Investing Insights

Stocks: An Unhappy Anniversary

Wed, 08 Oct 2008 18:31:08 -0500

Thursday marks a rather depressing anniversary. On Oct. 9, 2007, major U.S. stock indexes closed at an all-time high. The broad S&P 500 index closed at 1,565.15. Today -- on Oct. 8, 2008 -- the S&P 500 closed at 984.94.

That's a 37% drop in one year.

Even more sobering, from this point the S&P 500 would need to post a 59% gain to re-attain record levels.

In retrospect, the stock market's peak last October looks bizarre. Problems in the credit market became apparent to fixed income investors in July 2007. While the full extent of the crisis wasn't yet known, many experts were already very worried -- and those credit market participants have remained pessimistic ever since.

Equity investors were far more optimistic at the start of the crisis.
While stock markets showed some concern in August 2007, by September many said the subprime crisis was probably "contained" and the market hit new highs in October. How wrong they were.

The VIX: Could the “Fear Gauge” Call a Market Bottom?

Wed, 08 Oct 2008 14:50:53 -0500

Since the Dow started its precipitous drop from its record high of 14,000 one year ago, options traders and savvy investors have been waiting for the S&P Volatility Index, or VIX, to take notice. The VIX is often referred to as the fear index, but no matter what happened -- the popping of the housing bubble, the collapse of Bear Stearns, the implosion of the monoline insurers -- it stubbornly refused to trade above 35, a remarkable sign of complacency (the VIX traded as high as 150 in 1987). Even the government takeover of Fannie Mae and Freddie Mac failed to move the needle.

That all changed on September 17, when Lehman Brothers came under intense pressure leading up to its bankruptcy filing and the VIX took up home in the 30s. And when Congress failed to pass a bailout bill after the close on September 26, the market collapsed and the VIX spiked to 46.72. Today, it trades in the 50s. (See Chart) Now, it appears investor complacency has gone the way of Lehman.

But contrarians everywhere see the rise in fear as a possible buying opportunity. The Dow has dropped 5,000 points, they say, and though the market may still drop another 1,000 points or more the VIX is one sign confirming that we may be oversold. Of course, the problem with being oversold as that you can always get more oversold, but Barry Ritholtz of Ritholtz Capital Partners believes the VIX is signaling a trading low, if not a permanent one. "It doesn’t mean you run out and go crazy but this is not the time to panic," Ritholtz says. "The time to panic was a year ago."

QUICK BUYBACK NOTE

Wed, 08 Oct 2008 10:01:25 -0500

The current price vs the employee option strike price is critical to the base buyback purchases. With prices falling so quickly, options in the money are dwindling, so buybacks may be cut back further. Many (of the reported) average strike prices expiring this year are near their current price. The situation speaks more to Q4 and January (taxes), but reduced need in Q3 should also take its toll.

Also, i will be looking for issues that use existing shares (treasury) to satisfy options, therefore netting positive cash-flow from the event and avoiding the buyback expense and not having to go to the market for additional cash (getting money under the radar).

FYI - the full impact of the dividends cuts will be felt in Q4. I expect a strong single-digit decline (Q4,'08 vs. Q4,'07); last such decline was Q2 2003 at -1.54%, if more decreases materialize we could see a double-digit decline, last seen in Q3 1958 at -24.4%.

The Joke's On Us

Tue, 07 Oct 2008 14:50:53 -0500

In his October 1 testimony before the House Committee on Banking and Financial Services, Henry Hu, Allan Shivers Chair in the Law of Banking and Finance at the University of Texas, Austin, took a minute to tell a joke that he believed explained the cause of the financial crisis:

Three econometricians were hungry and went out hunting and came across a large deer. The first econometrician fired but missed, by one meter to the left. The second econometrician fired, but also missed, by a meter to the right. The third econometrician didn't fire but shouted in triumph, "We got it! We got it!"

Hu didn't tell the joke last week, however -- he spoke in 1998 following the collapse of hedge fund Long Term Capital Management. Ten years later, we're witnessing an economic deep-freeze because no one got the joke.

Bill Miller Gets Fired From Masters funds

Tue, 07 Oct 2008 13:52:49 -0500

This item was written by Lewis Braham, who recently authored a piece on focused funds for BusinessWeek

Has the master lost his touch?

Legendary value manager Bill Miller of Legg Mason Funds was fired on October 3 as a subadviser to the Masters Select Value and Masters Select Equity funds.

The move comes as a bit of a shock as the funds' advisory firm Litman/Gregory Advisors is known for doing extensive research on the managers it selects to run its funds. Litman is also known for its patience when a manager's style is out of favor.

Miller ran Masters Select Equity for more than eight years with famous co-managers Mason Hawkins of Longleaf Partners and Chris Davis of Davis Select Advisers. But with his fund down more than 40% this year thanks to some bad bets on highly leveraged financial stocks such as AIG and Freddie Mac, his long-term record of beating the market has been ruined. So Litman/Gregory replaced him in its roster of star managers with Clyde McGregor who runs Oakmark Global Fund.

Interestingly, both Masters Select Funds already have one Oakmark manager, Oakmark Select's Bill Nygren, whose bet on Washington Mutual also floundered but whose fund has held up better than Miller's during the slide. According to Litman/Gregory, there should be little overlap between the two Oakmark managers in the funds.

Still, the decision to let Miller go at this juncture seems ill timed. Given that his fund has already fallen so much, he may be due for a comeback. But then the two Masters funds have also lagged the market this year, in part because of Miller's screw up.

Maybe the pressure to remove him now was too great.

Why I’m buying

Mon, 06 Oct 2008 16:19:26 -0500

The market is in free fall. Friends are calling and emailing in a panic. My response: I’m buying.

Investors today seem as fearful as they’ve been since, perhaps, the Great Depression. And as Warren Buffett once famously said: “Be fearful when others are greedy, and greedy when others are fearful.”

As he always does, Buffett’s put his money where his mouth is, garnering stakes in Goldman Sachs and General Electric on the cheap as the $700 billion bailout plan was under debate. Yet the bailout’s passage has done little to quell the fears. Instead, fear seems to have turned to panic.

Today, the Dow plunged below 10,000 for the first time in four years. The broader S&P 500 index is off 27% since the beginning of the year.

Is the economy going to disappear? Are all businesses going to close their doors due to lack of credit? Is every single investment bad?

Maybe. But I’m willing to bet that’s not the case, at least not long term. So before the market closed, I took a deep gulp against the rising panic that tomorrow could be worse and sent cash to one of my lagging international equity funds.

What Happens When the Dow Dips Below 10,000?

Mon, 06 Oct 2008 10:23:34 -0500

Back in July, John Carter, president of Trade the Markets, predicted that the Dow Jones Industrial Average would dip below 10,000 by year end. Another unscientific Industry Standard poll finds that 85% of respondents think the Dow will go below 10,000 by December. (Even though it has happened, the poll is still open so cast your vote if you like feeling superior.)

Well, today is the day of reckoning. The Dow dropped below 10,000, a level it hasn't seen in nearly four years. (The Dow first hit 10,000 at the end of March, 1999.)

Is 10,000 merely a psychological threshold, or is this just another nail in the bear market's coffin?

SEPTEMBER WAS THE WORST MONTH FOR DIVIDENDS, BUT JANUARY MAY BRING INSULT TO INJURY

Fri, 03 Oct 2008 12:33:30 -0500

Blue-chip dividend investors aren't happy campers these days. Their favorite financial stocks have declined significantly, and cut or omitted their dividends. The insult to injury however may come next January, when they find out that since their company didn’t make any money, they didn’t pay any U.S. Federal income taxes, and therefore, the dividends that they were paid are not dividend qualified, meaning they have to pay 35% tax on them instead of 15%. On the bright side, since dividend investors usually hold on to their stocks for decades, many of them will still show a gain over the decades, that is if the company is still around.

For the record, 138 companies decreased their dividend during the third quarter of 2008, representing a 557% increase from the 21 issues that decreased their dividend during the third quarter of 2007. Reported dividend increases fell 21.2% to 346 from 439 reported in the third quarter of 2007. It was the worst September for dividends since S&P started keeping dividend records in 1956, with 60 issues decreasing their payment. During the second quarter companies were nervous and cautious; during the third quarter they took action, and that action took $22.5 billion out of the pockets of investors.

Financial issues accounted for about two-thirds of the dividend cuts and 93% of the dollar damage during the third quarter. Also, no longer is it just blue chip companies cutting dividends, now I am seeing smaller and more regional issues. The problem has trickled down.

However many issues are still increasing their dividend rate despite the massive number of dividend cuts, and given the uncertainty of the markets and the economy, they have to be extremely confident of their future earnings and cash flow to do so – we’ll see.

Lehman Bankruptcy Gets Ugly

Thu, 02 Oct 2008 12:07:15 -0500

The Lehman Brothers bankruptcy is quickly becoming one giant mess.

Scores of hedge funds that had hundreds of millions in cash and other securities parked with Lehman’s prime brokerage operation in London have had their accounts frozen. A number of these hedge funds have filed formal objections with the bankruptcy court and at least one fund, New York-based Bay Harbour Management, is mounting a legal challenge to the court’s hastily-approved sale of Lehman’s brokerage arm to Barclays Capital.

Now a new and even more troubling scenario is arising: legal disputes stemming from the estimated $1 trillion in derivatives transactions that Lehman had entered into on behalf of itself and some of its customers. Already, at least three lawsuits have been filed, alleging that nearly $600 million in collateral posted by some of Lehman’s trading partners in derivatives transactions hasn’t been returned and is in jeopardy of disappearing as the bankruptcy process unfolds.

To date, the most aggrieved of Lehman’s trading partners is Bank of America, which at onetime was considering buying Lehman as the investment firm was lurching towards bankruptcy. The Charlotte, NC based lender is seeking to recover nearly $500 million the bank “posted as collateral to “support derivative transactions between BofA and the respective Lehman Entities,’’ according to a lawsuit filed in New York State Supreme Court.

The lawsuit alleges the accounts at Lehman that held the collateral were “frozen,’’ when the investment house filed for bankruptcy on Sept. 15. The complaint describes numerous attempts by BofA to persuade Lehman officials to unfreeze the funds, but each time the bank was rebuffed. In one email exchange, a Lehman employee says: “All activity has been suspended until further notice. Since everything is frozen, we cannot return the remaining collateral at this time.’’

BofA contends that Lehman “has wrongfully refused’’ to return the collateral and is violation of its agreement as a trading partner. The dispute could be the first of many since it’s not uncommon for derivative transaction to be part of tangled web, in which on trading partner is on the hook to make payments to other trading partners. A derivative is a sophisticated contractual agreement that is dependent on the performance of an underlying security, such as a bond, a stock or a commodity.

The dispute between BofA and Lehman appears to stem from the fateful decision by Lehman officials in New York to transfer $8 billion in cash from the firm’s London offices on the eve of the bankruptcy filing. The $8 billion cash and securities sweep left Lehman’s London offices with no money to pay employees or to provide cash to hedge funds that made use of the firm’s overseas prime brokerage operations.

The list of hedge funds entangled in the Lehman bankruptcy keeps growing by the day. Besides Bay Harbour, the list of hedge funds caught-up in the great $8 billion cash transfer include, GLG Partners, Newport Global Opportunities Fund, Amber Capital and Harbinger Capital Partners.

Texas-based Newport Global, a nearly $700 million fund with close ties to private equity giant Providence Equity Partners, got squeezed when Lehman officials apparently failed to comply with the funds’ request to move all its assets to Credit Suisse. Newport, which used Lehman as a prime broker, notified Lehman on Sept. 10 to “transfer assets held by “Lehman’s London affiliate to Credit Suisse. Newport executives had believed the transfer was completed and were shocked to learn that the assets were never moved before Lehman filed for bankruptcy.

Now Newport’s assets are frozen in the wake of the $8 billion transfer. In court papers, Newport says, “if these assets are not located and recovered immediately, there is the very real specter of serious and irreparable harm to not only the funds, but also to their respective investors.’’

The trouble is there are now a lot of questions about what happened to that $8 billion. It does not appear that $8 billion in cash and securities was ever part of the deal that enabled Barclays to buy Lehman’s New York operation. Trading partners like BofA and hedge funds like Newport that had money parked with Lehman, are now worrying they may never get their assets back. There’s growing concern that some hedge funds may be forced to shut-down if they can’t get their funds unfrozen soon.

It’s looking like Lehman, contrary to the conventional wisdom, may have been too big to fail after all. And the fallout from the bankruptcy may further undermine investors' confidence in the financial system.

with David Henry

Free fallin' -- only four out of 500 in S&P 500 holding gains

Mon, 29 Sep 2008 14:33:29 -0500

It's an across-the-board massacre in the stock market after the House of Representatives voted down the Paulsen bailout plan. I just took a spin through all 500 components of the Standard & Poor's 500 Index and only four stocks are up on the day. It's a mixed bag:

Campbell Soup (Symbol: CPB), which increased its dividend and stock buyback plan a few days ago.

Consolidated Edison (ED), utilities overall are holding better and somebody must like getting paid a yield of over 5%.

Edison International (EIX), another utility.

Biogen IDEC (BIIB), on no new news

And that's all folks. Ouch.

The New Wachovia

Mon, 29 Sep 2008 10:55:56 -0500

Talk about fast transformations. It was only a week ago when Goldman Sachs and Morgan Stanley shed their investment banking skins to become commercial banks in a bid to stem a bloodbath in both firms’ stocks. And now it’s troubled Wachovia’s turn to do a sudden, life-saving metamorphosis.

With the help of the FDIC, Wachovia has converted itself into one of the nation’s largest stand alone asset-management firms. In selling its banking operation to Citigroup for $2.1 billion, Wachovia now becomes a publicly traded brokerage with $1.1 trillion in customer trading accounts and a money-management firm with $243 billion in assets under management. The Charlotte, NC-based firm retains the nation’s third-largest fleet of brokers. Its Evergreen Investments money-management firm is a major operator of institutional money market funds.

Wachovia’s big move into the retail brokerage business began in 2003 when it entered into a joint venture with Prudential Financial, which led to the formation of Wachovia Securities. Last year, the brokerage division got even bigger with Wachovia’s $6.8 billion acquisition of St. Louis-based A.G. Edwards. Prudential still retains a sizeable 28%equity stake in Wachovia Securities. Prudential had no comment.

Of course, it’s not clear how long the slimmed down Wachovia will remain as an independent entity. An asset-manager that’s not weighed down with toxic mortgage-backed securities may be attractive to a firm looking to beef-up its retail brokerage operation.

Community Reinvestment Act had nothing to do with subprime crisis

Mon, 29 Sep 2008 09:24:59 -0500

Fresh off the false and politicized attack on Fannie Mae and Freddie Mac, today we're hearing the know-nothings blame the subprime crisis on the Community Reinvestment Act -- a 30-year-old law that was actually weakened by the Bush administration just as the worst lending wave began. This is even more ridiculous than blaming Freddie and Fannie.

The Community Reinvestment Act, passed in 1977, requires banks to lend in the low-income neighborhoods where they take deposits. Just the idea that a lending crisis created from 2004 to 2007 was caused by a 1977 law is silly. But it's even more ridiculous when you consider that most subprime loans were made by firms that aren't subject to the CRA. University of Michigan law professor Michael Barr testified back in February before the House Committee on Financial Services that 50% of subprime loans were made by mortgage service companies not subject comprehensive federal supervision and another 30% were made by affiliates of banks or thrifts which are not subject to routine supervision or examinations. As former Fed Governor Ned Gramlich said in an August, 2007, speech shortly before he passed away: "In the subprime market where we badly need supervision, a majority of loans are made with very little supervision. It is like a city with a murder law, but no cops on the beat."

Not surprisingly given the higher degree of supervision, loans made under the CRA program were made in a more responsible way than other subprime loans. CRA loans carried lower rates than other subprime loans and were less likely to end up securitized into the mortgage-backed securities that have caused so many losses, according to a recent study by the law firm Traiger & Hinckley (PDF file here).

Finally, keep in mind that the Bush administration has been weakening CRA enforcement and the law's reach since the day it took office. The CRA was at its strongest in the 1990s, under the Clinton administration, a period when subprime loans performed quite well. It was only after the Bush administration cut back on CRA enforcement that problems arose, a timing issue which should stop those blaming the law dead in their tracks. The Federal Reserve, too, did nothing but encourage the wild west of lending in recent years. It wasn't until the middle of 2007 that the Fed decided it was time to crack down on abusive pratices in the subprime lending market. Oops.

Better targets for blame in government circles might be the 2000 law which ensured that credit default swaps would remain unregulated, the SEC's puzzling 2004 decision to allow the largest brokerage firms to borrow upwards of 30 times their capital and that same agency's failure to oversee those brokerage firms in subsequent years as many gorged on subprime debt. (Barry Ritholtz had an excellent and more comprehensive survey of how Washington contributed to the crisis in this week's Barron's.)

There's plenty more good reading on the CRA and the subprime crisis out in the blogosphere. Ellen Seidman, who headed the Office of Thrift Supervision in the late 90s, has written several fact-filled posts about the CRA controversey, including one just last week. University of Oregon professor and economist Mark Thoma has also defended the CRA on his blog. I also learned something from a post back in April by Robert Gordon, a senior fellow at the Center for American Progress, which ends with this ditty:

It's telling that, amid all the recent recriminations, even lenders have not fingered CRA. That's because CRA didn't bring about the reckless lending at the heart of the crisis. Just as sub-prime lending was exploding, CRA was losing force and relevance. And the worst offenders, the independent mortgage companies, were never subject to CRA -- or any federal regulator. Law didn't make them lend. The profit motive did. And that is not political correctness. It is correctness.

Oakmark Boots WaMu: Too Late?

Fri, 26 Sep 2008 14:51:57 -0500

This item was written by Lewis Braham, who recently authored a piece on focused funds for BusinessWeek

In a surprisingly anti-climactic turn of events Oakmark Funds' manager Bill Nygren issued the following statement in the wake of Washington Mutual's declared bankruptcy this Friday:

A Message on Washington Mutual 9/26/2008
Our normal policy is to explain position changes only following the end of each quarter. However, we are making an exception to comment on Washington Mutual. Earlier this month we sold Washington Mutual in Oakmark, Select, and Global Select funds. Our decision was influenced by both taxes and by the business value uncertainty created by the turmoil in the financial services sector.

We will more fully discuss the Washington Mutual sale in the next quarterly report.

We appreciate your continued interest in the Oakmark Funds.

Whether or not Nygren and Oakmark Select deserve investors continued interest is another story. As recently as June 30th, the date of the latest shareholder report, Select held almost a 5% position in WAMU.

Of course, holding one or two losers in this market is no crime, except for the fact that Nygren runs concentrated "focused" funds with very few holdings. For managers of focused funds, knowing the strengths and weaknesses of every stock in their portfolios is of paramount importance.

In Nygren's case, one can argue he should have known better. He's held WAMU in Oakmark Select for years, and it once was his largest holding, representing as much as 15% of his portfolio in 2006. Throughout the company's subsequent decline, he would continue to talk of its fundamental strengths and would even add to his position from time to time.

One can argue that a manager who has this much exposure and history with a single company should be held accountable for his mistake. But there is a psychological phenomenon known as "anchoring" in the financial world in which investors become attached to their favorite stocks to the point of irrationality. When anchoring occurs, investors are stuck in what can be termed an abusive relationship with a stock and will refuse to admit anything's wrong. Perhaps Nygren fell victim to this delusion.

In fairness to Nygren, no one could have anticipated the run on the bank that had occurred to WAMU in the past two weeks, depositors having withdrawn several billion dollars and moved to other banks. But the amount of leverage WAMU always had and the amount of bad mortgage loans on its books should have given a manager of Nygren's experience and intelligence pause long ago.

He really blew this one.

Another Way To Rejigger Your Portfolio

Fri, 26 Sep 2008 14:19:52 -0500

In this week's issue of BusinessWeek, we asked top financial advisers how they would invest $250,000 for moderate growth over the next five to seven years. We didn't have space to run all of the detailed recommendations in the magazine.

Here's how John Burns, a certified financial planner at Burns Advisory Group in Oklahoma City, Okla., would invest $250,000.

Rationale: "Because of the possible 5-year time frame for this investor, the fixed income options used are tilted towards shorter-term bonds," Burns says. "If equity markets continue to struggle, we will go here first to raise cash for withdrawals. The equity portfolio is designed to capture areas of the market (notably smaller companies and more value oriented companies) that typically outperform the broad market over time, especially when equity markets are recovering from a substantial downturn. Although the portfolio is tilted towards smaller and value companies, the portfolio is globally diversified and holds thousands of stocks including larger and some growth companies."

Recommendation:
Burns allocates 70% in stock funds and 30% in bond funds. His picks are:

Vanguard Short Term Inv. Grade Bond (VFSTX): 15%

PIMCO Total Return Inst (PTTRX): 10%

Loomis Sayles Bond Inst. (LSBDX): 5%

DFA Global Real Estate Portfolio (DFGEX): 5%

DFA US Large Cap Value (DFLVX): 14%

Selected American Shares D (SLADX): 8%

Amer. Fds. Growth Fund of Amer. F2 (GFFFX): 8%

DFA US Small Cap Value (DFSVX): 15%

DFA International Value (DFIVX): 5%

American Funds EuroPacific (AEPFX): 5%

DFA International Small Cap Value (DISVX): 5%

DFA Emerging Markets Value (DFEVX): 5%

Look Out for Bloody Tuesday

Fri, 26 Sep 2008 12:31:00 -0500

There’s no relief these days for stock investors, who’ve already seen their portfolios get pounded by the fallout from the now 13-month long credit crisis. Now there’s a new worry for average investors: Bloody Tuesday, which is the deadline for hedge fund investors to put in requests to get their money back by year’s end.

With so many hedge funds--including some very large ones--posting negative returns this year, there’s a big fear that wealthy investors and pension funds are itching to take some money off the table. Many funds limit redemptions to four times a year in order to give managers breathing room to navigate choppy markets. But in order for an investor to qualify, managers generally require investors to submit a request 90 days before the end of the quarter.

Already, the redemption requests have been pouring into hedge funds well ahead of the Sept. 30 deadline. But it’s not uncommon for investors to wait until the last moment to submit a redemption demand. Sources say at some funds investors are seeking to recoup about 10% of their money, which is relatively high. The trouble is that most managers don’t keep too much cash on hand. To comply with their investors wishes, hedge fund managers may have to start selling lots of stocks—a move that could push equity prices even lower in the coming months.

It’s important to note that hedge fund managers don’t need to start selling right away. The 90-day window gives them an opportunity to try and persuade investors to change their minds. If stocks were to rally in the coming weeks, some investors might be convinced to sit tight and keep their money put. But with so much turmoil in the credit markets and uncertainly surrounding the health of the banking industry, a big year-end stock rally looks unlikely.

Right now, things look ugly for hedge funds, which control nearly $2 trillion in assets. The average hedge fund was down 5.8% going into September, which has been another brutal month, according to The Barclay Group, a hedge fund tracking service. The performance is even worse for so-called hedge fund fund-of-funds, which spread investor money between lots of different funds. Through the end of August, the average fund-of-funds was down 6.6%. Sol Waksman, Barclay Group’s president, says this is the worst period for hedge funds he’s ever seen.

A flood of year-end redemptions won’t only mean a tidal wave of selling by hedge funds. It also could lead to outright liquidations and closings of funds. So far, the number of hedge funds that have closed shop isn’t much great than in past years. But many in the industry are bracing for a wave of fund closing, especially smaller funds with under $2 billion in assets. In the current environment, it’s harder for smaller hedge funds to raise money and keep the investors they already have from leaving. Small fund-of-funds also may roll up the carpet.

In short, the next three months could be a blood bath in the hedge fund world.