Richard Russell (Dow Theory Letters): Characteristics of secondary reactions

Monday, May 25th, 2009

Richard Russell, author of Dow Theory Letters, offers wisdom on price movements, explaining the nature of upside moves, particularly, bear market rallies.

“The most difficult and puzzling study of the stock market is that which deals with secondary reactions against the primary trend. Because we’re in a bear market, I’m going to limit the following discussion to (upward) reactions in bear markets.

“Over the weekend I pulled out my volume of Robert Rhea’s ‘The Dow Theory’. I went over some of Rhea’s comments on secondary reaction in bear market.

“‘For the purpose of this discussion, a secondary reaction is considered to be an important advance in a bear market, usually lasting three weeks to as many months, during which interval the price movement generally retraces from 33% to 66% of the primary price change since the last preceding secondary reaction.

“‘Those who try to place exact limits on secondary reactions are doomed to failure, just as surely as would be the weather man who forecasted a snowfall of exactly three and one half inches within a specified time.

“‘In a bear market steady liquidation of securities by those who prefer or need cash reduces quotations day after day, with professionals, realizing there is more room on the bottom than on the top, hastening the decline with short sales. Eventually, the market is forced to a lower level than is warranted by conditions. The short interest is perhaps too extended, with wise traders sensing the fact the liquidation has, for the time, at least, run its course.

“‘Quiet, weak spots in bear markets are generally good ones to short, as they generally develop into serious declines.

“‘In a primary bear market the rallies are apt to be violent and erratic, and always occupy less time than the decline, which they partially recovery. Often the primary movement of several weeks is retracted in a few days.

“‘Rallies in a bear market are sharp, but experienced traders wisely put out their shorts again when the market becomes dull after a recovery.

“‘In bear markets, primary movement has an average duration of 95.6 days, whereas the secondary movement averages 66.5 days or 69.6% of the time consumed in the preceding primary movements.’

“All the above pertains to the price action during rallies in bear markets. But what about business conditions during bear market rallies? My studies show that bear market rallies are technical phenomenons which do not necessarily reflect on business. I’m looking at a chart of the great 1929 to 1930 rally which occurred after the 1929 crash. The Federal Reserve Index turned down in late-1929, and despite the great bear market rally, the Fed Index continued lower into early 1932.”

Source: Richard Russell, Dow Theory Letters, May 18, 2009.

Hat tip: Investment Postcards

Tags: Bear Market, Bear Markets, Decline, Declines, Dow Theory Letters, Exact Limits, Failure, Few Days, Interval, Liquidation, Market Rallies, Nature, Quotations, Rallies, Richard Russell Dow Theory, Robert Rhea, Short Interest, Snowfall, Stock Market, Weather Man, wisdom
Posted in Markets | No Comments »

Roadmap to Inflation and Sources of Cheap Insurance

Thursday, March 26th, 2009

*This article is a guest contribution courtesy of John Mauldin, “Outside the Box.”

What happens when inflation once again returns. As this week’s Outside the Box writer, James Montier, writes, we may want to start thinking now about inflation insurance and he mentions a few ways to do so. But this letter is a must read for his bringing to light a speech by Fed chairman Ben Bernanke in 2000 given to the Japanese, where he suggest inflation targeting:

I think you will find this week’s OTB to be exceptionally thought provoking. Montier is one of my favorite economic thinkers (and a good friend). He works for Societe Generale in London in their Cross Asset Research group.

John Mauldin, Editor
Outside the Box

**********************************************

As Albert [Edwards] and I regularly point out during meetings, we have never been more unsure on the inflation/deflation outlook. I have previously said I was torn between the deflationary impact of the bursting credit bubble, and the inflationary pressures of the policy response. When we read something by the deflationists we sit there nodding our heads in agreement, then we pick up something by the proponents of a return of inflation and we find ourselves agreeing with that as well. The respective sides seem deeply entrenched in their positions.

In contrast, we are trying to keep an open mind on the subject. Albert is biased towards a Japanese style outcome, and I am biased towards an inflationary outcome, but neither of us has any strong conviction.

Fisher and the debt-deflation theory of depressions

In the face of this uncertainty I decided to return to history and see what it has to say about the way out of a depression. My first point of call was Irving Fisher’s “The debt-deflation theory of Great Depressions” published in 1933¹. Fisher is probably most infamous to those in finance for his pronouncements of a new era of permanently high stock prices in 1929. But in the wake of his disastrous calls he turned to trying to understand the experience of the depression. Incidentally, he also invented the Rolodex.

In his debt-deflation theory, he posits “two dominant factors” in driving depressions “Namely over-indebtedness to start with and deflation following soon after… In short, the big bad actors are debt disturbances and price-level disturbances”. He continues “Deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debt cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed.” That is to say, debt-deflation spirals can easily become self-reinforcing.

The good news is that Fisher is also very clear on how to end a debt-deflation spiral: “It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors… I would emphasize… that great depressions are curable and preventable through reflation and stabilization”. The irony of Fisher’s route out of deflation is that, probably only the Fed - after helping lead us into this mess² - can now get us out of it.

Romer’s lessons from the Great Depression

After reading Fisher’s analysis of the 1930s, I came across a recent speech given by Christina Romer, who is now the head of the Council of Economic Advisers, and who made her name in academic circles studying the events which ended the Great Depression. In the speech, Romer offers six lessons from the Great depression for the current juncture.

Lesson 1 – Small fiscal expansion has only small effects

Romer wrote a paper in 1992³ arguing that fiscal policy was not the key driver in the recovery from the Great Depression. Not because fiscal expansion is ineffectual per se, but rather because the fiscal stimulus that was conducted wasn’t large. As Romer notes “When Roosevelt took office in 1933, real GDP was more than 30% below its normal trend level… The deficit rose by about one and a half percent of GDP in 1934″.

Lesson 2 – Monetary expansion can help heal an economy even when interest rates are near zero

Romer notes that actually it was the Treasury rather than the Federal Reserve that drove the monetary expansion (a peculiarity of the system under the Gold Standard). In April 1933, Roosevelt suspended convertibility to gold on a temporary basis, and the dollar depreciated. When the US returned to gold at the new higher price, gold flowed into the US, allowing the Treasury to issue gold certificates which were interchangeable with Federal Reserve notes. As Romer notes “The result was that the money supply, defined narrowly as currency and reserves, grew by nearly 17% per year between 1933 and 1936″. Romer argues that this “Devaluation followed by rapid monetary expansion broke the deflationary spiral” - empirical evidence to support Fisher’s hypothesis outlined above.

Lesson 3 – Beware of cutting back on stimulus too soon

The monetary expansion seems to have produced remarkable results in terms of real growth: the US economy grew by 11% in 1934, 9% in 1935 and 13% in 1936 in real terms. This lulled the authorities into thinking that all was well with the system again. Hence, in 1937, the deficit was reduced by approximately two and half percent of GDP. Monetary policy was also tightened, as Romer notes “The Federal Reserve doubled the reserve requirement in three steps in 1936 and 1937″. She concludes “taking the wrong turn in 1937 effectively added two years to the Depression”.

Lesson 4 – Financial recovery and real recovery go hand in hand

Romer points out the inseparable nature of the real and financial recoveries. This meshes with our analysis that the banks aren’t really the problem in a debt-deflation environment, rather they are a symptom of the problem. The current policy in the US seems to be aimed at “fixing the financial system”, witness Bernanke’s recent comments “Recovery is not going to happen until the financial markets and the banks are stabilized”. This appears to be a misperception, as, Romer notes “Strengthening the real economy improved the health of the financial system. Bank profits moved from large and negative in 1933 to large and positive in 1935, and remained high through the end of the Depression”.

Investors seem to be rather excited about banks posting profits at the moment. Frankly, if a bank didn’t post a profit in this environment it should be shot out of kindness. The environment for profitability from banks has rarely been better, but that doesn’t make them solvent. If you were starting a business today, then setting up a bank would be a very attractive option. However, history - as represented by the balance sheet - cannot simply be ignored when it is inconvenient. As John Hussman noted “The excitement of investors last week about Citigroup posting an operating profit in the first two months of the year simply indicates that investors may not fully understand the term “operating profit.” Citigroup could burst into flames while Vikram Pandit sells lemonade in the parking lot, and Citi would still post an operating profit. Operating profits exclude what happens on the balance sheet.”

Lesson 5 – Worldwide expansionary policy shares the burdens

Given the worldwide nature of the current slump, Romer makes an interesting point on the effectiveness of competitive devaluations, “Going off the gold standard and increasing the domestic money supply was a key factor in generating recovery… across a wide range of countries in the 1930s… These actions worked to lower world [real] interest rates… rather than just to shift expansion from one country to another”.

This is something that Albert and I have been discussing of late. We have been pondering the possibility of competitive devaluation (obviously ultimately a zero sum game in terms of exchange rates) having enough of an impact on local monetary creation to increase inflationary expectations, thus helping countries reflate. It appears as if Romer has sympathy with this view.

Lesson 6 – The Great Depression did eventually end

The final lesson that Romer offers may be of use to investors at the current juncture. She makes the point that the Great Depression did finally end. As Romer puts it “Despite the devastating loss of wealth, chaos in our financial markets, and a loss of confidence so great that it nearly destroyed American’s fundamental faith in capitalism, the economy came back. Indeed, the growth between 1933 and 1937 was the highest we have ever experienced outside of wartime. Had the U.S. not had the terrible policy-induced setback in 1937, we, like most other countries… would probably have been fully recovered before the outbreak of World War II” This is a reminder that the current obsession with no scenario being too pessimistic is probably ill advised.

Bernanke and the policy options

The final source for signposts to watch comes from a speech given by Bernanke in 2000 to Japanese policy makers. As I wrote in Mind Matters 6 January 2009, in this speech Bernanke clearly acknowledged the greater threat that deflation poses in a highly leveraged economy, “Zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer-term credit, than the economies of the nineteenth century.”

Bernanke clearly believes that monetary policy is far from impotent at the zero interest rate bound. In essence his argument is an arbitrage based⁴ one as follows “Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero.”

In the speech, he laid out a menu of policy options that are available to the monetary authorities at the zero bound. First, aggressive currency depreciation, as per Romer’s analysis of the end of the Great Depression. Second on Bernanke’s list is the introduction of an inflation target to help mould the public’s expectations about the central bank’s desire for inflation. He mentions the range of 3-4%!

Third on the list was money financed transfers. Essentially tax cuts financed by printing money. Obviously this requires co-ordination between the monetary and fiscal authorities, but this should be less of an issue in the US than it was in Japan. Finally, Bernanke argues that non-standard monetary policy should be deployed. Effectively, quantitative and qualitative easing. Bernanke has repeatedly mentioned the possibility of outright purchases of government bonds - as the UK is now doing.

This menu should provide us with a roadmap of policy options to watch for. If (and when) the deflationary pressure builds, we should expect to see more and more of these options wheeled out. Note that we aren’t talking about trying to ‘fix the system’, to reflate the bubble (which would be the equivalent of giving crack cocaine to a heroin addict trying to deal with withdrawal). Rather, the suggestion from Fisher is that inflation erodes the real value of debt; it is the most painless way out of our current mess. Whether the authorities can create just a little inflation remains to be seen, as does their ability to actually create inflation in any way. Such imponderables are beyond my ken.

Investment implications – Cheap insurance

Howard Marks recently suggested that today’s investment decisions must focus on “value, survivability and staying power”. These factors lie at the heart of the three-pronged approach that I have been suggesting since the end of October last year.

The first prong is cash. This is a legacy from the lack of opportunities that characterised markets in the last few years. But it is also a hedge against outright deflation. The second prong is deep value opportunities in both debt and equity markets (as detailed for the equity markets most recently in Mind Matters, 4 March 2009). The third element is sources of cheap insurance. The idea behind this element of the portfolio is to prepare for a wide variety of outcomes by buying cheap insurance (which ideally, although not always, pays off in multiple states of the world). Of course, it should be noted that the purchase of cheap equities also contains an inflation hedge element.

Inflation/deflation insurance I – TIPS

The first and most obvious source of inflation/deflation protection when I first started thinking about this subject was US TIPS. These bonds have a deflation floor on the principal, so in the event of deflation I receive my cash back - representing a real rate of return equivalent to whatever the deflation rate is. In the event of inflation, I get whatever the yield is on the TIPS when I purchase them plus the inflation, of course (buying the new issue TIPS avoids the problem of accrued inflation).

When I started looking at TIPS, the yield was over 3.5%. This has dropped since then, resulting in the 10 year TIPS delivering a 9% return since the end of October. The 10 year TIP is currently yielding 2.1%, against the 10 year nominal bond yield of 3%. This implies that the market expects US inflation to be a mere 1% p.a. over the next decade - this strikes me as an exceptionally low rate.

Inflation/deflation insurance II – Gold

The second inflation/deflation hedge I suggested in late October was gold. Now, gold concerns me for a variety of reasons, not least of which is that it has no intrinsic worth: I can’t really value gold - beyond extraction cost.

However, it has some attractive features from an insurance point of view. Most obviously, in a world of competitive devaluations, gold is the one currency that can’t be debased. Thus it provides a useful hedge against the return of this sort of beggar-thy-neighbour policy. In the event of significant prolonged deflation, what is left of our financial system is likely to collapse, thus holding a money substitute isn’t such a bad idea against this cataclysmic outcome.

Of course, recently everyone has been talking about gold (not hugely surprising given that it is up some 30% since late October) - something that makes me nervous. However, gold is institutionally massively under-owned, so whilst it may have been moving up the list of attractive assets of individual investors (if the EFTs are anything to go by) and sensible hedge funds (such as the likes of Greenlight, Paulson, Third Point, Eton Park and Hayman), the mainstream institutional appetite for it has remained depressed.

Inflation insurance I – Dividend swaps

As we noted in Mind Matters, 2 February 2009 the European and UK dividend swap markets are pricing in an outcome that implies greater dividend declines than witnessed in the US during the Great Depression. The pricing then implies that essentially the dividends won’t recover, pretty much forever. This strikes me as excessively pessimistic.

In addition, dividends have a relatively close relationship with inflation (as detailed in the aforementioned Mind Matters). Thus dividend swaps look like a deeply distressed asset fire sale, with the added advantage of offering inflation insurance if I buy the longer dated swaps (up around 7% from my original note in February). The most common rebuttal to my fondness for dividend swaps is counterparty risk. However, the European dividend swaps have an exchange listed future, which obviously doesn’t have any counterparty issues.

Inflation insurance II – Inflation swaps

The second of the pure inflation hedges comes via the inflation swap market. The charts below show the zero-coupon fixed rate necessary to build a swap against zero-coupon CPI appreciation over 10 years. When I first looked at the US version in January (see Mind Matters, 6 January 2009) the rate was a mere 1.5%. Today it has risen, although not dramatically, to 2.3%.

However, the cheapest inflation swaps in the world seem to be Japanese swaps. They are available for -2.5%! Both the US and Japanese inflation swaps strike me as cheap ways of buying inflation insurance at the moment. Although counterparty risk is obviously a significant factor in these long duration swap transactions.

Eurozone break-up insurance: Spanish and Portuguese CDS

The final element of the insurance policy concerns the risk of a euro break-up. In a world of competitive devaluation, it isn’t clear that the Eurozone will be able to stand the pressure. The one area of the world which has anything like the gold standard in place is the Eurozone. As Albert opines during our meetings with clients, this is less a function of economic realities and more a function of political expediency (I’ll leave a detailed exposition of this logic to Albert in a future note).

To protect against this risk (or even rising perceptions of this risk) the natural insurance is provided by the CDS market. If even one country was to publicly contemplate leaving the Eurozone then these CDS spreads would explode. I find it hard to believe that Portuguese and Spanish CDS are below those of the UK - where we have the ability (and have used it) to print our own money.

Footnotes:

¹ Available from http://www.fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf This is one of few articles published in Econometrica that I have ever read!

² See Bill Flecksenstein’s excellent book, Greenspan’s Bubbles or John Taylor’s insightful paper The Financial Crisis and the Policy Responses: An empirical analysis of what went wrong, available from http://www.stanford.edu?~johntayl/FCPR.pdf, or any of Albert Edwards’ myriad of rants on Greenspan.

³ Romer (1992) What ended the Great Depression?, The Journal of Economic History, Vol 52

⁴ As Stephen Ross once said, to turn a parrot into a learned financial economist it needs learn just one word: arbitrage. To my mind economists are far too happy to rely on arbitrage assumptions to rule out solutions. Indeed the second chapter of my first book, Behavioural Finance is spent detailing failures of arbitrage (both causes and consequences thereof, including the ketchup markets!).

Source: John Mauldin, Outside the Box

Tags: Bad Actors, Ben Bernanke, Cheap Insurance, Credit Bubble, Currency Depreciation, Depression, Dominant Factors, Economic Thinkers, End Of The Great Depression, Fed Chairman, Finance, Great Depression, Great Depressions, Indebtedness, Inflation Deflation, Inflation Target, Inflationary Pressures, Irving Fisher, James Montier, Japanese Style, John Mauldin Outside The Box, Liquidation, Monetary Authorities, New Era, Policy Options, Policy Response, Pronouncements, Proponents, Rolodex, Societe Generale, Stock Prices, Strong Conviction, Uncertainty
Posted in Bonds, Credit Markets, Economy, Gold, Markets, Outlook | No Comments »

10-Yr+ US Treasury and Canada Yields Falling

Monday, December 1st, 2008

During the December 1st liquidation of stocks, the yield on 10-Yr. US treasury securities fell to 2.81%, a level not seen since 1954. Incidentally, during the 1935-1955 period, the yield on these was at levels far below current levels, this being the period following the collapse of the US financial market post circa 1929.

With the bond market rallying in the longer durations, its hard to NOT see how this plays right into the hands of the US government’s needs for long-term funds to pay for a trillion-dollar war and a trillion-dollar plus bailout, not to mention just staying in business.

Bloomberg says: Yields on two-, 10- and 30-year debt dropped to levels not seen since the U.S. began regular sales of the securities after Federal Reserve Chairman Ben S. Bernanke said the central bank may purchase Treasuries and target long-term interest rates to combat the deepening recession.

Which once again begs the question:

What incentive does the US Government have for reviving the equity market, except to levels which keep some hope alive? Not much, right now.

With investors being crowded out of equity markets by continuing volatility and losses surmounting from deleveraging, it should eventually be a snap for Washington to amortize very sizable short term obligations by selling bonds to fleeing investors. Bernanke is merely pointing out the obvious in a roundabout way.

Debt is the new equity. Why would you bet against the Fed? This is the direction they have been moving us in, deliberately.

Canada Long Bond Yields Falling

By the way, the 30-year Canada rates fell from 3.97% last week, to 3.76% today, in the face of the 9% drop in the TSX. Until 5 months ago, the Canadian economy was bolstered nicely by rich commodities prices. Now that commodities prices have fallen sharply and fairly quickly, Canadian investors haven’t yet adjusted to the reality that Canada is in recession too, and given that, it is likely the long-term Canada yields will fall. Our three key industries are now dealing with a slump; autos, financials, and commodities.

Which is the likely scenario over the next one to two years: Long-term Canada Yields go up, sideways, or down, given that Canada is entering a full-blown recession?

Bloomberg says: The yield on the two-year bond declined 12 basis points, or 0.12 percentage point, to 1.59 percent at 4 p.m. in Toronto, the lowest since Bloomberg records began in 1989. The price of the 2.75 percent security due in December 2010 rose 23 cents to C$102.29.

The 10-year note’s yield fell 19 basis points to 3.13 percent, also the lowest since at least 1989. The price of the 4.25 percent security maturing in June 2018 climbed C$1.66 to C$109.18.

“Long-term rates are playing catch-up in terms of the decline in yields we have seen in short-term bonds,” said Mark Chandler, RBC Dominion Securities Inc. “There is limited downside in short-term yields,” he said.

“The relatively greater drop in yields on long-term bonds compared with short-term bonds is a theme that could continue into the first half of 2009,” Mr. Chandler said. “This is known as a yield curve flattener,” as the spread between the short-term and long-term rates narrows.

Currently, Canada’s yield curve is steep, defined by short term rates near zero percent, and 30 year rates, which closed today (12/01) at 3.761%, down 21 bps from last Thursday (11/27) morning.

As Hugh Hendry recently put it:

“I withdrew my hard-earned money from a bank this summer. But it may surprise you to learn that I bought government bonds of long duration. Surely I should have bought gold? Except that I believe the way to make money is to seek opportunities through paradox.

And therein lies our brinkmanship: everyone has skipped our story and read the conclusion. They fear financial anarchy. Gold coins are sold out. Everyone is in. And yet the price of gold has fallen this year. So, for now, I would stick with the bonds. The 18-year British gilt yields 4.8pc but, with the Bank of England likely to follow the Fed and slash rates to 1pc, I believe we could see gilt yields below 3pc.

And I promise you that if bond yields broke 3pc there would be a stampede to buy. At this stage gold might trade close to $500, and those who missed its rally from 2002 would have the solace of schadenfreude when in reality they should be buying the stuff and selling their bonds. What delicious irony: deflationists and inflationists could both claim to be right. But how many will have profited?”

Tags: Bailout, Basis Point, Basis Points, Bernanke, Blog, Bloomberg, Bond Market, Bond Yields, Bonds, Bps, Br, Canada, Canada Rates, Canadian Economy, Canadian Investors, Collapse, Commodities, Commodities Prices, Current, Deflation, Dollar, Dollar War, Dow, Eco, Economy, Equity Market, Fed, Federal Reserve, Federal Reserve Chairman, Financials, Gold, Government Bonds, Hugh Hendry, Img, inflation, interest rates, Investors, Key Industries, Liquidation, Loc, Loom, Markets, Money, oil, Rally, Recession, REW, Rose, Roundabout Way, Snap, Stocks, Stuff, Target, Term Bond, Term Funds, Term Interest, Term Obligations, Treasuries, Treasury Securities, Trillion, Tsx, Us Government, Us Treasury, Volatility, Yield Curve
Posted in Bonds, Canadian Stocks, Commodities, Economy, Gold, Markets, Oil and Gas | No Comments »

Bill Ackman: Pershing Square Q3 2008 Letter

Thursday, November 27th, 2008

Pershing Square Q3 2008 Investor Letter
by Bill Ackman, November 15, 2008 at 11:44 pm

These are extraordinary times particularly for active participants in the capital markets. While I do not normally choose to write about macro and regulatory events, I thought it would be useful for you to understand how we think about recent events and their impact on our portfolio.

We are currently witnessing the greatest deleveraging event in history. What began as a credit bubble bursting has now spread to the equity markets as banks, investment banks, hedge funds, structured products, mutual funds, pension funds, endowments and other leveraged and unleveraged market participants have been forced to liquidate assets by their counterparties, leverage providers, redeeming clients, and as a result of downgrades, other debts or other commitments that need to be funded.

These actions have led to forced and indiscriminate selling in security markets around the world, which in turn has caused other investors to panic or simply to sell, to get out of the way of other forced sellers.

As a fund which is generally substantially more long than short, we have also suffered large mark-to-market declines in our long investments. Year to date, however, our performance has substantially exceeded that of the broader equity markets, which at this writing have seen a more than 34% decline. Our outperformance is largely due to large gains on our investments in Longs Drugs and Wachovia Corporation as well as profits on our credit default swap and other short exposures. Our market losses have been further mitigated because we operate unleveraged and have substantial cash balances. Currently, we have cash and near-cash (Longs Drugs and Wachovia/Wells Fargo long/short) equal to approximately 39% of our capital.

When, you might ask, will the selling end? While I don’t proclaim to be a market prognosticator, I will make a few observations. Unlike the deleveraging that takes place when banks and other financial institutions sell assets to meet regulatory requirements, which is typically a longer term process, the forced deleveraging that is now taking place in the equity markets is being implemented largely by the prime brokerage firms and margin account managers at broker dealers around the world. Prime brokers are not known to be laggardly in their approach to liquidating an account that no longer meets margin requirements. This is likely to be even more true in the current environment. As such, it may be reasonable to conclude that the forced liquidation that is now taking place may not be a prolonged process.

Security prices around the world have come down tremendously. In the larger capitalization U.S. markets, which are the focus of our strategy, the reductions have been substantial. As of the market close on October 31st, the S&P 500 is down 34.0%, year to date, and down by 37.5% from its high on October 31, 2007; and this is after last week’s rally in which the S&P 500 rose more than 12% from the lows. Unlike the bear market of 1973 and 1974, in which stocks declined by 45% from the highs, this bear market was not preceded by the “Nifty 50″ bubble in which large capitalization growth stocks traded at extraordinary valuations. While valuations were not cheap one year ago, in a long-term historical context, the market as a whole (particularly if one were to exclude financials) was not particularly expensive either.

As such, in today’s market, we are finding extraordinary bargains, the kinds of opportunities that are normally associated with market bottoms. While there are still weak and poorly capitalized businesses that are likely still overvalued, the high quality, well-capitalized, larger capitalization businesses which are the focus of our strategy look very cheap to us.

While this means that now is likely to be a much better time to be a buyer rather than a seller, it does not mean that the market will not continue to decline, even substantially, from current levels, particularly in the short term. In fact, because of tax-loss selling over the next 60 or so days, there will likely be additional selling pressure. At some point, however, the forced selling will come to an end. Large amounts of cash are sitting on the sidelines waiting to be deployed when investors feel the coast is clear. In the event the market were to start to rise again, it would not be a surprise to see institutional, retail, and hedge fund investors rapidly deploy capital so as not to miss a, perhaps, explosive market rally.

What does this all mean for Pershing Square? Despite the fact that we occasionally have an opinion, we spend little time trying to outguess market prognosticators about the short-term future of the markets or the economy for the purpose of deciding whether or not to invest. Since we believe that short-term market and economic prognostication is largely a fool’s errand, we invest according to a strategy that makes the need to rely on short-term market or economic assessments largely irrelevant.

Our strategy is to seek to identify businesses and occasionally collections of assets which trade in the public markets for which we can predict with a high degree of confidence their future cash flows - not precisely, but within a reasonable band of outcomes. We seek to identify companies which offer a high degree of predictability in their businesses and are relatively immune to extrinsic factors like fluctuations in commodity prices, interest rates, and the economic cycle. Often, we are not capable of predicting a business’ earnings power over an extended period of time. These investments typically end up in the “Don’t Know” pile.

Because we cannot predict the economic cycles with precision, we look for businesses which are capitalized to withstand difficult economic times or even the normal ups and downs of any business. If we can find such a business and it trades at a deep discount to our estimate of fair value, we have found a potential investment for the portfolio. Next we look for the factors that have led to the business’ undervaluation, and judge - based on our assessment of the company’s governance structure, management team, ownership, and other factors - whether we can effectuate change in order to unlock value. When the price is right, the business is high quality, the management is excellent, and there are no changes to be made, we are willing to make a passive investment.

Our assessment of the short-term supply and demand for securities plays almost no role in our determining whether to invest capital, long or short. If we believed that it was possible to accurately predict short-term market or individual stock price movements and we had the capability to do so ourselves, we might have a different approach. Below I quote Warren Buffett in his 1994 Letter to shareholders where he perhaps says it best:

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results…

Stock prices will continue to fluctuate - sometimes sharply - and the economy will have its ups and down. Over time, however, we believe it is highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate.

I believe we will look at the current U.S. stock market valuations for high quality mid and large capitalization businesses as presenting perhaps the best investment opportunities of our lifetimes.

Portfolio Update

The last quarter and, in particular, the last few weeks have been an extraordinarily busy and productive time for Pershing Square. During this time, we have made considerably more buy and sell decisions than usual, taking advantage of the liquidity of our holdings, the enormous volatility of the market, and new opportunities that have presented themselves in recent weeks.

In the third quarter, we disposed of our investments Cadbury PLC, Canadian Tire, and Austrian Post at prices generally higher than current levels. We also disposed of the substantial majority of our investment in Sears Holdings. We hold a residual interest in Sears (which represents approximately 1.5% of fund capital) as its price declined to a level at which it made no sense to continue to sell. We redeployed the capital from these sales into Wachovia Corporation, which I will discuss further below, as well as a new investment in which we are in the process of accumulating a position.

We sold these positions not because we thought they would be poor investments, but rather because we believed that we could redeploy the capital in investments that offered a more attractive risk-reward profile. As we have often stated, we are always willing to sell an existing holding at a profit or a loss, if we can find a better use for the funds. For our taxable investors, sales at a loss have the additional benefit of offsetting taxable gains.

Our sales were also motivated by the fact that three of the above companies - Sears, Canadian Tire, and Austrian Post - each have a controlling shareholder. Because we believe that one of our important competitive advantages is our ability to effectuate change at companies in our portfolio, other than in special circumstances, we do not expect to make investments in controlled companies in the future.

As a result of recent changes in the portfolio and strategic developments with respect to Longs Drugs and Wachovia Corporation, our long portfolio is now comprised of higher quality, more economically resilient businesses, companies for which we can be a catalyst to create value, and a large amount of cash and soon-to-be cash that we can redeploy in new opportunities.

On the short side of the portfolio, we have been opportunistic in unwinding single-name credit default swaps in cases where spreads have increased significantly, and have covered certain short positions where stocks have declined substantially as a result of company-specific as well as market-related events. We recently repurchased CDS on the investment grade credit index as certain technical factors have made this investment/hedge attractive once again.

Longs Drugs

In last quarter’s letter, I alluded to a new position on which we expected to file a Schedule 13D shortly. That position was Longs Drugs, a West Coast based drugstore retailer. While Longs’ was valued in the market as an underperforming drug store retailer, we valued the business based on its component parts which included: (1) owned and long-term, below-market, leasehold real estate, (2) RxAmerica, a rapidly growing pharmacy benefit manager (”PBM”) which generated more than 20% of the company’s trailing operating income, and (3) an underperforming, low-margin drugstore retailer. At our cost, we believed that Longs real estate value alone more than covered our purchase price and we were getting the PBM and the retailer for less than free. We estimated the fair market value of the company to be $85 to $95 per share assuming each of the company’s assets was sold to the buyer who could pay the highest price.

Unlike many of our previous active investments, we concluded that Longs had reached the end of its strategic life and should be sold to one of its larger competitors, namely CVS or Walgreens. While it has been rare for us to buy a stake in the company with a view that a strategic sale was the right exit opportunity, we have done so in the past. For example, our original investment in Sears Roebuck & Company was predicated on a strategic outcome at the company which was ultimately achieved when it was acquired by Kmart.

In the current weak (to use a euphemism) credit environment, we are particularly wary of investments which are predicated on a sale. However, in this case, we were comforted by the fact that Longs Drugs would be a must-have acquisition for CVS and Walgreens and that both companies, which are many times the size of Longs, could easily finance the acquisition. Even in the event a sale did not go through, we had purchased Longs at an attractive price which offered a substantial margin of safety against a permanent loss of capital.

Within one week of our 13D filing, Longs announced that it had entered into a transaction to be sold to CVS for $71.50 per share in a cash tender offer, an approximately 44% premium to our average cost. While we were happy with the deal, we were somewhat unhappy with the purchase price, particularly when we learned that the company had not run a competitive auction. Thereafter, we hired the Blackstone Group with whom we have worked successfully in past transactions in an attempt to achieve a better outcome for all shareholders.

We and Blackstone were successful in attracting a bid of $75 per share from Walgreens; however, the greater regulatory risk and potential time delay in a transaction with Walgreens led Longs’ board to reject the transaction in favor of the CVS offer. Walgreens subsequently withdrew its offer citing market conditions, and a day later, the CEO of Walgreens stepped down. We anticipate that we will be fully cashed out of our investment in Longs’ by the close of trading today.

Wachovia Corporation

Wachovia is a good example of the types of opportunities that have emerged in the current highly volatile environment. On Monday morning September 29th, Wachovia Corporation announced that it had entered into an agreement in principle to sell its banking subsidiaries to Citigroup. The transaction was structured in an unusual manner. In the deal, Citi was paying $2.1 billion of its own stock to Wachovia Corporation (the publicly traded holding company for the Wachovia banking subsidiaries) and assuming $53 billion of senior and subordinate holding company debt in addition to the debt and other liabilities of the Wachovia banking subsidiaries. The description of the transaction was limited to a several paragraph press release and a conference call presentation by Citigroup that morning. Wachovia stock opened later Monday afternoon at approximately $1.80 per share, down 82% from Friday’s close.

The market’s reaction to the Citi transaction was severe, particularly as the transaction was announced only four days after Washington Mutual’s subsidiary banks were seized by regulators and sold to J.P. Morgan. In that transaction, WaMu’s holding company filed for bankruptcy, wiping out shareholders and materially impairing holding company creditors.

The Wachovia transaction, however, was structured in a materially different manner from the WaMu seizure. It appears that the government, in order to protect bank holding company bondholders from losing their investment and perhaps to avoid triggering a CDS credit event, structured this deal so that Citi would assume the holding company debts. Interestingly, as part of the Citi transaction the government provided an excess-of-loss guarantee on Wachovia mortgages to protect Citi, which the government could likely have avoided if it had not required Citi to assume $53 billion of holding company debt. It appears that the government had concluded that additional bank holding company debt defaults would create systemic risk or reduce the ability for bank holding companies to access this important source of capital, and therefore chose to protect the Wachovia banking subsidiary and the holding company bondholders.

The unusual structure of the transaction created an interesting investment opportunity. By removing the holding company debts, Wachovia Corporation, now orphaned from its bank subsidiaries was left with some very attractive assets. Based on our reading of the public filings, conference call transcripts, and internet research over the course of Monday morning and afternoon, we estimated that Wachovia was left with the following assets: approximately $2 billion or more of cash, $2.1 billion of Citigroup Stock, the Wachovia Securities wealth management operation, A.G. Edwards (which had been purchased one year ago for approximately $7 billion), Evergreen Asset Management (a mutual fund manager with $245 billion in assets under management), Wachovia Insurance Services, and other ancillary assets.

In light of the Citi debt assumption, the only material liability of Wachovia Corporation was $9.8 billion of non-cumulative, perpetual preferred stock. Because this preferred is both non-cumulative and perpetual, Wachovia has no obligation to ever pay a dividend on these securities making these liabilities effectively a free form of equity financing. These types of preferred securities are typically structured to qualify as an attractive form of bank holding company equity which gets favorable regulatory and rating agency treatment. Now that they were orphaned by the transaction, at best these liabilities were worth less than 50 cents on the dollar.

We also determined that the structure of the transaction would create a large tax asset for the holding company. By selling the bank subsidiaries for less than their net tangible asset value, we estimated that a $26 billion tax loss would be created. This tax loss could by carried back two years enabling the holding company to recover approximately $7.5 billion of cash taxes that had previously been paid.

Our conservative estimate of value of New Wachovia was in excess of $8 per share even assuming that the preferred stock was redeemed or valued at par. We began buying the stock shortly after it opened on Monday afternoon. My instructions to our traders Ramy Saad and Erika Kreyssig were to buy every share we possibly could, including pre- and post-market trading. They did a superb job.

Between Monday afternoon and late Thursday we acquired 178 million shares, or approximately 8.3% of the company, at an average price of $3.15. On Friday morning before the open, Wells Fargo announced a definitive agreement to acquire Wachovia for 0.1991 shares of Wells common stock, or more than $7.00 per share based on Friday’s trading price. We began selling our Wachovia stock on Friday. We could not, however, hedge the Wells Fargo stock price because the short selling ban was still in effect.

Citi, which thought it had an exclusive to complete the transaction with Wachovia, brought litigation later that Friday to enjoin the Wells Fargo deal. By late the following week, Citi, likely as a result of pressure from the government, had agreed to allow the Wells transaction to go forward while retaining their lawsuit for damages against Wells Fargo.

As of this date, we have hedged 100% of our exposure to Wells Fargo shares, and have been opportunistic in unwinding a substantial portion of the position. Assuming we waited until transaction closure and taking into consideration Wachovia shares already sold, we have locked in a 67% profit on this $560 million investment.

The government and all of the parties appear to be doing everything they can to consummate the transaction promptly. The transaction received HSR approval in one day and the Treasury and banking authority approvals over the following weekend. Wells has been issued 39% of the voting stock of Wachovia and transaction closure is anticipated by year end. The transaction requires the recently filed form S-4 to be approved by the SEC and the completion of the mechanics of the shareholder meeting in order to be consummated. It is an excellent deal for Wells Fargo and for Pershing Square.

A Mistake

While most of our long investments are comprised of great businesses or assets at fair prices with a catalyst to create value, we occasionally are willing to invest a small amount of fund capital in situations which offer the potential for a many-fold profit at the risk of a large or near-total loss of capital invested. I typically call these investments mispriced options. Our CDS investments fit this profile. While not all mispriced options will be profitable for the funds, I expect our collective experience in these commitments to be quite favorable over time.

We purchased stock in American International Group, Inc. (AIG) after the announcement of the government bailout. In summary, we did so because at the price paid, we purchased AIG at a substantial discount to book value, and we believed that book value was a conservative estimation of the value of AIG’s underlying businesses net of derivative losses. We also believed that there was the potential for a renegotiation of the government’s extremely harsh financing commitment to AIG which provided for 80% dilution, enormous commitment fees, and a high interest rate.

In particular, we believed that if AIG could pay back the government promptly through a combination of asset sales, termination of certain CDS contracts at potentially less than fair market value, and equity investments from existing and potentially other investors, that there was a chance to renegotiate the 80% zero-strike warrant package to the government. If the warrant dilution could be mitigated, it would be possible for AIG shareholders to make a many-fold return on investment. Initially, we believed that the potential for return outweighed the risk of loss. Because of the inherent leverage of AIG, the risk of a permanent loss of capital on this investment was material. As such, we limited the size of our investment to 2.5% of fund capital.

After acquiring our position, we met with other large holders, policymakers and contacted Berkshire Hathaway and other potential investors about a proposed recapitalization of AIG. Unfortunately, the collection of shareholders that were attempting to restructure the government deal was exceedingly disorganized and some large holders were conflicted by a desire to buy certain assets from the company.

We ultimately concluded that the return on invested brain damage from this investment exceeded the probability-weighted opportunity for profit, and we decided to fold the tent. We sold our stock and incurred a modest loss to the funds.

Our Business Model

In order to achieve long-term success, Pershing Square must make good investments and operate with a robust business model. With much media attention focused on hedge fund failures, I thought it would be worthwhile reviewing the characteristics of our business model and explaining why we will withstand industry-specific and overall environmental threats to the investment and hedge fund businesses. The principle factors which contribute to the robustness of our business model are as follows:

* Our portfolio management approach is inherently low risk (where risk is defined as the probability of a permanent loss of capital), particularly when compared with other hedge fund business models. An important distinguishing factor about Pershing Square compared to most other hedge funds is that we do not generally use margin leverage in our investment strategy. The lawyers prefer that I put in the word “generally” to give us the flexibility to use margin to manage short-term capital flows, but, to-date, we have not used any but an immaterial amount of margin, and only for a brief period of time, and we have no intention of changing this approach,
* We generally invest in higher quality businesses with dominant and defensive market positions that generate predictable free cash flow streams and that have modestly or negatively leveraged (cash in excess of debt) balance sheets. We buy these businesses at deep discounts to our estimate of intrinsic value giving us a margin of safety against a permanent impairment of capital. I say “generally” again here because we do make exceptions in certain limited circumstances; that is, we may buy a more leveraged or lower quality business if we believe the price paid sufficiently discounts the risk.
* We often seek investments where we can effectuate positive change to catalyze the realization of value. This serves to accelerate the recognition of value, helps us avoid “dead money” situations, and protects us somewhat from managerial actions which can destroy value.
* We are diversified to an adequate but not excessive extent. This has further benefits for risk and operational management which I will discuss below.
* There is an inherent balance to our long/short investment approach. Historically, when equity or credit markets weaken, our shorts become more valuable, and occasionally materially more valuable, offsetting somewhat the mark-to-market declines in our long portfolio. If we choose to unwind these short positions during market downturns, we can generate capital to invest in a now less expensive market. These short investments generally stand on their own in that they do not typically require a stock market or credit market decline to be successful. That said, they have served as a useful hedging tool during periods of dramatic market declines.
* We have been paranoid about counterparty risk since the inception of the firm. First, we trade with counterparties which we believe to be creditworthy. Second, we have negotiated ISDA agreements which provide us with daily mark-to-market cash and U.S. Treasurys equal to the previous day’s market value of our derivative contracts. In cases where we are required to post initial margin and therefore have some exposure beyond the market value of our derivative contracts, we have typically purchased CDS on our counterparties to further mitigate counterparty risk. While our approach to counterparty risk has protected us from any counterparty losses to date, please be forewarned there is no perfect approach to avoiding counterparty risk.

Our simple approach to investing also allows us to avoid complicated approaches to risk management. Our investment strategy does not require us to open offices all over the globe. As such, we don’t need traders working around the clock. We can go to sleep at night and sleep. Our weekends are largely our own (Ok. I admit it. I am writing this letter in the office on Sunday.) Our risk management approach is to: (1) put our eggs in a few very sturdy baskets, (2) store those baskets in very safe places where they cannot be taken away from us and sold at precisely the wrong time due to margin calls, and (3) to know and track those baskets and their contents very carefully. We call this approach the sleep-at-night approach to risk management. If I can’t, we won’t.

I am extremely skeptical of more automated, algorithmic, Value at Risk, and other business school sanctioned approaches to risk management. None of these approaches saved Lehman, Bear Stearns, Fannie, Freddie, AIG, WaMu, Wachovia or any of the other institutions that used these and other ostensibly more sophisticated risk management strategies.

Our investment strategy and approach to counterparty risk serves to limit the risks inherent in our individual investment selections, our counterparty risk, and the portfolio as a whole. There are, however, other important risks to our business, principally operational, reputational, and regulatory risk.

Operational Risk

Our investment approach is largely straightforward and relatively simple. This, coupled with the concentrated nature of the portfolio, allows us to run our business with a limited number of personnel. We have five senior investment professionals including myself. Shane Dinneen, still officially a junior investment professional, is fast earning his stripes as an eventual senior member of the team.

We could manage our portfolio with less human talent than we have. For members of the investment team reading this letter, don’t be concerned because I have no intention of shrinking the team, but I make the point nonetheless. Simplicity in our investment approach allows for a simpler back office and a smaller overall staff. We have 31 people total at Pershing Square. It could be fewer, but one of Tim Barefield’s (our COO) important risk management principles provides for back-up talent for every role in the firm.

Our Noah’s Ark approach to personnel duplication makes for a good analogy for the ship we have designed. We have worked hard to build a business that can withstand the Great Deluge, and this goes beyond counterparty risk. For example, it is not yet clear this year whether there will be any incentive allocation to be shared at the firm. That said, whether or not the funds’ finish the year in the black, it will be extremely unlikely that a member of our team leaves by choice, and I have no intentions of letting anyone go. This is due to several factors:

* Pershing Square’s large amount of assets under management per investment principal and per overall employee are important ratios to consider when evaluating the sustainability of Pershing Square or any hedge fund for that matter. The economics of a high Asset per Employee ratio attract and allow for the retention of top talent. Our team can be compensated appropriately even in times of short-term underperformance. Hedge funds which barely (or don’t even) cover their costs with management fees are inherently unstable enterprises because in an unprofitable year they cannot pay their people and are likely to lose their most talented professionals to other firms.
* Pershing Square is a nice place to work. While this sounds like an obvious approach to retaining talent, many and perhaps most hedge funds don’t fit this description. We are big believers in taking care of our team not just financially and with attractive benefits, and we have those in spades. We consider every employee at the firm a member of our extended family, and we treat and care for them appropriately. We do this not for business reasons, but it has important long-term business benefits.
* Pershing Square is an extremely exciting place to work. We believe our work creates value beyond the profits we historically have generated for our investors. Our approach to value creation at businesses has created enormous value for investors who happened to own companies to which we contributed to the creation of value. Similarly, investors and counterparties who listened to our views on the bond insurers, Fannie Mae and Freddie Mac, etc. saved themselves from large losses or perhaps profited by short sales. The fact that our work creates value for the markets as a whole provides additional motivation to the team.

Bottom line, we are built to last, and we will continue to work hard to deserve your continued support.

Reputational and Regulatory Risk

Reputational risk is one of the key risk factors for a business that is subject to a high degree of regulatory scrutiny in an industry that seems to generate considerable public scorn. Our approach to assessing reputational risk is to apply the New York Times test. We ask ourselves whether we would be comfortable having our family and friends read a front page New York Times story about actions taken by Pershing Square written by a knowledgeable and intelligent reporter who has access to all of the facts. If we are comfortable with such an article being read by our close friends, our families, and the public at large, our action passes the test. If not, we reconsider our potential action.

More recently, I have decided to participate in the public dialogue about hedge funds, agreeing to occasional appearances on television or otherwise talking to the press, speaking at industry events, meeting with Congressman, Senators, and other officials. I do so not for any desire for public recognition, but rather because I believe that it is important for the hedge fund industry to come out of the shadows and defend the importance of our work. If we and others (that includes hedge fund investors in addition to the managers) don’t do so, the industry, in my view, is at even greater risk of further regulatory, tax, and other legal changes that will materially harm our business models and industry.

One does not need to look further than the recent short selling ban which was an extremely ill-advised regulatory change that contributed to market turmoil and the recent market decline. By imposing a ban on an investment approach that has been legal for generations with no warning or opportunity for public debate, the SEC caused a short squeeze and subsequent market disarray that wiped out large amounts of hedge fund capital, caused forced selling as long/short, market neutral, quantitative, and other managers had to sell long positions to rebalance their books. More significantly, it cost the U.S. capital markets its highly respected position as an exemplar free marketplace where the rule of law prevailed. It also contributed to hedge fund underperformance, thereby leading to investor redemptions, further reducing industry capital.

I believe the short selling ban also contributed to continued market declines since the ban was put into place. In that hedge funds are among the most opportunistic investors in the world, destroying large amounts of hedge fund capital likely contributed to market declines because of a dearth of opportunistic hedge fund buyers who would normally step in and purchase the compelling values created by falling markets.

Even though the restriction on short selling has been eliminated, the longer-term consequences of populist regulatory actions will continue to be felt by the markets and its participants until such time as our securities regulator makes clear that the U.S. will never again change the rules of the game mid play.

Specifically, the short selling ban was harmful to Pershing Square because we lost the opportunity to lock in even greater gains on our Wachovia investment by not initially being able to hedge our Wells Fargo exposure. I estimate this loss at approximately 3% to 4% of fund performance. This loss was somewhat offset by our ability to sell certain investments into the short squeeze at higher than anticipated prices. We were otherwise not materially affected because short selling equities has not been a material part of our investment program, although we did cover one large equity short at a loss which is now trading at a more than 40% lower price, another 4% to 5% potential loss of profit assuming we had not covered at higher prices.

Hedge fund investors - the pension funds, state plans, charitable, healthcare and other institutions and the individuals who invest in hedge funds - are a much more appealing constituency to defend the industry than the managers themselves. I encourage you to consider becoming part of the public debate on the industry. We collectively need one another’s support.

Investor Risk

The stability of a hedge fund’s capital base is critical to its long-term success. We have endeavored to attract high quality investors who have a deep understanding of our investment approach. We do our best to continually inform you of the progress of our holdings and business, and remind you of the inherently volatile nature of our concentrated strategy. Our investment strategy is also transparent. The nature of our approach requires most of our holdings to eventually be disclosed publicly. As such, it is easier for you to understand how we have made and lost money over the years, and to assess our ability to replicate our historic strategy and performance.

Over the last nearly five years, we have delivered very little of the volatility that investors are concerned about, that is, downward volatility. As such and with strong historical performance, we have not “tested” our investor base. We hope never to “test” our investor base.

While we have considered a longer-term lock-up structure, we chose not to modify our existing liquidity terms because we did not want our terms to be overly burdensome to investors and to present a hurdle to the reinvestment of capital, particularly during a period of temporary underperformance. Year to date, we have had minimal redemptions. New commitments have exceeded our redemption requests by approximately 3 to 1. We have a pipeline of new prospects that are in the process of completing their due diligence. That said, the continuity of our investor base is a long-term success factor for the funds and for this we are relying on you.

Is Now a Good Time to Invest in Pershing Square?

I have never before suggested that one time or another would be a better time to invest in Pershing Square. I am going to take the risk of doing so now. At the risk of sounding promotional, I believe that now is perhaps the best time in our history to increase your investment in Pershing Square. A few thoughts to consider:

When one invests in Pershing Square today, with respect to our current portfolio and potential opportunities in the market, the spread between price and value is the widest it has been since the inception of Pershing Square and likely over the last 30 or more years in our opinion. Investments like Target Corporation which we purchased initially in the mid to high $50s per share now sell at approximately $40 per share and there has been no meaningful diminution in the per-share value of Target since our initial purchase 18 months ago. In fact, the probability of Target and other Pershing Square holdings implementing a value-creating transaction are higher today than before because of management and shareholder frustration with current share price levels. Consider that Target management options are nearly all out of the money, and a meaningful number of vested options will soon likely expire worthless if there is no change in the status quo.

An additional investment in Pershing Square today also purchases a pro rata interest in our cash and near-cash investments. While purchasing cash indirectly is not an inherently attractive proposition, we are currently analyzing a number of long and short investments that appear extremely interesting, and subject to completion of our due diligence, may become large new commitments. While for the first nearly five years of our business, we found only a limited number of interesting opportunities, albeit a sufficient number to generate attractive returns, we are now presented with tens of intriguing situations that are worthy of careful review. One could reasonably conclude that the greater spread between price and value and a wider selection of attractively priced opportunities will lead to higher rates of return on these commitments than during previous periods of greater market efficiency which characterized the first four years of the funds’ existence.

While many have portrayed the current environment as a highly risky time to invest, these individuals are likely confusing risk with volatility. We believe risk should be determined based on the probability that an investor will incur a permanent loss of capital. As market values have declined substantially, this risk has actually diminished rather than increased. Risk is high now for the leveraged short-term investor, but actually much lower for the unleveraged, long-term investor in high quality, mid and large capitalization, modestly leveraged businesses.

Unlike levered hedge funds whose risk increases as NAV declines, Pershing Square’s risk has declined with the recent decline in the value of our portfolio. Why? This is due to the fact that a leveraged manager’s probability of being sold out by its prime broker increases as its portfolio’s equity declines. Many hedge fund strategies are confidence and credit sensitive because they require continued access to low-cost financing. Recent declines may also require leveraged hedge funds to post additional collateral on trades which did not require an initial down payment. Because our investment strategy does not require leverage to operate, recent increases in financing costs and reductions in leverage afforded to hedge funds have no impact on our current or future prospects. In our case, the margin of safety of our investments actually increases, the greater the decline in our holdings’ share prices. We, of course, also have no margin leverage creating the risk of a forced sale. So yes, I believe now is a good time.

Pershing Square Advisory Board Addition

Matt Paull joined the Pershing Square Advisory Board on September 1st. For some of you, Matt’s name may be familiar for he was formerly the CFO of McDonald’s Corporation before his retirement earlier this year. I have known Matt for about 10 years, and interacted with him intensively in mid to late 2005 and in early 2006 when Pershing was advocating for change at McDonald’s.

As CFO of McDonald’s, Matt was one of the most highly regarded public company CFOs in the country. Shareholders were the beneficiaries of superb capital allocation and strong share price appreciation during his tenure as CFO. I consider it one of Pershing Square’s greatest accomplishments that we were able to garner Matt’s respect and friendship even though there were occasionally contentious moments during our engagement with McDonald’s.

Matt has already proved enormously helpful in our interactions with Target Corporation. As a former CFO, particularly one that has been on the other side of one of Pershing Square’s most significant engagements, Matt brings a uniquely valuable perspective to the firm and to the management teams of our portfolio companies.

In addition to his Pershing Square advisory role, Matt is currently serving on the business school faculty of University of San Diego.

Organizational Update

We completed our move to the 42nd floor of 888 Seventh Avenue in August. The second time round, we really got it right. The space is beautiful, promotes communication, and is extraordinarily well organized and efficient.

After the move, we made several additions to the team. Courtney Leonardo and David Robinson joined the IR team in administrative roles, roles which had previously been filled by temporary employees. Alex Song joined us from Goldman Sachs as the newest junior member of the investment team. Amy Stern joined the Finance and Accounting team from Tiger Global, and will focus her efforts on management company accounting. Amy is also attending the NYU Stern School of Business where she is working on a business school degree. Jill Skousen replaced Whitney Stodtmeister as the administrative assistant for the investment team after Whitney moved to Santa Barbara. Helena Tunner joined us to work with Dianna Baitinger at front desk reception.

On other news, Alex Kaufmann of our IR team will be attending Columbia University’s Executive MBA program on Fridays and weekends. We are big believers in continuing education for our personnel.

As always, we are extremely appreciative of your support, particularly during uncertain times. If there are any questions I have failed to answer above, please call Doreen, Alex, Ashley or myself.

Sincerely,
William A. Ackman

Tags: 10 Years, Analogy, Array, Bailout, Banks, Bear Market, Bear Stearns, Bill Ackman, Blackstone, Bondholders, Br, Brokers, Canada, Cash Balances, CDS, Cement, Citigroup, Columbia University, Commitments, Commodity, Commodity Prices, Counterparties, Credit, Credit Bubble, Credit Default Swap, Credit Market, Credit Markets, Current, Desc, Diffe, Dollar, Earnings, Economics, Economy, Extraordinary Times, Failure, Fannie Mae, Financials, Focus, Freddie Mac, Gold, Health, Hedge Fund, Hedge Funds, Img, interest rates, International, Investment, Investment Banks, Investment Strategy, Investor Letter, Investors, Letter To Shareholders, Leverage, Liquidation, liquidity, Loc, Longs Drugs, Market Declines, Market Losses, Market Participants, Markets, Mining, Money, Mortgage, Mutual Funds, New York Times, Ny Times, oil, Outperformance, Pershing Square, Portfolio Management, Prognosticator, Rally, Real Estate, Redemptions, Regulatory Events, REW, risk, S&P 500, saa, Security Markets, Shareholders, Short Selling, Short squeeze, spreads, Squeeze, Stock Market, Stock Prices, Stocks, Structured Products, Substantial Cash, Systemic Risk, Target, Trading, Treasury Bill, Valuations, Value, Volatility, Wachovia, Wachovia Corporation, Warren Buffett, Wells Fargo
Posted in Bonds, Credit Markets, Economy, Gold, Markets, Oil and Gas | No Comments »