October 2011


A pretty serious bankruptcy. The ‘firm’ was large. Corzine, you would have thought, after his ‘experiences’ watching and losing money in Long Term Capital Management’ in 1998 would have seen the similarities. LTCM placed massive leveraged bets on the Russian rouble just before Russia defaulted…sovereigns never default right?

Reaching for yield (and prospectively capital appreciation) while shortening duration had become the new ‘smart money’ trade as we saw HY credit curves steepen earlier in the year (only to become the pain-trade very quickly). The attraction of those incredible yields on short-dated sovereigns was an obvious place for momentum monkeys to chase and it seems that was the undoing of MF Global. The Dec 2012 Italian bonds (of which MF held 91% of its ITA exposure in), as highlighted in today’s Bloomberg Chart-of-the-day, appears to be the capital-sucking instrument of doom for the now-stricken MF.

However, that happened to a bunch of people today with the bankruptcy of MF Global ($MF). Traders couldn’t access their accounts and the trading MF did was liquidation only, meaning closing positions. I feel bad for the employees of MF Global. They didn’t have a hand in running the company into the ground.

This dislocation is only a short term operational problem. Money in clearing firms is segregated away from the assets of the firm itself. Traders don’t worry about that. But when assets get frozen up and you need to post margin on positions it’s a royal pain in the you know what.

The market decline today wasn’t about MF Global. It was about continued worry in Europe. The Europeans papered over their problems by throwing more money at it. Do you really think the Italians can continue to auction of debt at 6% interest rates and pay for it? Not a chance. The broader market isn’t affected by one futures firm. The only reason it’s a big story is they are led by a former Goldman CEO, and former government official (Senator, Governor) that was rumored to become a Treasury secretary.

MF Global went bankrupt for the same reason a lot of clearing firms go under. They chase yield. All the guys like me that have excess money in their account after their positions are margined give firms a chance at some cash flow. The firms that go bankrupt use that money to buy overnight treasuries and earn some interest on it. The problem today, no one is paying any overnight interest so that cash flow stinks.

When you are an operation like MF Global, you might do some financial budgeting based on earning a certain return on assets. When you don’t earn that return, you need to bump up the risk you take to earn more yield. In MF’s case, instead of buying US Treasuries, they decided to buy European securities. What could go wrong?

A haircut that’s what.

Boom went their balance sheet. Now they are done. Refco and MF Global followed a similar strategy. They rolled up IB’s and then tried to sell a lot of value add products and generate cash flow from deposits and commissions. In Refco’s case, fraud brought them down. MF just made some really poor business decisions.

Those of us in the know in the futures industry never thought MF was a particularly clean house anyway. My friend Dan Dicker from New York can tell you chapter and verse about their reputation on the NYMEX/COMEX floor. It wasn’t very good.

I mean, what did you expect? Their CEO ran the state of New Jersey into the ground. His claim to fame was front running customer business at Goldman before he became a US Senator. All you have to do is read “When Genius Failed”. Goldman downloaded the positions of LTCM before they lent them the money, then pressed the positions and caused them to go bankrupt. They took the other side as they blew out and made a ton of dough. Karma sucks. What did Corzine run better? MF or NJ?

Eastman Kodak Company (EK) is expected to book a wider loss than a year ago when it reports third quarter earnings on Thursday, November 3, 2011 with analysts expecting a loss of 41 cents per share, down from a loss of 2 cents per share a year ago.

What to Expect:

The consensus estimate remains unchanged over the past month, but it has decreased from three months ago when it was a loss of 27 cents. Analysts are expecting a loss of $2.43 for the fiscal year per share.

Analysts look for revenue to decrease 6.1% year-over-year to $1.65 billion for the quarter, after being $1.76 billion a year ago. Revenue is projected to roll in at $6.36 billion for the year.

Based on all the analysis that I have completed, Eastman Kodak should survive. At the moment this looks to be a really ‘stupid’ position to take. Here, in a nutshell is one aspect of the great difficulties found in ‘investing’ or ‘speculating’.

I already have a fairly substantial position. Do I compound the error if wrong, and turn a really bad position into a horrific position, or, if the common shares survive and the strategy succeed in turning their business around, look like a genius?

I am going with my own analysis, and I will increase the position tomorrow. I have placed a GTC order at limit $1.13.

It is just 12 years since we reached six billion and the growth is set to continue, to nine billion by 2050 it is estimated – that’s around three times the number of people on Earth when I was born.

These figures would be unimaginable to the pessimists, from Thomas Malthus onwards, who have consistently warned that the world cannot sustain any more people. The challenges presented by such rapidly growing demands on the planet’s water, energy resources and farmland are significant. Yet, human ingenuity has succeeded thus far in not just providing for a rising population but massively increasing the living standards of most people.

One of the curious paradoxes of population growth is that the more able people are to sustain large families, because they become wealthier, the less inclined they are to actually have more children.

So, while greater affluence is often blamed for increasing the strains on the world’s finite resources, it is possible that a richer world may be a more sustainable one because it will cause a natural levelling off in population growth.

That is some way off, however. In the short term the number of people will continue to rise and this has a number of implications for investors. Three of the more important are related to food, urbanisation and growth in consumption.

It is estimated that food production will need to rise by 50pc by 2030. In part this is to do with more mouths to feed, but it is also a consequence of those mouths’ changing appetites. As people grow wealthier their diets change and they consume more protein such as meat and dairy products.

With 7kg of grain required to produce just 1kg of meat, this puts an increasing strain on existing agricultural acreage. The solution cannot simply be to bring more land into cultivation because the most productive has already been used and industrialisation and urbanisation are eating into what is already under the plough.

The second consequence of the current rate of population growth is a rapid increase in the proportion of urban dwellers. In 1950, around one third of the world’s people lived in cities but by 2025 it is forecast that 60pc will live in urban areas.

The biggest implication of this growth is for infrastructure spending and the raw materials that make that kind of development possible. One recent estimate by the OECD suggested that 3.5pc of the world’s economic output needs to be channelled each year into building, or rebuilding, electricity, road, rail, water and telecoms networks.

The third big consequence of population growth is a rapid increase in the high-consuming middle class.

This group of people, which has moved beyond subsistence to a life in which it can realistically aspire to own consumer goods and spend money on services such as health care, education and finance, is predicted to rise from around 400m to 1.2bn between 2000 and 2030. As the chart shows, much of this will be in just two countries, China and India.

Understanding changing consumption patterns is a key concern of investors today. For example, the growing female participation rate in the workforce in many developing markets is important because of women’s differing spending patterns. Brazil is already the world’s third largest market for cosmetics, fragrances and toiletries.

Other areas of growth include financial services – where mortgages and consumer loans are relatively undeveloped in emerging markets like Russia; beverages – Nigeria is now the world’s biggest market for Guinness; and, inevitably, cars – the ultimate signifier of “arrival”.

Investment is in part about recognising and attempting to profit from trends. Sometimes these can be hard to spot and harder to understand. In the case of population growth, however, the direction of travel and its consequences are unusually predictable. Wherever you are, number seven billion, all the best.

Tom Stevenson is an investment director at Fidelity Worldwide Investment. The views expressed are his own. He tweets at @tomstevenson63.

Generational bear markets, with losses exceeding 40% are the exception, not the norm. Since 1940, only one in four bear markets reached such a loss.

• The 2000-02 bear market was so severe because of record overvaluation extremes at the start, and the washout of the high-tech bubble with a -78% loss in the Nasdaq (of which many of the largest stocks were also components of the S&P 500).

• Unweighted indexes declined only ~25% in the 2000-02 bear market;

• The 2007-09 bear market was extreme because the collapse suddenly exposed all of the mortgage derivatives on the balance sheets of major banks. The extent of this exposure was not well known — even to CEOs of the banks.

• Bear markets without recessions are more of a rarity. Since 1940, when they have occurred, the declines are usually milder. The 1987 Crash, with a loss of -34% was the exception; but ’87 was triggered in a monetary climate where interest rates were soaring and the U.S. dollar was tumbling.

• Average valuation, as measured by the P/E ratio of the S&P 500 Index, at the start of all the bear markets exceeding 30% was 21.8. Today, the P/E ratio of the S&P equals 14.7.

Currently the market breaks down in the following manner:

#Stocks………………P/E………….As%
733………………….30/higher…….32%
247………………….25/30………..11%
367………………….20/25………..16%
1347…………………Total………..59%

602………………….10/5………..26%
325………………….5/lower……..14%
927………………….Total……….41%

As of the end of September 2011 from January 1871: compounded returns:

Index….+4.03%
Dividends +3.29%
Earnings +3.89%
CPI +2.07%

SPY
P/E 13.44
Yield 2.12%

The data rather suggests that overall, the market is not unreasonably expensive at a P/E of 13.44. It is not ‘cheap’ as has been the case at the ‘bottom’ of major bear markets, viz. below a P/E of 10. It is not unduly expensive either.

The ‘two tier’ market of roughly 50/50 has some very expensive stocks, and some very cheap stocks based upon historical or trailing P/E ratios. With the long term growth rates at 3.89% in earnings over 141yrs, it would seem reasonable to use this ‘earnings growth’ as a baseline assumption to project forwards.

The question then becomes at what capitalization rate? For a reasonable ‘guess’ at this rate, we would need to look at the ‘interest rate’ on government securities. Unfortunately the market is currently heavily manipulated by the Federal Reserve, and yields are at historical ‘lows’.

With some historical context:

From the data, we can see that in times of ‘war’ where the ‘State’ has greater need of funds to pay for increased expenditures, the interest rate has been in a range of 4%-9%. With Iraq/Afghanistan, like WWII, the Federal Reserve is suppressing rates: to do so requires ‘money creation’ or inflation. Once the suppression is removed, rates will likely rise.

The capitalization rate for common stocks would be 4/3’rds of the interest rate. Currently that would equate to 3.06% which provides a P/E of 32, which for the ‘growth stocks’ seems to be already factored into the price.

If however the interest rate rises to 6%, then stocks would require 8% or a P/E of 12.5 which is slightly lower than where we are currently. As we are dealing with the future, and the future is unknown, what else can we glean from the historical record? The primary fact is this: while the bond yield can go significantly higher, it can only fall very marginally.

The conclusion therefore must be, if you are invested in common stocks, common stocks with ‘low’ P/E values provide the probability of higher returns than do common stocks already factoring in above ‘average’ earnings growth rates via capitalization rates.

Earnings are reported next week. The ‘chart’ would suggest higher. You would imagine that ‘the bad news’ is already out of the stock. You might imagine that any small positive might signal higher prices.

I continue to hold. My dilemma is: do I add shares down here at these prices, or just sit the position out with my existing exposure. I’m inclined, due to the wobbly nature of the company currently, just to sit tight.

When is a default not a default?

Investors struggled with that question Thursday after European officials outlined plans that would see owners of Greek bonds take a 50 per cent loss on the face value of their holdings.

The International Swaps and Derivatives Association, an industry group that oversees the CDS market, says the Greek deal probably won’t trigger default clauses in CDS contracts because the 50 per cent “haircut” is voluntary.

That view is starting to roil the $25-trillion market for credit default swaps because it calls into question the fundamental reason for purchasing insurance against losses on bonds. If investors can no longer count on being able to hedge against the possibility of a loss, they may start demanding higher yields as compensation for increased risk.

“I would think [such a ruling by the ISDA] would be quite a negative for the market,” said Lawrence Chin, director of research at the Cundill division of Mackenzie Financial. “You could get hit on the debt, but you don’t get the insurance [payout].

I have a GTC order in the market to sell some shares at $33.92. US Steel is up 20% in the last two days [currently] and looking to move at least to the $30 mark.

From history…

October 26, 1948: Skies over Donora, Pennsylvania darken as fog settles onto the small river valley town. Donora of the 1940s was a thriving town with a population of about 14,000. Today, as part of the Rust Belt, that population is dwindling along with job opportunities and there are fewer than 2,500 households in the town that is 20 miles south of Pittsburgh and located on the Monongahela River.

For five days, beginning on October 26 and ending not a moment too soon on October 31, weather conditions conspired to trap air pollution over the town. The smog was a combination of noxious gases from the American Steel and Wire Plant, owned by US Steel, and Donora Zinc Works. By the time the smog lifted, 20 were dead and between 6,000 and 7,000 were ill, some suffered lifelong disabilities. A local doctor, Dr. Rongaus, claimed that the death toll would have reached 1,000 if the smog had lasted another day.

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