather than equity and shorter rather than longer-term debt.

He then points out some inadequacies in the current manner of exchange rate management (or lack thereof):

There is nothing very new about a decline in currency of a country running a large current account deficit and whose economy is softening. But in important respects the situation of the dollar is almost without precedent.

The vast majority of the US current account deficit is now being funded by central banks accumulating reserves as they seek to avoid appreciation of their home currencies. While the US dollar is usually viewed as a floating rate currency, substantial and critical parts of the world economy operate with currencies pegged to dollar parities or at least managed with them in mind.

Finally he advocates for change:

This suggests the need for rethinking traditional approaches to dollar policy at a time when the global economy is more vulnerable than it has been since 1998.

The Clinton administration approach of asserting the desirability of a strong dollar based on strong fundamentals while allowing its value to be set on foreign exchange markets was highly successful in its time and has largely been followed by the Bush Treasury. But it is insufficient in the current world, where the dollar’s trade-weighted exchange rate is to an important extent managed abroad. Some means of engagement must be found with those who have yolked their currencies and so their financial policies to that of the US.

The US has responded in an ad hoc way by carrying on a “strategic dialogue” with China – by far the largest economy with an exchange rate linked to the dollar – backed by congressional threats to address exchange rate issues using the tools of trade policy and references to communiqués from the Group of Seven leading industrial nations. In reality the dialogue is anything but strategic. Like so much of American international policy in recent years, it seems to confuse the firm statement of legitimate desire with the serious conduct of diplomacy.

I think a new currency strategy is a must, but I am definitely concerned about what the "next administration" might come up with. If you hear me advocating for the status quo it is likely from a position of concern about the new policy rather than an expression of satisfaction with the existing policy. (Out of left field: Does Larry remind anyone else of Nouriel Roubini in saying the global economy is the most vulnerable since 1998?)

US policymakers aren't the only ones concerned about the weak dollar being financed by China. I read that OPEC is likely to review pricing oil using a basket of currencies rather than just using the dollar. I also wouldn't be surprised to hear about Middle Eastern countries dropping their dollar pegs. Our firm is actually going through a similar evaluation of our firm's currency overlay policy to determine if we should hedge our currency exposure to a basket currencies rather than arbitrarily using the US dollar as our home currency.

In all of this I think that one fact is abundantly clear; any policy change is better than a move towards the North American Union (NAU) and the Amero. The NAU is a President Bush supported idea to combine Canada, Mexico and the US into a Union to rival the rise of the European Union. The Amero would be the combined currency of the three countries. When I first heard it I thought it was definitely just a crackpot conspiracy theory, but then I saw this clip from Lou Dobbs (not that Lou Dobbs is the official arbiter of what is conspiracy and what is mainstream):



I think this interviewer was completely blindsided by the Amero discussion:


Here is a picture of the Amero. Looks harmless enough, eh? (I'm just getting used to being a part of Canada)
Hat Tip: Brad Setser

Images for the week

Maybe I'm just lazy and didn't want to write full posts, but this past week I've come across quite a few great self-explanatory images. I've included a few below:







Hat Tips: Barry Ritholtz, Greg Mankiw, Calculated Risk, Bespoke, WSJ

Fire Time Lapse Video

Microsoft Buys $240 Million Stake in Facebook

It was a two horse race between Google and Microsoft to determine who would buy a stake in Facebook and get the rights to broker Facebook's international ads. Today Microsoft won that race, purchasing a 1.6% stake in Facebook for $240 million. This is another move in Microsoft's strategy of regaining relevancy in the online advertising world after getting blindsided by Google in recent years. While this deal pales in comparison to the company's $6 billion purchase of aQuantive/Avenue A Razorfish it does signal that Microsoft is still willing to spend some of its $21 billion dollars of cash on key internet advertising assets.

This deal is also interesting because it gives us a real value for Facebook: $15 billion. Mark Zuckerberg probably has a big smile on his face right about now as he thinks back to the $1 billion offer he received from Yahoo about a year ago. Many thought Mark should have taken that offer, but obviously he's going to get the last laugh on this one. At $15 billion Facebook is bigger than the market capitalizations of Bear Stearns, H.J. Heinz and Baidu.com and is about the same size as Sempra Energy, Ameriprise Financial and Xerox.

To put all of this in perspective Sempra Energy has about $11.6 billion of revenue and roughly $1.1 billion of net income compared to Facebook's $150 million of revenue and $30 million of net income. Okay, okay I know comparing a technology company with a gas utilities company is comparing apples and oranges, but you must admit it is a sobering perspective. Before this deal I find it hard to imagine that Facebook had much more than $20-30 million of cash and Sempra has about $1.3 billion, but I digress . . .

The 100x multiple on trailing earnings may seem a little rich, but Facebook is also making huge gains on MySpace its chief competitor in the social networking space. It is also experiencing dramatic revenue growth, particularly from Canada and Asia. Even from a quick glance at Alexa the ground Facebook has made up is stunning. You may have to click the graph to really see it, but you can see how Facebook's daily reach as measured by Alexa has risen dramatically over the past year, gaining on Myspace all the while:
During September Facebook attracted 30.6 million US visitors to Myspace's 68.4 million. So although it is growing faster it still has some ground to make up. But, Facebook's control over the US market is not what excites investors. He's a blurb from a Wall Street Journal article that describes it well:

Facebook, a service that lets people set up their personal Web pages, is seen as the next big venue for placing online display ads. The company has nearly 50 million users, many of them the young audience that advertisers covet. In addition to selling ads on its own, the company over the past year has started placing ads through a deal it signed last year with Microsoft, under which Microsoft brokers banner ads on Facebook's U.S. site until 2011.

The deal signed today is an expansion of that agreement and focuses on international versions of the Facebook service, which Facebook is now starting to open. A deal with Microsoft would allow Facebook to shift some of the burden of selling international display ads to its larger partner. Microsoft in recent years has built up a large online advertising sales force and has invested in technologies to broker advertising over the Web.

By the end of this year, Asia will account for 35% of the world's social networking users, with 28% of users in Europe, the Middle East and Africa, 25% in North America, and 12% in the Caribbean and Latin America, according to research firm Datamonitor Plc.

It is that strong international growth, particularly in Asia that has investors giddy. I think if we have learned one thing at this point it is to not underestimate Mark Zuckerberg or Facebook. I think it is not beyond the realm of possibility to expect a Facebook IPO sometime in 2009.

Foreclosure Wave is Not Over Yet

I think this IMF chart is self explanatory:

Hat Tip: Calculated Risk

San Diego Fires

San Diego is experiencing some horrible fires today. In fact you can actually see the huge smoke plumes from satellite images (right). Hundreds of homes have burned already in a firestorm that has reminded many of the devastating Cedar fire in San Diego 3 years ago. The difference this time is that there are actually between 6 and 8 fires across the county and the high winds and Santa Ana conditions that provoked these fires are due to stick around for a few more days. The bottom line is that there are simply not enough firefighters to fight these fires. The vast majority of the firefighters are spending their time helping the 250,000 evacuees flee their homes.

Please keep San Diego in your prayers over the next few days.

What is this Super SIV thing?

Over the weekend several readers asked me questions about the video clip I posted last week. They wanted more background on Structured Investment Vehicles (SIVs) and the Master Liquidity Enhancement Conduit (MLEC) that has been in the news this week (I foreshadowed the potential for such a fund back on September 5th). Then today the Wall Street Journal had a nice little article about what SIVS are, how they work and how they are related to the subprime situation:

Structured Investment Vehicles (SIVs) and similar instruments called conduits are entities that issue short-term, low-yielding notes called commercial paper. SIVs use the proceeds from selling such paper to buy longer-term, higher-yielding instruments such as credit-card debt and mortgage-backed securities. SIVs differ from conduits in that they can also issue longer-dated notes and use leverage. Though banks typically keep SIVs off their balance sheets, they usually assure that some or all of the vehicles' IOUs will be repaid.
The Pros: SIVs are a source for investors of commercial paper, typically considered a safe-haven investment. They can be profitable for affiliated banks, while generally keeping the risks associated with their higher-yielding debt off their sponsor banks' balance sheets.
The Cons: If the vehicles either can't sell commercial paper or suffer losses in the assets they hold, their affiliated banks could wind up having to help by lending funds to keep the vehicles operating or taking some losses back onto their balance sheets, potentially resulting in a massive hit to profits.
The Context: The popularity of SIVs has boomed since the strategy was invented by two Citigroup bankers in the late 1980s. But they became a source of worry for bankers and policy makers when a credit crunch that began this summer sapped demand for both commercial paper and risky asset-backed securities -- a double-whammy for SIVs. The Treasury Department recently brokered the creation of a $100 billion fund to buy assets from SIVs in hopes of kick-starting the moribund commercial paper market. Some critics call the fund a bailout of Citigroup, the largest sponsor of SIVs. The fear is that trouble for SIVs could compound problems in the credit market, hurting the broader economy, while also slamming the balance sheets and reputations of major U.S. banks.

Citigroup is the bank at the center of the storm. They have the most exposure -- some $80 billion -- to off-balance sheet entities like SIVs and conduits and as such are taking the lead on structuring the "super fund" that will take on the assets of the struggling entities. As you might expect there are a quite a few skeptics out there. Nouriel Roubini calls the whole thing a "Super Bailout Shell Game." Clearly those aren't words of confidence. It seems Roubini has more questions than answers:

What should we make of the SIV rescue plan, the so called Master Liquidity Enhancement Conduit (MLEC), also informally referred to as the Super-Conduit? Does it make financial and economic sense? Is it all a smoke and mirrors con game or a serious attempt to deal with the liquidity crunch in the SIV/ABCP market? Is it another case of moral hazard – with the US Treasury playing a critical role – or is Treasury only solving the collective action problem of coordinating the actions of many players? And is this just another musical chairs game or “don’t ask, don’t sell” game – reshuffling SIVs assets and liabilities with nice fees for the participating dealers – with no financial effect on the underlying illiquid assets or a way to defrost such illiquid assets? And how similar is this rescue plan similar or different to that of LTCM? Is this effectively a scheme to bail out Citigroup that is the most SIVs-exposed US bank? And are the implicit claims of Treasury and the Fed that this is not a bailout where there is no public money at risk credible?

Roubini has had his finger on the pulse of this credit issue since earlier in the year. He has been saying all along that this isn't just a liquidity issue, that this is an insolvency issue. No amount of financial engineering or wizardry is going to keep subprime borrowers seeing 30-50% jumps in their mortgage payments from defaulting on their mortgages. If that truly is the case and the issue here is that most of these SIVs hold low quality assets linked to risky borrowers then this whole scheme would seem to only delay the inevitable.

Alan Greenspan also has his concerns. (Is anyone surprised that Alan has an opinion on this matter? This guy can't stay out of the news these days)

I for one am not all that confident that this is the solution. I think that there are a lot of big banks and hedge funds who are realizing that when they finally find a market for some of the assets on their books the mark downs they will take could be devastating. There just hasn't been a lot of good news in the ABS markets. For those of you who have been following the ABX indices you may have noticed that after finding stable footing for a while in late August the BBB-rated indices are in a dramatic free fall once again. After starting the year over 90, the ABX HE-BBB-07 index is now trading just over 20. The ABX index itself probably won't last too much longer. There are far fewer than 20 eligible subprime securitizations this year, not enough to establish a liquid index according to Markit's rules. The index itself is not even two years old, but without subprime originations the liquidity in the existing index might begin to dry up putting further downward pressure on the index. I don't care how you slice it, which fund you put it in, what fancy name you put on it, or who helps organize it, the underlying "Super-SIV" assets are toxic waste and for every dollar market participants put in only pennies are likely to come out.

HESP Friday Performance

On top of tracking my Equity Select Portfolio I also track a fully hedged version of the same portfolio. I went back to check on that portfolio's performance on Friday, in what was a tough day for the markets with all major indices off over 2.5%.

On a day that saw the S&P 500 tumble 2.56% and the Equity Select Portfolio fall 2.17% the Hedged Equity Select Portfolio (HESP) managed to stay in the green on Friday with a 0.03% return. You can see in the graph below that although the S&P 500 has dropped about 3.7% from its peak the HESP has actually outperformed over that period. It's performance during the last market swoon was also much less pronounced than that of the market. (Click graph to enlarge)
This portfolio's strong market beating return is certainly commendable, but more importantly the portf0lio is behaving in a manner much different than the broader market. In fact with a beta of 0.13 it has a beta of roughly half that of domestic bonds. The portfolio has also demonstrated exceptional performance during down months in the market. In the monthly return graph below notice that the HESP has beaten the market during every down month for the S&P 500. Put differently, this portfolio is demonstrating very low downside capture ratio.

It is always great to be long when the market is on fire, but having a lower correlated portfolio to supplement core positions during market volatility can be a very comforting thing.

Only Funny Because its True

There is nothing better than listening to a Brit explain how "dodgy" debt becomes a SIV . . . hilarious.

Black Friday 20 Years Later

Twenty years ago, on a day now known as Black Monday the Dow dropped 508 points, or 22.6% in a single session. Black Monday was the fifth largest point drop in the history of the Dow. Today the market fared just a little bit better. The Dow's 366 point drop while registering as the 13th largest drop in the history of the Dow, amounted to a measly 2.64%. Though it did put the Dow below the levels it was at after the Fed's rate cut. If there was any doubt about what the Fed is going to do at the next meeting I think an extended decline in stock prices will surely have Bernanke priming the pump yet again. (Click the graph below to enlarge.)

While many investors think that another Black Monday is unlikely, there are some who take the opposite tack. Nouriel Roubini for one thinks that we are perhaps even more likely now to have a financial meltdown. His lengthy list of potential causes for another Black Monday is sure to put you in a bad mood heading in to the weekend:

All these factors mean that there’s an even greater risk today than in 1987 that things will get out of hand and trigger a financial free fall. Today you have the following: trade protectionism and asset protectionism (the increasing restrictions to foreign direct investments in the United States); hedgy and trigger-happy investors and rising geopolitical risks; the risk of a disorderly fall in the U.S. dollar that is now sharply weakening; a slush of financial and credit derivatives that are a black box of opaque financial innovation that no one truly understands; increasingly risky investment strategies based on growing levels of leverage (i.e. the ability to multiply risk bets by borrowing a lot to finance such bets); frothy markets where years of easy money created bubbles galore—the latest in housing—that have now started to burst; greater opacity and lack of transparency as there is no supervision or regulation of the activities of many highly leveraged and opaque financial institutions; risk management techniques in financial institutions that fail to truly test the risk of large losses in extremely rare events (such as a major market meltdown like in 1987 or in 1998 at the time of the near collapse of Long-Term Capital Management, then the biggest U.S. hedge fund); risk-hedging strategies that—like in 1987—can hedge nothing once everyone is rushing to the doors and dumping assets at the same time (with this summer’s liquidity crunch a perfect example of the vulnerabilities associated with the poor management of liquidity risk); a housing market whose rout has already triggered systemic effects through the subprime carnage; and the fact that subprime mortgages had been pooled in mortgage-backed securities and that these in turn were repackaged in other risky, complex, and illiquid securities (the various tranches of collateralized debt obligations) that were then given a misleadingly high rating by the rating agencies.

In order to cheer you up after that I thought I would at least add something more light-hearted:

Okay maybe that wasn't exactly 'light-hearted.' But you have admit that it is funny . . .

Hat Tips: Bespoke, Barry Ritholtz

Tower Tech Has the Wind at its Back

One of my 'watch list' holdings that just barely didn't make it in to the rabbit portfolio has gone on quite a run since the snub. In fact it is up over 35% in the last 5 trading days alone, including its 18% surge this morning. The company is Tower Tech Holdings. Here is the business description from Google Finance:

Tower Tech Holdings Inc., formerly Blackfoot Enterprises, Inc., through Tower Tech Systems, Inc., is engaged in the manufacturing of fabricated towers for wind turbines that are sold to a limited number of customers for use in the support of wind turbines. These wind turbines are used in the generation of electricity throughout the United States. The Company’s operations are located in Manitowoc, Wisconsin, where it leases 163,400 square feet of production space, with an additional 40,000 square feet of administrative and engineering space. It offers customers wind tower support structure and monopiles. Until February 6, 2006, the Company was not engaged in any operations. Effective February 6, 2006, an arrangement was completed between the Company and Tower Tech Systems, Inc. (Tower Tech). On October 1, 2007, the Board of Directors of the Company completed its acquisition of all of the outstanding stock of RBA, Inc., a fabricator of components for energy-related industries.

The company is well positioned to take advantage of a surge in demand for wind turbines. They recently completed a purchase of RBA, Inc., a manufacturer of components for energy related industries. This micro cap stock originally showed up on my radar because of a prominent shareholder that caught my attention; Jeffrey Gendell. He owns roughly 20% of the company as a personal holding, not a holding of his hedge fund Tontine Capital Partners.

What is Mechanism Design?

If you have been following the Nobel Prize awards this past week you know that three economists accepted the award for the 2007 Economics Nobel (knows as the Sveriges Riksbank Prize in Economic Sciences in Honor of Alfred Nobel) for their work on mechanism design theory. So the question from the uninitiated is what exactly did the three economists - Leonid Hurcwiz, Eric Maskin and Roger Myerson - prove that was so interesting. Well I was originally going to try and write a blog about this topic that would describe what mechanism theory is, but then I stumbled upon a post by Alex Tabarrok that did the job quite well. Read on:

Mechanism Design for Grandma

Ok, Grandma may still have some difficulty but in honor of today's Nobelists, Hurwicz, Maskin and Myerson let's give it a go. Suppose that you are selling a rare painting for which you want to raise the maximum revenue. There are two potential buyers, Tyler, who values the painting at $100,000, and Alex who values it at $20,000. The problem would be simple if you knew this information - you would then set the price at $99,999 and Tyler would buy maximizing your revenue. But how much Tyler and Alex value the painting is their own private information. How then should sell the painting?

One possibility that springs quickly to mind is an auction. In a standard English open-cry auction Alex and Tyler will bid for the painting and the bids will keep rising until Alex is forced to drop out at $20,001. Thus the auction earns you $20,001. Not bad but is this the maximum revenue possible? Remember that Tyler values the painting at $100,000 so you could be leaving a lot of money on the table.

What else can you do? Well, how about an auction with a reserve price, say $50,000 - think of a reserve price as a secret bidder who calls in his bids on the phone. A reserve price of $50,000 works well in this case as Tyler will pay $50,001. But note that you just got lucky, if Tyler had valued the good at $30,000 you would have earned nothing at all. Thus you would like to know whether a reserve is always optimal and how to set it. (Riley and Samuelson, and much more generally Myerson both show that a reserve price is always optimal and how to set it).

But why stop at a reserve price? How about a reserve price and an entry fee? But why stop at reserve prices and entry fees? You can add any kind of requirement to the auction that you want but will these requirements help you to raise revenue? Lets boil the problem down to its essence. Think about an auction as a mechanism - bidders put information into the mechanism, their bids, and the mechanism tells them the outcome. (Hurwicz was the first to really start thinking about mechanisms in these very general terms.)

You want to design the mechanism to achieve a certain outcome. The mechanism can be as complicated as you want but it must satisfy certain conditions. First, the bidders must participate voluntarily - you can't boil them in oil - so there is a participation constraint. At the end of the day the bidders must expect to be at least as well off as if they did not play the mechanism game (at least on average).

Second, there is an incentive compatability constraint. You don't know how much Alex and Tyler truly value the painting so suppose that Tyler mimics whatever Alex does - Tyler can do this since he values the painting at least as much as Alex does. It follows that whatever outcome the mechanism assigns to Alex, Tyler must get at least as much. This is a significant constraint because it means that if you want Tyler to do something different than Alex, and you do, you want Tyler to bid more, then you must give Tyler something in return. Thus, even in the optimal mechanism you, the seller, are not going to get everything. Tyler is going to walk away with some surplus.

We still haven't solved for optimal mechanism, however. And here is where the magic comes. Not magic as in something wonderful but magic as in hand-waving. Maskin and Myerson proved something very useful about mechanisms with these types of constraints. It turns out that if you follow the constraints then you can restrict attention to mechanisms in which Tyler and Alex always tell the truth about their values, this is called the revelation principle. (In a sense, this is obvious for imagine that we find the optimal mechanism given that Tyler and Alex submit whatever bids/information they want. Then you tell Tyler and Alex - next time why don't you tell the truth about your values and we promise to give you exactly the outcome that we would have given you under the previous mechanism.)

In the case of auctions the direct mechanism is well known, a second price auction. In a second price auction the high bidder wins but pays the second highest-bid. In this auction it makes sense for every bidder to bid his true value - see if you can work out why - and it turns out that as the revelation principle says, revenues in this direct auction are the same as in say a regular English auction (under certain conditions, of course).

Ok, I have gone on for a while. Here's the bottom line. The basic set-up of agents with private information submitting "bids" which are then fed into a mechanism resulting in outcomes is very general. How to raise taxes, regulate a monopolist, fund a public good (here's my own contribution to mechanism design), allocate organs, assign interns to hospitals, split common costs, allocate electricity across a grid - all can be thought of as mechanism design problems. The tools that Hurwicz, Maskin and Myerson developed and their methods of paying attention to participation and incentive compatability constraints and using the revelation principle helps us to design, at least in principle, the best solutions to all of these problems.

Hat Tip: Marginal Revolution

Blog Action Day: The Environment


Today is Blog Action Day. Over 16,000 blogs with RSS subscribers of over 13 million readers all posted about the environment.

As my small part I have listed a few of those articles below for your enjoyment:

TheIssue.com - Engineering our Planet
This is a great piece looking at the role of bio-engineering can play in reversing climate change. This is a great review of an interesting idea that is also potentially very polarizing.

This video is from the YouTube Blog:

Here are some other resources on the web:

• Eyeka's Blog Action Day Page - Eyeka contributors have made hundreds of photos and videos freely available for use in Blog Action Day!
  
• Treehugger - Easily the best environmental blog on the web, Treehugger has a great section called How to Go Green as well as tons of other useful stuff. It's manned by some 40 writers around the world and contains no less than 14,000 posts!
• Wikipedia's list of environmental issues - With enough links to keep you busy for hours, Wikipedia should easily set you off on your environmental web travels.
• Digg's Popular Environment Stories - lists tons of popular posts and articles on all sorts of subjects.
• Green TV - If you need visual stimulation, Green TV has a lot of videos to get you going, divided up into channels of content, it is eminently watchable.
• We can live green - A lot of things boil down to practicality and We Can Live Green will help you find actual products and consumables that are environmentally friendly.
• IMDB's Highest Rated Environmental Movies and Documentaries - Al Gore's Inconvenient Truth isn't the only environmental DVD to watch, check out IMDB's list of features ordered by user ratings.
• The Union of Concerned Scientist's Green Tips Page - A page full to the brim with great ideas and tips!
• The Nature Conservancy's Carbon Calculator - This calculator leaves all other carbon calculators in it's wake!
• The Sustainable Community Action Wiki - Share, learn and help with this fantastic wiki with over 2000 pages!
• Greenliving English and Spanish - Plenty of great information here from NRDC.

Market Cheat Sheet

Cheat sheet: reacting to data and market releases

weak data = Fed ease, stocks rally

consensus data = lower volatility, stocks rally

strong data = economy strengthening, stocks rally

bank loses $4bln = bad news out of the way, stocks rally

oil spikes = great for energy companies, stocks rally

oil drops = great for the consumer, stocks rally

dollar plunges = great for multinationals, stocks rally

dollar spikes = lowers inflation, stocks rally

inflation spikes = will inflate all assets, stocks rally

inflation drops = improves earnings quality, stocks rally

Hat Tip: Barry Ritholtz

Ray Kurzweil On Acceleration

Ray Kurzweil is a very, very interesting man with a long history of success in innovation. Much of that work has centered on recognizing patterns. There are many great biographies out there about Ray so I won't attempt to recreate them here. The reason I write about him today is his emergence as a hedge fund manager. This revelation shouldn't be surprising as it seems everyone is trying to become a hedge fund manager these days. But somehow, with Kurzweil, it actually makes sense. His background in innovation and pattern recognition should help him deliver the returns he has promised his investors. Here is an excerpt from the aptly named Fortune Magazine article "The Smartest (and Nuttiest) Futurist on Earth" by Brian O'Keefe:

If you went around saying that in a couple of decades we'll have cell-sized, brain-enhancing robots circulating through our bloodstream or that we'll be able to upload a person's consciousness into a computer, people would probably question your sanity. But if you say things like that and you're Ray Kurzweil, you get invited to dinner at Bill Gates' house - twice - so he can pick your brain for insights on the future of technology. The Microsoft chairman calls him a "visionary thinker and futurist."

Kurzweil is an inventor whose work in artificial intelligence has dazzled technological sophisticates for four decades. He invented the flatbed scanner, the first true electric piano, and large-vocabulary speech-recognition software; he's launched ten companies and sold five, and has written five books; he has a BS in computer science from MIT and 13 honorary doctorates (but no real one); he's been inducted into the Inventor's Hall of Fame and charges $25,000 every time he gives a speech - 40 times last year.

And now, if anything, he's gaining momentum as a cultural force: He has not one but two movies in the works - one a documentary about his career and ideas and the other an adaptation of his recent bestseller, The Singularity Is Near, which he's writing and co-producing (he's talking about a distribution deal with the people who brought you "The Day After Tomorrow").

When Kurzweil isn't giving keynote addresses or reading obscure peer-review journals, he's raising money for his new hedge fund, FatKat (Financial Accelerating Transactions from Kurzweil Adaptive Technologies). He's already attracted a roster of blue-ribbon investors that includes venture capitalist Vinod Khosla, former Microsoft CFO Mike Brown, and former Flextronics-CEO-turned-KKR-partner Michael Marks.

Being a hedge fund manager may seem an odd pursuit for an expert in AI, but to Kurzweil it's perfectly natural. The magic that has enabled all his innovations has been the science of pattern recognition - and what is the financial market, he postulates, but a series of patterns?

You can check out Kurzweil's Fat Kat Hedge fund website here. You can also watch an incredibly interesting video of Kurzweil speaking at the 2005 Ted Conference below:

Only Funny Because its True

Hat Tip: Greg Mankiw

The EMC and VMware Arbitrage

A while back Toro explored an intriguing qeustion: Is there a pricing discrepancy between EMC and VMware? EMC is a data storage company and until this year VMware was its wholly owned subsidiary. VMware of course was one of the most hyped tech IPO's in recent memory and their virtualization solutions are utilized by ALL of the Fortune 500. EMC spun out a stake in VMware earlier this year though VMware is still 87% owned by EMC. Therefore we would expect there to be a fairly strong link between the stock prices of EMC and VMW, and if the link was weak we would expect there to be an arbitrage opportunity. Check out Toro's take below. I have updated his numbers to reflect mid-day prices today. As you can see EMC has become more attractive relative to VMW as VMW's stock price has surged:

EMC (EMC) is a data storage company, and VMware (VMW) makes nifty cool virtualization "solutions" that are going to make pretty much all hardware obsolete, or so I'm told.

Google Passes $600, May Soon Pass Berkshire

Today Google passed the $600 dollar mark for the first time. It seems that Google, much like Buffett's Berkshire Hathaway, is very content in not splitting their shares. If things go according to plan their shares should hit $1000 in the next few years.

An interesting side note is that Google's market capitalization is roughly equal to that of Berkshire Hathaway. In all likelihood Google will pass Berkshire Hathaway in market capitalization within the next few weeks or months. Both firms however will have to grow another 168% in order to pass Exxon Mobil, the largest US company in market capitalization:

Hare and Hedged Hare Portfolios

As announced yesterday, I have put together an aggressive growth portfolio that I am calling a "hare" portfolio. Because most of the stocks in this portfolio are high beta, momentum based selections I have also constructed a fully hedged "Hedged Hare" portfolio that shorts the ETF's of three broad market indices that this portfolio tracks. Specifically it is short 40% FXI, 40% VWO and 20% SPY. The short sale rebate is invested in the short term treasury ETF, SHY. This portfolio will probably not be beta neutral, but I will try my best to keep the beta near zero (or negative). If necessary I will make changes to the hedge during the quarter to make sure it is accomplishing its goal. I will not change the core Hare Portfolio holdings themselves until the beginning of Q1 2008.

The stock selection strategy was a little different from my Equity Select Portfolio. Equity Select focuses on growth stocks with strong franchises, strong management, leadership in their market with the wind at their back. The goal with Equity Select is to identify companies that can be held for 5 years.

The Hare Portfolio strategy is quite different. It seeks to identify momentum stocks that have a significant change to outperform over a 3-6 month time horizon. Stock selection was accomplished through a combination of methods:

1. A simple momentum and growth stock screen;
2. Best ideas from a few top of the line hedge fund managers (Gendell, Klarman etc.);
3. A dolop of good old fashioned gut feeling.
   

If anything I think this portfolio will provide a fun ride. Don't be surprised if at the end of the quarter one stock is up over 50% and another is down over 50%.

The 10 stocks held are as follows:

1. VMware (VMW) is a provider of virtualization solutions.
2. Vimpel Communications ADR (VIP) is a Russia-based provider of wireless telecommunications services in Russia, Kazakhstan, Ukraine, Tajikistan, Uzbekistan, Georgia and Armenia
3. Smith International (SII) is a global provider of products and services to the oil and gas exploration and production industry.
4. Companhia Vale do Rio Doce (RIO) is a diversified metals and mining company.
5. China Life Insurance Company Limited (LFC) is an insurance company in the People's Republic of China.
6. KHD Humboldt Wedag International Ltd. (KHD) is an industrial plant engineering and equipment supply company.
7. Freeport-McMoran Copper & Gold (FCX), through its majority-owned subsidiary, PT Freeport Indonesia, is engaged in copper, gold and silver mining and production operations.
8. Cummins Inc. (CMI) designs, manufactures, distributes and services diesel and natural gas engines, electric power generation systems and engine-related component products, including filtration and emissions solutions, fuel systems, controls and air handling systems.
9. Baidu.com, Inc. (BIDU) is a Chinese-language Internet search provider.
10. America Movil (AMX) is a provider of wireless communications services in Latin America.

Looking at this portfolio you probably noticed a few major themes:

• Strong International and Emerging Market exposure.
• Sectors: Energy, Telecom, Materials, Tech, Industrials.
• Strong momentum.
• An almost complete disregard for valuation.
  

Here's three days worth of performance on the portfolio. Obviously this isn't long enough to tell anything about the portfolio:

Here's the three days performance on the Hedged Hare Portfolio (notice the negative beta):
Tomorrow I will post the tortoise portfolio as well as the hedged tortoise and the hedged Equity Select Portfolio. I'm starting to think that market neutrality might be a very useful thing over the next 12 months.

Tortoise and Hare Portfolios

I have designed 2 new tracking portfolios and will be launching them this week. The stocks have been selected and I will start the tracking from the open of the market on Monday (the beginning of the quarter). The first portfolio is an aggressive growth "hare" portfolio and the second is a conservative growth "tortoise" portfolio. The management of the portfolios will mimic that of the Equity Select Portfolio:

1) The portfolios will have a long only, buy and hold mandate.
2) The portfolios will remain 100% invested in equities at all times.
3) The tortoise portfolio will have a maximum of 5 equity positions, the rabbit will have 10.
4) There will be no market cap limitations on the portfolios. Domestic and international equities can be utilized.
5) Starting with the first trading day of each quarter there will be a 10 trading day period in which changes can be made to the portfolio.
6) A strong emphasis will be placed on limiting portfolio turnover.
7) The portfolio will be tracked and performance reported on this site at least quarterly.

I expect to get the portfolios up by the end of the day.

Equity Select Portfolio, 27.4% YTD

The five stock Equity Select Portfolio (ESP) I track is up 27.4% after three quarters. The S&P returned 7.69% over the same span. I do not have any money directly invested in this portfolio. It is used solely as a research tool. You can see from the graph below that the ESP had a very difficult quarter. However because the ESP has a long-only, buy and hold mandate I did not change any of the positions in spite of a turbulent August.



Some of the key portfolio stats have fallen since a phenomenal first quarter performance, but the Sharpe ratio is still comfortably above 1 and the performance has been strong. Apple was again a top performer in the quarter, making up for weakness in the financial stocks during the ongoing credit market crisis:

The change I made at the close of the market on July 11th to switch from Sears Holdings (SHLD) to BHP Billiton (BHP) turned out to be a smart one in the short term. However, at first the change seemed to have backfired. Five weeks after the change BHP was down almost 20% and it looked like my decision to increase international exposure and increase exposure to basic materials was a bad move. But, over the last 5 weeks of the quarter BHP went on quite a run, ending up 18.92% since the change. Over that same period SHLD is off 17%. At the time of the change the other serious consideration for the spot to replace SHLD was CVS. Since the change CVS is up 9.69%. CVS has also been significantly less volatile than BHP or SHLD. While I would love to add CVS to the portfolio is is not a top 5 position at the current time. Below is the performance of SHLD, BHP, CVS and the S&P 500 since the change on July 12th:

This portfolio has done quite well through three quarters. I have two weeks from today to review the portfolio and make any changes. While I don't foresee any changes to the equity holdings I might pursue a portfolio rebalancing to take advantage of the loss position on Sears Holdings. If you have suggestions for an addition to the portfolio please let me know.