Oct

16

As someone who has become very tired of my investment peers whining, I thought to restate some points we have made to clients recently:

* At what point do you add risk? At some point, traders will have to decide between a "Hail Mary trade" and unemployment. History shows late October, early November is their last chance.

* The public has seen a large number of people in the investment business lie and panic (in that order). The likely follow-on effect will be for those managers/asset classes to lose large numbers of clients once the market stabilizes; Debt is out, equity is in. God help private equity or anything else that relies on cheap debt and easy access to it. Cash is king. This is how we are positioned.

* The auction of the Washington Mutual credit default swaps is next week. That should be the last "whale" liquidity need for this year.

* Details are not forthcoming yet on many of the government support actions, both here and abroad. It appears safe to say the US was embarrassed into following the UK's lead. Whether from malice or incompetence, these details should be available after Election Day.

* As the size of the government increases in the economy, volatility in markets should drop. In reality, there are lots of assets sitting "off market" on the government balance sheets. They will be there a while, and more are being added. The pool of sellers is shrinking.

* Overseas economies/markets should lead the US out of this panic, as they have been far more proactive in addressing systematic liquidity (except for Europe). We are positioned with companies that have lots of overseas revenue sources. Additionally, platform companies - those who have intellectual property but shift the locations of their plants around the world frequently - are very attractive. This is the most adaptable company structure here and is essentially big cap. Very small cap should also hold up if they have narrow protected niches. We are concerned the middle cap sector is where alpha will be lost. The loss of the middle seems to be a recurring investing and economic theme.

* Who the hell knows what the "real" risk free rate is when gov'ts yield 4%, agencies 5% and bank loans 6% all with gov't guarantees? This throws all quantitative models to hell, but lead to the biggest (in all senses) convergence trade in my lifetime. All assets are reverting toward that new risk free rate, and the move will likely be finished post election (once the DC types decide to release the details). I'd suggest this is the equivalent of at least a 200 bp parallel shift in the yield curve upwards over a 10 day period. Most financial institution asset/liability models were not set up for this as a probability. Consider the possibility/probability that this move can be reversed. If this is not immediately clear, please call and I'll explain the math.

* Looking behind the 9% sell-off in the S&P 500, it seems that "quality" names suffered less than "lower quality" names. The data shows investors have been moving towards quality and "fortress" names. For instance, stocks whose debt is rated "investment grade" outperformed "high-yield" by 300bp. Larger cap names (>$50b) outperformed smaller caps (<$2b) by 300bp. Those stocks with lower short interest have outperformed those more heavily shorted by 600bp over the past five days.

* Even with a reduction of 20% from existing earnings estimates, earnings yields on many stocks are greater than their own corporate bonds. This is not a stable situation historically, and one that should reverse. As our high yield default probabilities are still rising, we'd expect that debt prices will adjust, again favoring equities. Another way to look at it: with dividend yields at these levels, you have an equity "bond" - with an equity call option included for free.

* If you are not long here, when would you be long? Many statistical risk/return relationships have become extremely asymmetric. This has become more pronounced after the recent financial slaughter of statistical arbitrage firms. I've been asking many of the consulting firms we speak with: "How many standard deviations do things have to get out of whack before you re-balance assets?" This needs to be discussed and addressed. It's time to pull up our britches and make these calls. Friends help friends invest rationally. Salesman tell clients to invest emotionally. Stay the course isn't enough to tell clients. Show them the darn map. Show them the math. Give them facts!

* The enemy is out of bullets, and is changing magazines. It is time to move OUR position forward. This is when you press the advantage. Call out the troops. Advance the agenda.

* Semper Fidelis! This is not the time to give up, it is time to earn our fees.

This is a thoughtful piece sent to friends by one of our esteemed contributors, a former partner of the late John Kuhn, ever exuberant, creative and poignant. — Vic and Laurel.


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