Why Currency Exposure Matters

Most investors don't think about currency when they are investing. I think that is a mistake. Today Bespoke provided a perfect example of why currency matters . . . .

If you own all domestic stocks and bonds and the dollar drops consistently against a basket of other currencies your real currency weighted return is actually much lower. Ignoring currencies is not a smart decision.

Yale's Endowment Turns In Another Stellar Year

Yale's David Swensen is a pioneer in multi-asset class investing. I've taken to reading Yale's annual reports to dissect Swensen's asset allocation and methodology. Something tells me I'm not the only one doing this. When Swensen inherited Yale's $1.5 billion endowment in 1985 their asset allocation was roughly two thirds stock and one third bonds. In the graph below, the first thing you will notice is how dramatically Yale's portfolio has changed over the years. Swensen has invested heavily in hedge funds, private equity, real estate, commodities and other alternatives. Today he has only 3.8% of Yale's portfolio in fixed income and just 11.8% in domestic stocks. I expect both of those figures to continue to trend lower. You can see in the graph below that Swensen has gotten progressively lighter on domestic equities over the past 10 years and recently he has gotten rid of most of his fixed income exposure:
Yale's $22.5 billion endowment is the second largest in the country behind Harvard's $34.9 billion endowment. But, Yale has been the top performing large (>$1billion) endowment over the last 22 years. This past year was no different as Harvard turned in a very respectable 22% return under Mohamed El-Erian and Yale put in a best of class 28% return:It is absolutely amazing that David Swensen is still at Yale and not running his own fund. If their was ever a guy who could raise $5 billion on a whim and immediately cash in it is David. There must be something else that drives him to stay in the ivory tower . . . .

Hat Tip: WSJ

Enjoying 6 Months Sans Rent

I don't know why they are trying so hard . . . they should just kick back and enjoy the house mortgage free until the bank comes and kicks them out. I just don't envy that insulting tax bill that comes saying that the loss you took on that house is actually income . . .
Hat Tip: Jim the Realtor (I can finally see your pictures!)

Hedge Fund Fraud: Our Tenth Year!

The SEC posted a press release today that almost made me fall off my chair laughing (until I started feeling bad for the investors who fell into the trap). Allegedly a San Francisco based "Hedge Fund Manager" raised $10 million of seed capital for his startup fund in 1997. For ten years he falsified performance statements and bragged about his performance to his investors. In reality however he actually just used the fund as his personal bank account. He bought real estate, cars and European shopping sprees for his ex-wife (unlike his investors it sounds like she got out just in time) . The hedge fund was called the Fahey fund. You can check out his "low budget" website here. The guy actually has a form on his site to set up a self-directed IRA in order to invest in his fund. Now, it would seem as if a mere 5 minutes of due diligence would expose this guy, yet he lasted for a full 10 years (see the "Out Tenth Year!" celebration above), so he must have been good. You can read the full press release below:

SEC Brings Fraud Charges Against San Francisco Hedge Fund Manager

FOR IMMEDIATE RELEASE
2007-203

Washington, D.C., Sept. 26, 2007 - The Securities and Exchange Commission today charged a San Francisco hedge fund manager with defrauding investors by dramatically overstating the fund's profitability and misusing fund assets. The Commission alleges that Alexander James Trabulse sent account statements to investors in his Fahey Fund that inflated the fund's returns by as much as 200 percent, while using investor money to purchase cars and finance shopping sprees for his family members.

"Trabulse betrayed the trust investors placed in him by fabricating performance figures and treating the hedge fund as if it were his own personal bank account," said Linda Chatman Thomsen, Director of the SEC's Division of Enforcement. "The Commission is determined to hold hedge fund managers accountable when they deceive investors."

Helane L. Morrison, Director of the SEC's San Francisco Regional Office, added, "Trabulse encouraged his existing investors to serve as references for new investors. As a result, his false account statements not only lulled existing investors into believing their investments were hugely profitably, but lured new investors into the fraud."

According to the Commission's complaint, filed today in federal district court in San Francisco, Trabulse founded the Fahey Fund in 1997 and raised about $10 million from approximately 100 investors. He told investors the fund invested in financial instruments like stocks, derivatives, and foreign currency. The complaint alleges that Trabulse lured investors by touting the fund's spectacular performance, when in reality the statements he provided to investors bore no relation to the fund's actual performance.

The Commission also alleges Trabulse misused fund assets to pay for a wide variety of personal expenses, using the fund's bank account to pay for cars, a home theater system, and his ex-wife's overseas shopping allowance. He even gave one relative free reign to use the fund's bank accounts for personal use, according to the Commission.

The Commission's complaint alleges Trabulse violated the antifraud and registration provisions of the federal securities laws, and seeks disgorgement, penalties, and other relief. The Commission also has named as relief defendants several entities associated with Trabulse that received assets through Trabulse's fraud.

Hat Tip: Footnoted.org

Biggest Home Price Drop Since 1991

Home price declines are accelerating after August's credit crunch put additional pressure on underwater borrowers. According to the S&P/Case Shiller Indices home prices for their 10 city index are off 4.5% year over year which is the largest fall in the index in 16 years. The Case Shiller Indices were pioneered by Karl Case and Yale economist Robert Shiller, who is perhaps best known for his best-selling book Irrational Exuberance, in which he examined asset bubbles throughout history. Shiller's second edition of Irrational Exuberance argued that the U.S. real estate market was a bubble in 2005.

I personally think that Shiller has made a very sound argument that real long term home price appreciation has been quite small (roughly 1%/year over the past 115 years). The graph he produced shows a significant break from trend in home prices in the latter half of the 1990's. It became increasingly difficult to explain the break from trend, and now it appears that home prices are moderating. How far they will fall is anybody's guess. Moody's thinks it will be about 11%, some aggressive economists are predicting a 25% total decline in prices. I bet if you asked Shiller he would be afraid to tell you for fear that you wouldn't take him seriously.


Before I start discussing the recent declines I think it is important to touch on why I rely on the Case Shiller numbers instead of median prices. I prefer the S&P/Case Shiller methodology because it tracks the price path of individual representative homes in a given geographical area by using "matched price pairs." This methodology enables the index to avoid many of the issues with using median based pricing models. For example in the current downturn home price declines were obscured in part by slower sales on the lower end of the spectrum while higher end homes continued selling at a brisk pace. So, although home prices were largely falling the lack of sales on the low end led to a drifting up of the median price, masking home prices declines. Needless to say I am not a big fan of median pricing. This is especially true because median prices are in large part reported by the National Association of Realtors, an industry group I don't see eye to eye with. The other index that is worth looking at is the OFHEO, which is calculated using a similar methodology to Case Shiller.

Here's the S&P Press Release:

New York, September 25, 2007 – Data through July released today by Standard & Poor’s for its S&P/Case-Shiller® Home Price Indices, the leading measure of U.S. home prices, shows a continuation of negative annual returns in the 10-City Composite and the 20-City Composite, as well as 15 of the 20 metro area indices. Both composite indices have registered negative annual growth rates since the beginning of the year. In addition, both indices rate of decline has become larger in each of the seven months from January through July.

Prices in my home town of San Diego are off 7.8% YOY, the third worst of any city of the 20 cities that S&P tracks. The worst home price depreciation occurred in Detroit, which is off 9.7% YOY. The best home price appreciation was in Seattle, which is up 6.9% YOY. The 20 city composite index is down 3.9% YOY.

The Economics of Buying a Hybrid

If you are considering buying a hybrid you must first go check out TheIssue.com's analysis of the economics of buying a hybrid:

Hybrid cars are often considered the perfect match for the thrifty and environmentally conscience consumer. They save gas money, reduce pollutive emissions and ease demands on strained energy sources. While these benefits are almost certainly true, the cost-benefit equation is more complicated. Many would-be buyers find that the technology premium outweighs gas savings, and others point to environmental drawbacks like battery manufacturing.

Read on at TheIssue.com.

A Post Rate Cut World

Here are the key issues I am following after the Fed Rate cut earlier this week:

• Dollar Devaluation: The US Dollar has taken a big hit on the back of the 50bp FF rate cut on Tuesday. For the first time in 30 years the loonie (Canadian Dollar) reached parity with the USD. The Euro broke through the key psychological level of $1.40 as it continues to rally against the dollar. The trade weighted dollar index dropped 1% to 78.5. Here are some other highlights from the dollar devaluation:
• Saudi Arabia: SAMA, Saudi Arabia's monetary agency, took no action after the Fed rate cut signaling that it might be considering dropping its peg to the US dollar. While this alone wouldn't crush the dollar there are concerns that sentiment is slowly switching among central bankers the world over how tied they want to be to a slowing US economy.
• Greenspan: Alan Greenspan has been hogging the spotlight with the release of his new book and his prognostications on the economy. According to Alan the odds of a recession are "somewhat more" than 1 and 3 even after the Fed rate cut. Alan also appeared
  on the Daily Show on the same day the Fed cut rates . . it yielded quite an interesting interview.
• 
  
• Commercial Paper: Many market participants have been tracking the commercial paper market to gauge the health of the credit markets in general. We have had 5 straight weeks of declines in commercial paper outstanding for a total decline of roughly 16%. The decline has been led by asset backed commercial paper (ABCP). After the declines slowed the past few weeks they picked up this week though the cause of the shift is largely due to a decline in supply instead of a decline in demand.
• Financials: In the face of strong headwinds Goldman Sachs put together a strong quarter, with a 79% surge in net income. Goldman is now the only major bank that is in the black on the year, up almost 3% on the year. Bear Stearns didn't fare quite so well, watching its net drop 61%. Its stock is off almost 30% on the year.
• GSE Portfolio Caps: President Bush and OFHEO reversed tack and allowed Fannie and Freddie to raise their loan capacity by 2% for a total increase of $34 billion. The change should help relieve some pressure on the mortgage market but isn't a quick fix.
  
• Middle East Sovereign Wealth Funds: Dubai purchased a stake in OMX and Nasdaq. Qatar purchased a 20% stake in the LSE. Abu Dhabi purchased a $1.75 billion stake in the management company of private equity firm Carlyle.
• Rally in the AAA ABX Indices: After briefly being down over 10% on the year the AAA ABX index has rebounded nicely off of its yearly lows.
  
• Stabilization in the BBB Rated ABX Indices: The BBB rated indices are still trading down 70% this year but look steady at current levels.
• Barack Obama's Rough August: Jim Simons and Mark Carhart aren't the only ones who had a tough start to August this year. If you track Barack Obama's likelihood to be the Democratic nominee for President on InTrade you may have noticed the Barack Obama had a rough start to August this year, falling from a virtual dead heat with Hillary Clinton into a distant second place.

Fed Funds Rate Cut to 4.75%, Discount Rate at 5.25%

After much speculation in the financial press and on Wall Street the Federal Reserve cut the Federal Funds rate to 4.75%. The Fed also lowered the discount rate to 5.25% keeping the spread between the FF rate and the discount rate at 50 bps. Fed Funds futures projected a 42% chance of a 25 bp cut and a 58% chance of a 50bp cut, though most economists predicted a 25 bp cut. In what is sure to be a very controversial move the Fed pursued a drastic policy action that may look to many as if it is seeking to "bail out Wall Street." Concerns about the strength of the economy will also be heightened as the Fed took a dramatic step today to ease in the face of a prolonged credit crisis and housing downturn. The broad market indices were up this morning on positive earnings from Best Buy and Lehman and should finish strong on the Fed's decision. You should also look for the USD to weaken further against most major currencies on recession concerns.
Here is the text from today's Federal Reserve Statement:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4%.

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Developments in financial markets since the Committee's last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric Rosengren; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 5-1/4%. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, St. Louis, Minneapolis, Kansas City and San Francisco."

There are dramatic changes in the release compared to August 7th's Federal Reserve Statement:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.

Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.

The Fed statement changed dramatically in the 6 weeks since the last release. Gone is the language about inflation moderation being "convincingly demonstrated" and gone is the emphasis on inflation as the "predominant policy concern." The Fed is clearly at the beginning of an easing cycle, though they emphasized the need to monitor incoming information and tried their best to warn investors that they are taking a balanced view on the prospects for inflation and economic growth.

I was personally quite surprised by the unanimous vote. The previous four Federal Open Market Committee meetings yielded unanimous votes to hold rates. The last time the FOMC failed to produce a unanimous vote was back on December 12, 2006 when Jeffrey Lacker advocated a 25 bps increase in the FF rate. That vote was one of a series of 4 straight votes that Lacker broke from the group in seeking to raise rates. But in light of the credit market conditions and uncertainty about the economy it definitely surprised me that between Thomas Hoenig and William Poole we didn't get a single vote for a 25 bps reduction in rates today. I expect a deluge of articles in coming days about moral hazard concerns and the perception that Bernanke is yielding to pressure from Wall Street and incumbent politicians who are hoping for a strong economy going into an election year.