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

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Words from the (investment) wise for the week that was (November 17 – 23, 2008)

Sunday, November 23rd, 2008

A new bout of fear gripped financial markets during the past week, causing the slide in global stocks, commodities and emerging-market assets to deepen. As investors’ angst escalated, positions in risky assets were liquidated in exchange for perceived safe havens such as the US dollar, government bonds and gold bullion.

“We have seen fundamental selling, technical selling, forced selling (deleveraging), short selling, capitulation selling and selling due to ennui,” commented David Fuller (Fullermoney).

Fueling the sell-off were mounting concerns that the economic recession could not only be more intense than previously feared, but also fall into a corrosive deflationary phase. Additionally, sentiment was undermined by renewed questions about the effectiveness of the US government’s bailout plans.

A clear sign of distress and fear was the US three-month Treasury Bill rate falling to zero on Thursday, before nudging up to (a still minuscule) 0.10% by the close of the week. “The financial situation at the moment is so bad that women are now marrying for love,” quipped an e-mail doing the rounds.

After the S&P 500 Index breached the grim milestone of the October 2002 lows and fell to levels last seen in 1997 – thereby threatening to wipe out the entire 2002 to 2007 bull market – Wall Street regained some confidence late on Friday. The trigger for a strong turnaround arrived just in time for the 15:00 witching hour and came in the form of Timothy Geithner’s (pronounced GYTE-ner) nomination as new Treasury Secretary, resulting in the S&P 500 recovering from an intraday loss of more than 1% to a gain for the day of 6.3%.

On the bailout front, the Detroit automakers sought $25 billion from the Treasury to avert bankruptcy. However, Congress withheld financial aid for the time being, giving the companies until December 2 to submit a “viable” recovery plan.

“Don’t be misled, though – the something that is rotten in the auto industry has nothing to do with the credit crunch, and everything to do with years of mismanagement, shoddy products and bad choices,” said Bloomberg columnist Mark Gilbert. “Consider the credit-rating histories of GM and Ford. For both companies, the rot started all the way back in August 2001, when Standard & Poor’s put the A grades they enjoyed for a decade on review for downgrade. In October of that year they each suffered a two-level cut to BBB+ that left them just three moves away from junk status.”

I received the following note from an American friend a few days ago: “…even the children in my son’s second grade class are depressed about the auto industry. I had to answer my son’s questions about bankruptcy since the kids are talking about it …” This comment says it all!

Elsewhere, Citigroup’s (C) share price plunged by 60.4% over the week to a 16-year low as the company wrestled the financial crisis and planned to slash 50,000 jobs. According to The Wall Street Journal, “Citigroup officials have been talking in recent days to Treasury Department and Federal Reserve officials, and those discussions are expected to continue throughout the weekend …”

A pointed comment regarding the principle of bailouts came from Jim Rogers, as quoted by the Financial Times: “What they’re doing is taking the assets away from the competent people, giving them to the incompetent people and saying to the incompetent: ‘Okay, now you can compete with the competent people, with their money.’ I mean this is terrible economics. This is outrageous economics.”

Next, a tag cloud of the text of the plethora of articles I have read since a week ago. This is a way of visualizing word frequencies at a glance. Keywords such as “banks”, “economy”, “market” and “prices” occur often, but words such as “gold” and “deflation” have also started creeping into the tag picture.

The following update on the stock market outlook arrived on Friday from Bennet Sedacca (Atlantic Advisors): “We have been barely invested, mostly void, in equities, since May. We went ½ long today near the lows for a rally that could last longer than some think. Mostly large cap, high-quality, excellent balance sheet companies with a little tech and financials thrown in. We must remember, buy when you can, not when you have to.”

Oversold conditions are bound to result in rallies from time to time (and possibly around Thanksgiving), but these should not be trusted at face value. For a more lasting market turnaround to happen, I would like to see evidence of base formations on the charts, a 90% up-day, and relative outperformance by the financial sector.

I am also closely monitoring the surges in the US dollar and Japanese yen – low-yielding currencies previously used for funding risky investments – as a break of the uptrends in these two currencies will be a good indicator of the forced deleveraging selling starting to subside. Once this situation has played itself out, we should see a return to lower volatility levels and a return of confidence. (Also read my recent posts “Economic woes torpedo stock markets” and “Panic-crash sentiment causes extreme volatility“.)

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economic reports
The Ifo World Economic Climate has worsened further in the fourth quarter of 2008 with the indicator falling to its lowest level in more than 20 years, according to the Ifo World Economic Survey. Not only the major economic regions of North America, Western Europe and Asia are affected, but also Central and Eastern Europe, Russia, Latin America and Australia. On the whole, the survey data point to a global recession.

Economic reports released in the US during the past week confirmed an increasingly dire situation.

- The US moved closer to deflation territory as the CPI decreased by 1.0% from September to October (the largest monthly decline since the 1930s), leaving the CPI 3.7% higher compared with a year ago and significantly down from September’s 4.9% rate. The continuing decline in US economic activity is pushing down inflationary pressure.

- Because of weak demand, producer prices for finished goods gave up ground for the third month in a row, falling by 2.8% in October largely as a result of much less expensive energy products.

- On par with expectations, residential construction slowed again in October, with a 4.5% month-on-month decline in total housing starts. At 791,000 annualized units, starts have hit another record low as exceptionally weak demand was constraining homebuilding.

- The NAHB housing market index fell further in November, setting a record low.

- Slumping demand is hitting US industry hard, although production bounced back in October from hurricane-related declines in September. Total industrial production increased by 1.3% after having fallen a downwardly revised 3.7% in September, but the indicator fell around two-thirds of a percent in September and October when excluding once-off effects.

- Initial claims for unemployment insurance benefits increased by 27,000 to 542,000 for the week ended November 15, putting claims at their highest point since the early 1990s. This is a serious warning signal about the health of the labor market.

- The Conference Board Index of Leading Economic Indicators declined by 0.9% in October, led by a sharp plunge in stock prices and decreases in residential building permits and consumer expectations. The LEI in the last three months has shown an acceleration in the rate of decline, adding to evidence that the US has entered a recession that will likely be much deeper than either of the previous two.

It comes as no surprise that the minutes of the Federal Open Market Committee’s meeting of October 28 to 29 indicate that members were extremely concerned about the near-term prospects for the economy, given the stresses in financial markets. With the problems in credit markets persisting, the FOMC’s forecast called for falling growth through the first half of 2009, with next year’s real GDP growth projection lowered to -0.2% to 1.1% (previously 2.0% to 2.8%).

Banks continue to hoard all the liquidity the Fed is injecting directly instead of lending it out. This raises the question: Is the Fed “pushing on a string”? Asha Bangalore (Northern Trust) commented as follows: “The lowering of the Fed funds rate, the Fed’s innovative programs to provide liquidity to financial institutions and more lenient rules for borrowing through the discount window appear to have exhausted the gamut of possibilities routed through monetary policy changes to influence aggregate demand.

“The provisions of the Emergency Economic Stabilization Act of 2008 allow for recapitalization of banks. The FDIC is working on obtaining an approval for the anti-foreclosure plan to address the housing market issues that are central to the current crisis. … the probability of a hefty fiscal stimulus package … is growing every day.”

Economic reports in other parts of the world were equally dismal.

Japan entered into its first recession in seven years as the financial crisis curbed demand for its exports. GDP growth contracted by 0.1% during the third quarter, or at an annualized rate of -0.4%, following a second quarter contraction of a massive 0.9%.

Source: Financial Times, November 17, 2008.

China also warned that the unemployment outlook was “grim” as a result of the financial crisis forcing the closure of more export-oriented factories.

In Europe, a further slowdown in economic activity caused the Swiss National Bank to announce a surprise 100 basis-point cut in its three-month target range to 0.5%-1.5% – the third emergency reduction in two months.

Week’s economic reports
Click here for the week’s economy in pictures, courtesy of Jake of EconomPic Data.

Date	Time (ET)	Statistic	For	Actual	Briefing Forecast	Market Expects	Prior
Nov 17	8:30 AM	NY Empire State Index	Nov	-25.4	-26.0	-26.0	-24.6
Nov 17	9:15 AM	Capacity Utilization	Oct	76.4%	76.5%	76.5%	76.4%
Nov 17	9:15 AM	Industrial Production	Oct	1.3%	0.1%	0.2%	-2.8%
Nov 18	8:30 AM	Core PPI	Oct	0.4%	0.0%	0.1%	0.4%
Nov 18	8:30 AM	PPI	Oct	-2.8%	-2.0%	-1.8%	-0.4%
Nov 18	9:00 AM	Net Foreign Purchases	Sep	$66.2B	NA	$17.5B	$21.0B
Nov 19	8:30 AM	Building Permits	Oct	708K	760K	772K	805K
Nov 19	8:30 AM	Core CPI	Oct	-0.1%	0.1%	0.1%	0.1%
Nov 19	8:30 AM	CPI	Oct	-1.0%	-0.7%	-0.8%	0.0%
Nov 19	8:30 AM	Housing Starts	Oct	791K	780K	780K	828K
Nov 19	2:00 PM	FOMC Minutes	Oct 29	-	-	-	-
Nov 20	8:30 AM	Initial Claims	11/15	542K	505K	503K	515K
Nov 20	10:00 AM	Leading Indicators	Oct	-0.8%	-0.7%	-0.6%	0.1%
Nov 20	10:00 AM	Philadelphia Fed	Nov	-39.3	-30.0	-35.0	-37.5

Source: Yahoo Finance, November 21, 2008.

Next week’s US economic highlights, courtesy of Northern Trust, include the following:

1. Existing Home Sales (November 24): Sales of existing homes are predicted to have declined in October after a small gain in September. Sales of existing homes advanced by 7.8% from a year ago in September, after posting declines since late 2005. Consensus: 5.00 million versus 5.18 million in September.

2. Real GDP (November 25): Incoming economic reports suggest a small downward revision of real GDP in the third quarter to a 0.5% drop from the advance estimate of a 0.3% decline. Consensus: -0.5%

3. New Home Sales (November 26): Sales of new homes are expected to have fallen in October after a 2.3% increase in September. Sales of new homes have dropped by 32.1% from a year ago in September. Consensus: 450,000 versus 464,000 in September.

4. Durable Goods Orders (November 26): Durable goods orders (-2.0%) are predicted to have dropped in October reflecting declines in bookings of defense and aircraft, which posted large gains in September. Consensus: -2.6% versus +0.9% in September.

5. Personal Income and Spending (November 26): The earnings and payroll numbers for October indicate a steady reading for personal income in October. Auto sales fell sharply in October and non-auto retail sales were noticeably weak, pointing to a likely drop in consumer spending (-0.6%). Consensus: Personal income +0.1%, consumer spending -0.9%

6. Other reports: Case-Shiller Price Index, OFHEO Price Index, Consumer Confidence (November 25).

Click here for a summary of Wachovia’s weekly economic and financial commentary.

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, November 14, 2008.

Equities
Global stock markets suffered badly during the past week on mounting worries about the severity of the economic slowdown. The week’s movements – MSCI World Index -9.6% and MSCI Emerging Markets Index -11.8% – tell the story of a rough ride for bourses all over the world and marked a third straight week of losses. And the scoreboard would have been even worse if not for a dramatic late-session recovery in the US on the news that Timothy Geithner would be named Treasury Secretary.

Not a single developed market closed the week unscathed. Similarly, large losses also abounded among emerging markets, with the sole exception being the Shanghai Stock Exchange Composite Index that recorded only a relatively small 0.9% decline. The Index plunged by 72.0% since its high of October 16, 2007 until hitting a low on November 4, but has subsequently bounced by 15.4% to flirt with its 50-day moving average and roundophobia 2000 level. Will the upside leadership for global stock markets come from China on this occasion?

The chart below shows the performances of the four BRIC countries during the past week.

Click here or on the thumbnail below for a (very red) market map, obtained from Finviz, providing a quick overview of last week’s performances of global stock markets (as reflected by the movements of ADR stocks).

The US stock markets all declined sharply over the week as shown by the major index movements: Dow Jones Industrial Index -5.3 (YTD -39.3%), S&P 500 Index -8.4% (YTD -45.5%). Nasdaq Composite Index -8.7% (YTD �‘47.8%) and Russell 2000 Index -10.9% (YTD -46.9%).

The S&P 500 closed below its October 2002 low of 777 on Thursday, but Friday’s rally (+6.3%) to 800 put it back above this key support level. The Dow remained above its 2002 low of 7,286 on Thursday and closed 760 points above this level after Friday’s surge.

Click here or on the thumbnail below for a market map, also from Finviz.com, showing the performances of the various segments of the S&P 500 over the week.

As far as industry groups are concerned, gold (+19%) was the top performer for the week, led by Newmont Mining (NEM) on the back of a sharp rise in the price of gold bullion.

On the other side of the performance spectrum, the industrial real estate investment trust (REIT) group (-40%) was the worst performer. The diversified financial services group (-38%) was the second worst performer, with each of the group’s large banks – Citigroup (C), JPMorgan Chase (JPM) and Bank of America (BAC) – dropping sharply. Investor concerns about future credit losses, valuations of “toxic” securities on the banks’ books, job layoffs and capital adequacy issues were the drivers for the declines.

David Fuller (Fullermoney) commented as follows on the outlook for stock markets: “… we have yet to see evidence of bottoming out on many major stock market charts. While this is worrying, to put it mildly, and sentiment is diabolical, investors should recall an extremely important behavioural conditioning process. The crowd has always turned progressively more bearish with each additional decline towards the eventual low for every bear market. This is inevitable as more people sell, and unfortunately, few are more bearish than a battered holdout who finally capitulates.

“If global stock markets are not close to a major buying opportunity, then I suggest we should all head to sea and become Somali pirates.”

Fixed-interest instruments
Government bond yields across the world plunged last week as spooked investors rushed out of equities into sovereign debt.

The ten-year US Treasury Note yield declined by a massive 57 basis points to 3.18%, the UK ten-year Gilt yield dropped by 20 basis points to 3.87% and the German ten-year Bund yield fell by 30 basis points to 3.38%. However, emerging-market bonds, in general, lost ground as further deleveraging took its toll on risky assets.

The yield on ten-year Treasuries touched a 5½-year low (3.01%) on Thursday before rebounding by the close of the week, whereas the yield on 30-year bonds dropped to its lowest level (3.53%) since the start of regular issuance in 1977 before snapping back by 14 basis points.

US mortgage rates also declined, with the 30-year fixed rate dropping by 9 basis points to 6.09% and the 5-year ARM also by 9 basis points to 5.89%.

A number of indicators show that the credit crisis is still severe. For example, credit default swaps that measure default risk for investment grade debt are trading at their highest levels of the bear market. This is seen from Bespoke’s index that measures default risk for 125 companies with investment grade debt ratings.

Currencies
The week’s feature among currencies was safe-haven flows into the US dollar and Japanese yen as investors liquidated risky assets previously funded with these low-yielding currencies.

The Swiss franc came under pressure as the Swiss National Bank slashed interest rates a full percentage point to 1% as an emergency step to soften the economic slowdown.

The chart below illustrates the accent of the US dollar and Japanese yen since September 15. (The US dollar is measured against a trade-weighted basket of currencies, whereas all the other currencies are measured against the US dollar.)

Emerging-market currencies had another bad week as a result of increasing risk aversion. Examples of losses against the greenback include the Brazilian real (�‘10.4%), the Turkish lira (-4.5%), the South Korean won (-6.7%) and the South African rand (-4.4%).

RGE Monitor raised the question whether Bulgaria and the Baltic states will be forced to reset their fixed exchange rate pegs to the euro as a result of their large external imbalances and the global financial crisis. “Because of their fixed exchange rates, these economies cannot conduct independent monetary policy so the burden of macro-economic adjustment falls on fiscal policy.”

Commodities
The Reuters/Jeffries CRB Index (-6.5%) witnessed a further decline amid fears of a protracted global economic recession and expectations that demand will drop.

Gold bullion (+6.6%) bucked the trend and surged as the yellow metal found support among nervous investors as a safe store of value. A report that China might embark on a gold-buying program provided an additional boost.

On the other hand, West Texas Intermediate crude declined by a further 13.3% to $49.9 – a level not seen since May 2005. OPEC meets on November 29 to consider additional production cuts.

The graph below shows the movements of various commodities over the past week – a continuation of the intense bear market that has been in force since the beginning of July.

Lau-Tzu said: “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.” Wise words indeed, but hopefully the news items and words from the investment wise below will cast some light on the lie of the investment land. And may the markets bring you additional reason to celebrate a joyous Thanksgiving.

That’s the way it looks from Cape Town.

Source: Pat Oliphant, Slate

Barry Ritholtz (The Big Picture): Record-breaking data everywhere!
“One of the interesting aspects of this unprecedented housing collapse, credit crisis, economic recession and market crash has been all the new records we keep seeing:

- Over the past year, the S&P 500 Index lost ~$1 trillion more than the entire 2000-2002 bear market, according to Standard & Poor’s. From the October 2007 highs of 1,565, to yesterday’s close of 806.58, the S&P 500 market capitalization lost $6.69 trillion. That’s almost $1 trillion more than entire 2000-03 bear market losses of $5.76 trillion. (Marketwatch)

- The S&P 500 hasn’t been this far below its 200-day moving average on a percentage basis since the Great Depression. (Doug Kass)

- CPI: US consumer prices in October registered their largest single-month decline since before World War II. It is the largest monthly drop in the 61-year history of the data;

- PPI, down 2.8% for the month, was also a record-breaking drop.

- The dividend yield on the S&P 500 is now greater than the yield on the 10-year Treasury. That hasn’t happened since 1958. (Barron’s)

- First-time claims for US unemployment insurance rose to the highest level since September 2001. The total number of people on unemployment benefit rolls jumped to the highest level since 1983.

- Housing starts fell to 791,000, off 38% from a year ago. That’s the slowest pace of starts since data began being compiled in 1959. Starts are now down 65% from the early 2006 peak – this has become the very worst housing downturn on record.

- Permits for new houses, at a 708,000 pace, were off 40% from a year ago, also the lowest total since it has been tracked starting in 1960. Put this into context of population – in 1960, the total US population stood at 180 million – 60% of today’s 300 million.

- The 30-year return for BBB-rated corporate bonds is now greater than the 30-year return for stocks. So it has not paid to take equity risk for 30 years! (The Street.com)

- The TIPS Spread ( Treasury Inflation Protected Securities versus the 10-year Treasury) is at a record low 54 basis points (1997).

- The Russell 3,000 now has 1,228 stocks a share price under $10. That’s 42% of the index. At the market’s 2002 lows, there were significantly less stocks trading below $10/share – just 884. (Bespoke)”

Source: Barry Ritholtz, The Big Picture, November 20, 2008.

The Wall Street Journal: Obama likely to pick Fed’s Geithner for Treasury
“President-elect Barack Obama is expected to nominate as Treasury Secretary Timothy Geithner, the president of the Federal Reserve Bank of New York and a figure who has been deeply involved in tackling the financial crisis.

“Mr. Geithner, 47 years old, would be one of the youngest-ever US Treasury secretaries. His nomination would come as Wall Street is being challenged by the financial crisis and a Washington power vacuum, and as the world’s debt markets show fresh signs of falling into deeper problems.

“Mr. Obama is expected to introduce his entire economic team on Monday, according to people familiar with the matter. The president-elect has been under pressure to speed up his transition as stock markets this past week fell to lows not seen since the late 1990s.

“Mr. Geithner served as a Treasury attaché in Japan in the 1990s and later at the International Monetary Fund. He was a protégé of former Treasury Secretaries Lawrence Summers and Robert Rubin. Mr. Summers, who was also a potential candidate, instead is expected to take a position within the White House as an economic adviser.

“Mr. Geithner has spent most of his career managing government responses to financial crises, from the 1990s bailouts of Mexico, Indonesia and Korea, to the debt-market meltdown that has brought Wall Street to its knees this year.

“Mr. Geithner (pronounced GYTE-ner) pushed for earlier intervention in the financial markets to stem the financial crisis, and looks likely to continue that activist approach in his new job. Among his first priorities could be a large fiscal-stimulus package.

“Unlike previous picks for Treasury secretary, who hailed from Wall Street, industry or the Senate, Mr. Geithner has been a technocrat most of his career.”

Source: Jonathan Weisman, Deborah Solomon and Jon Hilsenrath, The Wall Street Journal, November 22, 2008.

The Wall Street Journal: Paulson – we’re not experimenting with bailout
“Treasury Secretary Henry Paulson defended the Bush Administration’s $700 billion bailout plan, telling WSJ’s Alan Murray he doesn’t think he’s doing FDR-like experimentation with liquid assets.”

Source: The Wall Street Journal, November 17, 2008.

CNBC: Bernanke testimony
Federal Reserve chairman Ben Bernanke testifies before the House Financial Services Committee.

Source: CNBC, November 18, 2008.

Financial Times: US economy chiefs say policies bear fruit
“The cost of insuring top quality US companies against default hit a record high on Tuesday even as Hank Paulson and Ben Bernanke told Congress that their radical policy actions to ease the credit crisis were starting to bear fruit.

“‘We have turned the corner in terms of stabilising the system and preventing collapse,’ said Mr Paulson, Treasury secretary. He called for patience, saying: ‘There is a lot of work that still needs to be done in terms of recovery of the financial system.’

“Mr Bernanke said there were ‘some signs that credit markets, while still quite strained, are improving’.

“However, the Federal Reserve chairman noted that ‘overall credit conditions are still far from normal, with risk spreads remaining very elevated’.

“On Tuesday, the CDX index that measures the cost of insuring investment grade companies against default closed at a record high on mounting concern about the global economy, and there were fresh signs of dislocation in the swaps market.

“Meanwhile, indices that measure the value of securities backed by residential and commercial property loans – which have plunged since Mr Paulson abandoned his plan to buy toxic assets last week – continued to plumb new depths.”

Source: Michael Mackenzie and Krishna Guha, Financial Times, November 18, 2008.

The Wall Street: Paulson, Summers, Rubin debate crisis
“Current Treasury Secretary Henry Paulson and predecessors Lawrence Summers and Robert Rubin locked horns over the best way to get the US economy back on track.”

Source: The Wall Street Journal, November 17, 2008.

Bespoke: Paulson trying to rewrite his own history
“Treasury Secretary Henry Paulson spoke at the Reagan Library this afternoon, and judging by the speech, it appears as though Mr. Paulson is embarking on a PR campaign to rewrite the history of his handling of the credit crisis. One line that stood out was when he said: ‘By pro-actively addressing the problems we saw coming …’

“Judging by excerpts of prior comments the Treasury Secretary made during 2007, if Mr. Paulson saw the problems coming, he wasn’t telling anybody.

“Marketwatch 3/13/07: Paulson also said the fallout in subprime mortgages is ‘going to be painful to some lenders, but it is largely contained.’

“Reuters 4/20/07: ‘I don’t see (subprime mortgage market troubles) imposing a serious problem. I think it’s going to be largely contained.’

“Bloomberg 5/22/07: Paulson, also speaking to CNBC, said the housing slump was ‘largely contained‘ and that market’s correction was mostly ‘behind us.’

“Bloomberg 6/20/07: Subprime fallout ‘will not affect the economy overall.’

“Forbes 7/27/07: Appearing on CNBC with other members of the Bush administration’s economic team, he again said mortgage industry problems would be ‘largely contained.’

“Boston.com 8/1/07: Paulson added that he did not see anything that caused him to reconsider his view that the economic damage from the housing correction was ‘largely contained.’

“Another classic line from today was, ‘As I assess our current situation, I believe we have taken the necessary steps to prevent a financial collapse.’ Mr. Paulson, what is it going to take for you to consider this a financial collapse?

“Given that the extent of the credit crisis was underestimated by almost everyone, you can give Paulson somewhat of a pass for missing it. But to try and rewrite history through speeches even while the credit crisis is still playing out is inexcusable.”

Source: Bespoke, November 20, 2008.

Financial Times: Congress reaches an impasse on car bailout
“The US Congress is unable to approve a new emergency loan to the country’s troubled car sector, Democratic leaders said on Thursday.

“Industry chiefs’ pleas for aid appeared to backfire after two days of hearings on Capitol Hill. News of the impasse over one of the hardest-hit sectors of the US economy came as President George W. Bush agreed to extend unemployment benefits after US weekly jobless claims hit a 16-year high.

“Harry Reid, Senate majority leader, and Nancy Pelosi, speaker of the House of Representatives, said there were not enough votes to pass a $25 billion loan for Detroit that Democrats had advocated. They said car companies had to be more specific about restructuring.

“The pair gave the big three carmakers – General Motors, Ford and Chrysler – until December 2 to submit a ‘viable’ recovery plan, with the prospect of convening hearings immediately afterwards and possible congressional votes a week after that.

“The announcement came in spite of last-minute efforts by six Democratic and Republican senators from car-producing states to reach a deal on a bridging loan.”

Source: Daniel Dombey, Andrew Ward and Bernard Simon, Financial Times, November 20, 2008.

ABC News: Auto bailout – would be better to burn the money
“Congress is debating cutting the Big Three Autos a check … something to tide them over through these tough times. General Motors is bleeding money … some 2 billion dollars a day. Bail them out or let them go bankrupt? That’s the billion dollar question. And its billions of your money.

“One side says give them money – they’re too big to fail, too many jobs will be lost, the American economy will be hit hard, they need time to get fuel efficient cars to the market.

“The flip side – let them fail, they brought this on themselves, pouring 25 billion into these failed models is a waste, bankruptcy protections will let them out of their incredibly expensive labor contracts.

“… David Yermack from NYU Stern Business School chimed in: ‘The implications of this story for Washington policy makers are obvious. Investing in the major auto companies today would be throwing good money after bad. Many are suggesting that $25 billion of public money be immediately injected into the auto business in order to buy time for an even larger bailout to be organized. We would do better to set this money on fire rather than using it to keep these dying firms on life support, setting them up for even more money-losing investments in the future.’”

Source: ABC News, November 17, 2008.

Paul Kedrosky (Infectious Greed): The auto bankruptcy teeter-totter
“GM, for its part, isn’t taking this lying down. It has posted a video on YouTube explaining – okay, propagandizing – the implications of letting it die. Watch it to see how the straight-to-consumer “Save us!” game is played.”

Source: Paul Kedrosky, Infectious Greed, November 15, 2008.

CNBC: Financial crisis tab already in the trillions
“Given the speed at which the federal government is throwing money at the financial crisis, the average taxpayer, never mind member of Congress, might not be faulted for losing track.

“CNBC, however, has been paying very close attention and keeping a running tally of actual spending as well as the commitments involved.

“Try $4.28 trillion dollars. Not only is it a astronomical amount of money, it’s a complicated cocktail of budgeted dollars, actual spending, guarantees, loans, swaps and other market mechanisms by the Federal Reserve, the Treasury and other offices of government taken over roughly the last year, based on government data and new releases. Strictly speaking, not every cent is directed as a result of what’s called the financial crisis, but it arguably related to it.”

Source: CNBC, November 17, 2008.

Reuters: Financials need at least $1 trillion – analyst
“The US financial system still needs at least $1 trillion to $1.2 trillion of tangible common equity to restore confidence and improve liquidity in the credit markets, Friedman Billings Ramsey analyst Paul Miller said.

“Eight financial companies – Citigroup, Morgan Stanley, Goldman Sachs Group, Wells Fargo, JPMorgan Chase, AIG, Bank of America Corp and GE Financial – are in greatest need of capital, he said.

“‘Debt or TARP capital is not true capital. Long-term debt financing is not the solution. Only injections of true tangible common equity will solve the current crisis,’ he said.

“Currently, the US financial system has $37 trillion of debt outstanding, he noted.

“Combined, these eight companies have roughly $12.2 trillion of assets and only $406 billion of tangible common capital, or just 3.4%, the analyst said.

“Miller said these institutions need somewhere between $1 trillion and $1.2 trillion of capital to put their balance sheets back on solid ground and begin to extend credit again, given their dependence on short-term funding and the illiquid nature of their asset bases.”

Source: Reuters, November 20, 2008.

Mr Mortgage: The great mortgage modification pump
“Reworking loans to make ‘payments affordable’ without permanently reducing principal balances is the worst possible thing that can be done because it ensures the housing and foreclosure crisis will be with us for a long time. If these programs are widely accepted, housing is a dead asset class indefinitely …

“This style of modification does not sit well with owners of mortgage securities either, which make up the bulk of distressed mortgages. This is because deferred interest, 40-year terms and interest only teaser periods, greatly reduces the cash flows and lengthens the duration of the security.”

Click here for the full article.

Source: Mr Mortgage, November 19, 2008.

Credit Suisse: More fiscal action needed to ease crisis
“The US, Europe and Japan are in significant recession, says Giles Keating, Head of Global Research at Credit Suisse. He explains how the financial crisis is evolving and why capital injections are needed.”

Source: Credit Suisse, November 12, 2008.

The Wall Street Journal: Discussing the Great Depression
“Dorothy Womble and William Hague survived the Great Depression. They share their stories of living during that time as children.”

Source: The Wall Street Journal, November 14, 2008.

Reuters: Fed’s Hoening – Fed has done “as much as it can”
“Kansas City Federal Reserve President Thomas Hoenig said on Monday the US central bank has done what it can to buffer the economy through a downturn, and a painful process of readjustment is likely ahead.

“‘The Fed has done about as much as it can do,’ he said in an interview on PBS’s Nightly Business Report. Interest rates are already extremely low, he noted, according to a transcript of the program.

“‘We might put it out there, but banks are not able to, given their own capital constraints, able to lend as aggressively,’ he added.

“Hoenig said he was surprised at how quickly economic activity has slowed, but that a sharp reversal of consumption was clearly a key development.

“‘The consumer factor was a major part of the strong slowdown and the actual entering into the recession,’ he said.

“‘Part of it is working through the deleveraging,’ he said. ‘I don’t know of any painless way to rebalance your economy, you have to go through this adjustment, and we will get through it, but it’s not going to be without consequence,’ he added.”

Source: Mark Felsenthal, Reuters, November 17, 2008.

Bloomberg: NABE’s Varvares says US recession to extend into 2009
“Chris Varvares, president of Macroeconomic Advisers LLC and president of the National Association for Business Economics, talks with Bloomberg about the results of NABE’s survey of business economists.”

Click here for the article.

Source: Timothy R. Homan, Bloomberg, November 17, 2008.

Bloomberg: Nouriel Roubini – “I fear the worst is yet to come”

Source: Bloomberg, November 20, 2008.

Clusterstock: Roubini – How are we screwed? Let us count the ways
“Nouriel Roubini weighs in with another treatise of doom, this time focused on consumer spending. He lists 20 reasons consumer spending is headed to hell in a handbasket, taking the economy down with it. We’re short on Prozac, so we’ll summarize only a handful here, and we’ll let Nouriel take it away:

“Today’s news about October retail sales (-2.8% relative to the previous month and now down in real terms for five months in a row) confirm what this forum has been arguing for a while, i.e. that the US has entered its most severe consumer-led recession in decades. At this rate of free fall in consumption real GDP growth could be a whopping 5% negative or even worse in Q4 of 2008. And this is not a temporary phenomenon as almost all of the fundamentals driving consumption are heading south on a persistent and structural basis …”

Click here for the article.

Source: Henry Blodget, Clusterstock, November 15, 2008.

Asha Bangalore (Northern Trust): What is the Fed’s next move?
“The minutes of the October 28 to 29 FOMC meeting were published this afternoon [Wednesday]. The main thrust of these minutes is that economic growth is the topmost concern. The minutes noted that ‘members also saw the substantial downside risks to growth as supporting a relatively large policy move at this meeting, though even after today’s 50 basis point action, the Committee judged that downside risks to growth would remain. Members anticipated that economic data over the upcoming intermeeting period would show significant weakness in economic activity, and some suggested that additional policy easing could well be appropriate at future meetings.’

“The target rate was lowered to 1.0% on October 29, with the effective rate trading between 22 bps and 37 bps since then. Is there a benefit to lowering the Federal funds rate? A lower Federal funds rate, as suggested in the minutes of the October 28-29 meeting, would only accomplish validating the already low effective Federal funds rate. It is possible the Fed could cut the Federal funds rate and abandon attempting to manage the effective rate such that it trades close to the target rate. It appears that the Fed may be considering the possibility of a zero federal funds eventually, if economic conditions warrant it.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, November 19, 2008.

Bloomberg: Fed to cut rates to zero on deflation risk, JPMorgan predicts
“The US Federal Reserve will probably cut interest rates to zero percent over the next two months to staunch deflation, according to JPMorgan Chase.

“The Fed will lower borrowing costs by 50 basis points at each of the next two policy meetings on December 16 and January 28, JPMorgan economist Michael Feroli wrote in a note to investors yesterday. The central bank will hold rates at zero for the rest of 2009 to prevent prices from spiraling down as companies cut jobs and banks reduce lending, stifling spending, Feroli said.

“The Fed may not be the only central bank to begin offering free money to jolt life into their recessionary economies and keep prices rising as the 15-month credit crisis deepens. The Bank of Japan cut its benchmark rate to 0.3% last month, and the European Central Bank has signaled it’s ready to lower rates further after two reductions in the past six weeks.

“‘Taking the target rate to zero percent would not be costless for the Fed,’ Feroli said. Public confidence may drop ‘if there is a perception that the Fed has run out of ammo’.”

Source: Jason Clenfield, Bloomberg, November 20, 2008.

Asha Bangalore (Northern Trust): Leading index points to further weakening of economy
“The Conference Board’s Index of Leading Economic Indicators (LEI) dropped 0.8% in October after a revised 0.1% increase in September. The LEI has dropped in four of the last six months. On a year-to-year basis, the LEI has dropped 3.5%, the largest monthly decline for the current cycle.

“The LEI has sent a reliable warning of weakening economic conditions for all recessions since 1960, with the exception of the 1967 dip (the economy was weak in this period but it was not a recession).”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, November 20, 2008.

Asha Bangalore (Northern Trust): Industrial production is significantly weak
“The headline industrial production index rose 1.3% in October, after a 3.7% drop in September. The September estimate now shows a larger drop than the original estimate of a 2.8% decline due to revised estimates of the impact of Hurricanes Gustav and Ike on the chemical industry. According to the Fed, excluding the special factors of hurricanes and Boeing strike, industrial production dropped 2/3 percent in both September and October.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, November 17, 2008.

Asha Bangalore (Northern Trust): Decline in housing starts stress persistence of housing turmoil
“Total housing starts dropped 4.5% to an annual rate of 791,000 in October, reflecting a decline in starts of both multi-family and single-family units. These numbers along with the record low of the Housing Market Index of the National Association of Home Builders in November imply that the bottom of housing starts is not here yet.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, November 19, 2008.

Asha Bangalore (Northern Trust): Housing market update – grim news bolsters Sheila Bair’s plan to stem the crisis
“The grim housing market news continues to support opinions that the mortgage problem is the key to a resolution of the current financial market crisis. The crux of the issue is that falling home prices, foreclosures, and rising inventories need to be replaced by more stable conditions for the economy to turnaround. The National Association of Home Builders reported in the November survey that the Housing Market Index fell to 9.0 from 14.0 in October to establish a new record.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, November 18, 2008.

Asha Bangalore (Northern Trust): Consumer Price Index plunges
“Today the BLS reported that the Consumer Price Index (CPI) fell by 1.0% both seasonally adjusted as well as unadjusted. On an unadjusted basis, this was the largest monthly decline in the CPI since January 1938.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, November 19, 2008.

BCA Research: Heading for deflation?
“A deflation scare will grip the developed world over the next 12 to 24 months.

“Our research on past real estate bear markets and subsequent banking sector stress (throughout Europe, the US and Japan) highlights that these episodes always lead to a recession, followed by a multi-year period of sub-par growth (i.e. negative output gap). In turn, excess supply helps dramatically drive down core CPI inflation in the years that follow. Granted, it could be argued that the previous episodes occurred during a period of strong structural disinflationary trends, thereby amplifying the magnitude and duration of the decline in price pressures.

“Nonetheless, core CPI inflation is likely to drop sharply throughout the G7 over the next 12 to 24 months, to lows at least comparable to the 2003 deflation scare. In turn, it is likely that the US prints very low positive or even mildly negative headline CPI numbers, given the drag resulting from the recent plunge in food and energy prices.

“Headline inflation is less likely to turn negative in Europe given the rigidity of the price structure but a deflation scare similar to the US earlier this decade is likely. The implication is that policymakers will continue to ease aggressively and then stay on hold for an extended period, benefiting our long duration call. “While the longer-term consequences of such actions may be inflationary, government bond yields will adjust lower in the near term.”

Source: BCA Research, November 17, 2008.

Bloomberg: Bond-market yields signal deflation worldwide
“Bonds worldwide are showing that investors are betting that slumping economic growth will lead to deflation in every major economy. Britain’s five-year breakeven rate went negative Tuesday for the first time since Bloomberg records began in 1996.”

Source: Bloomberg, November 19, 2008.

Financial Times: In a weird world, yields on Tips point to deflation
“Would you believe that we shall actually have significant deflation in the US next year? And the year after that? And flat consumer prices for the year following? That’s happened only once in a developed country since the 1930s – when Japan recorded a negative 1.6% consumer price index for 2002.

“Yet, if you believe the yields on US Treasury inflation protected bonds, or Tips, we shall have a 2.2% fall in prices in 2009, a 2.5% decline in 2010 and only flat prices in 2011. If that turns out to be true, the real interest rate burden on even the highest-rated borrowers will be extremely hard to bear.”

Source: John Dizard, Financial Times, November 18, 2008.

John Davies (WestLB): Buy German bunds
“The 10-year German Bund yield could fall to a record-equalling 3 per cent in the months to come in response to worries about the eurozone economy, believes John Davies, bond analyst at WestLB.

“‘Given the contracting economy and mounting threat of deflation, we now expect the European Central Bank to cut rates to 1.5% by the summer [from 3.25% now], which is lower than the market expects,’ he says.

“Mr Davies notes that the rapid steepening of the spread between two-year and 10-year German yields, which started in September, has slowed as the market moves to price in rates of 2% by the spring.

“But he says: ‘Given our forecast of a more aggressive ECB rate cut cycle, we fully expect the curve-steepening trend to remain safely intact.’

“While the steepening will primarily be driven by moves at the short end of the curve, long-end yields will fall as recession fears overshadow a jump in new issuance, Mr Davies says.

“‘We expect the 10-year yield to fall from 3.6% to 3.25% within the next three-to-six months, and even test the 3% record low set in September 2005. It is only the rise in supply next year that stops us projecting a sub-3% yield.’”

Source: John Davies, WestLB (via Financial Times), November 18, 2008.

Bloomberg: China passes Japan as biggest US Treasuries holder
“China surpassed Japan in September to become the biggest foreign holder of US Treasuries, as foreign investors sought the relative safety of government debt as stocks plunged 9.1% that month.

“Total net purchases of long-term equities, notes and bonds increased a net $66.2 billion in September from $21 billion the previous month, the Treasury said today in Washington. Including short-term securities such as stock swaps, foreigners bought a net $143.4 billion, compared with net buying of $21.4 billion the month before.

“China led all foreign official investors in September by posting a net increase in US Treasuries for the sixth month in the past seven, bringing its total ownership close to $600 billion. Japan was a net seller of Treasuries for the fourth month in the past six.

“‘The details of the report paint a much more positive picture of cross-border investments than expected,’ said Michael Woolfolk, a senior currency strategist at Bank of New York Mellon Corp. ‘China, along with others, is showing more demand than anticipated for US assets.’”

Source: John Brinsley and Rebecca Christie, Bloomberg, November 18, 2008.

Bespoke: High yield spreads – no slowdown in sight
“If you’re looking for signs of stabilization in the credit markets, the high yield market is not a good place to start. Based on data from Merrill Lynch, high yield bonds are yielding nearly 1,800 basis points more than comparable Treasuries. In the last month alone, spreads have risen by more than 200 basis points, and since bottoming in the Summer of 2007 at 241 basis points, they are up 645%. To put this in perspective, with the 10-year US Treasury now yielding 3.4%, a high-yield borrower would need to pay roughly 21.4% per year to take out a ten-year loan. With terms like these, who needs loan sharks?”

Source: Bespoke, November 19, 2008.

Bespoke: Financial weapons of mass destruction aimed at Omaha
“Warren Buffett is credited with coining the phrase ‘financial weapons of mass destruction’ with respect to derivatives. However, after some big unrealized losses on index options that Berkshire has written in the last couple of years, it now appears as though the derivative market is taking aim at Omaha. Over the last eight days, the cost to insure debt of Berkshire Hathaway has risen to 475 basis points per year. To put this into perspective, Morgan Stanley’s credit default swaps are currently trading at 456 basis points, and that is the highest of the big global banks and brokers. Berkshire Hathaway has long been considered one of the safest of the safest financial companies, but if Black October 2008 has taught us anything, it’s that nothing is safe.”

Source: Bespoke, November 20, 2008.

Bespoke: S&P 500 200-day moving average spread at -32%
“Multiple market pundits have recently mentioned that the S&P 500 is trading the furthest below its 200-day moving average since the Great Depression. Below we have plotted the 200-day spread indicator going back to 1927. The index is currently trading 32% below its 200-day moving average, which is indeed the most negative spread since 1937. While the spread can remain negative for quite some time, the reaction to the upside has been extreme once the market turns. In the 1930s, and even following the big declines in the 70s, 80s, and early 2000s, the spread turned violently positive in the months following the ultimate low in the 200-day spread. Unfortunately, nobody knows when that low will be.”

Source: Bespoke, November 17, 2008.

Barron’s: Reversal of fortunes between stocks and bonds
“… the dividend yield on the Standard & Poor’s 500 stock index touched 3.57% at 1:13 PM Eastern time [on Tuesday], exceeding the 3.54% yield on the benchmark Treasury 10-year note, according to Bloomberg News. That’s something that hadn’t happened since 1958.

“I was aware that there was a time when equities provided more income than bonds, but that belonged to a long-gone era. That was a time I knew of only from old movies, yellowed newspaper clippings and stacks of old Life magazines. It was when gentlemen wore suits and fedoras, not just to work but even to the ballpark; when the Dodgers played in Brooklyn; a bygone era already a half century ago.

“To contemporary market observers, it’s more than nostalgia. For the S&P 500 to yield more than Treasuries suggests the market is very cheap by historical standards, says Jack Ablin, portfolio strategist for Harris Private Bank. ‘Dividend yield, like price-to-sales, is one of those persistent metrics. We can all quibble about earnings, but dividends, particularly those of the entire S&P 500, are remarkably consistent,’ he adds.

“‘You can fake earnings through account hanky-panky, but you cannot fake dividends,’ agrees Barry Ritholtz, chief executive of Fusion IQ. So after a 47% drop, stocks look relatively cheap for the first time in a long time, he adds.

“Scott Minerd, chief investment officer for Guggenheim Partners, calls the drop in Treasury yields below the S&P 500 dividend yield a ‘straw in the wind’ that the stock market may be bottoming. Still, he thinks the market is signaling that dividend cuts are in the offing, but this recessionary trend also will push Treasury yields still lower.”

Click here for the full article.

Source: Barron’s, November 19, 2008.

John Authers (Financial Times): US stocks fall on deflation fears

Click here for the article.

Source: John Authers, Financial Times, November 19, 2008.

Frank Holmes (US Global Investors): An emotionally impaired market
“Global equities are now trading on their lowest valuations since the early 1980s. History says we should expect stock prices to turn up before earnings do. A recovery in earnings, when it happens, has previously been a robust second leg for more significant price appreciation. The second leg will take place when the earnings recession ends and profits begin to recover. Investment research based on historical patterns by Citigroup suggests the second leg is about 12 months away. With this in mind, we’re nibbling on stocks we believe are undervalued based on fundamental screens and have been hit the hardest as candidates for price appreciation.

“Weak earnings and expectations of more bad news to come have weighed heavily on stock prices. The global equity market trades on 10 times trailing earnings and over 15 times expected trough earnings. The 40-year average global price-to-earnings ratio is 17 times. Citigroup’s research demonstrates that the global equity market is extremely undervalued, but valuations could continue to fall through year end.

“We believe the market and economy are now being emotionally impaired due to the cascading negative news by unbalanced media. Today [Friday] is the first day this week without negative grandstanding politicians on TV and the market was up. Stocks are so oversold and markets, as we have commented in the past, are due for a substantial rally. We believe the market is looking for certainty that President-elect Obama and his team are not going to raise taxes in this economic environment. If the new administration reverses course and denounces tax hikes for two years and proposes a budget to rebuild our infrastructure, then this week could have been the bottom for the market.”

Click here for article by Robert Buckland, Citigroup’s Chief Global Equity Strategist.

Source: Frank Holmes, US Global Investors – Weekly Investor Alert, November 21, 2008.

Bespoke: Trailing 12-month P/E ratios are low
“The S&P 500 Financial, Consumer Discretionary, and Telecom sectors currently have negative P/E ratios, which makes the overall index’s P/E high at 18.41. Sectors whose P/Es aren’t negative have very low trailing P/Es versus historical readings. The Energy sector currently has the lowest P/E at 6.55. The second lowest is Materials at 9.14, followed closely by Industrials at 9.44. And the Technology sector, which usually has a relatively high P/E, currently has a P/E of just 12.49.”

Source: Bespoke, November 17, 2008.

Bloomberg: Mobius says he’s buying China, India, South Africa
“Mark Mobius said he’s ‘aggressively’ buying consumer stocks, including cell-phone companies, retailers, banks and furniture makers, as faster economic growth in China, India, South Africa and Turkey offsets sagging demand from developed nations.

“‘We see a consumer boom in all of those countries,’ Mobius, who oversaw more than $24 billion in emerging-market stocks on September 30 as executive chairman at Templeton Asset Management, said in a Bloomberg Television interview from Johannesburg. ‘Per-capita income is growing at a very rapid pace in these countries.’

“China announced a $586 billion stimulus plan on November 9 after its gross domestic product grew 9% in the third quarter, the slowest pace in five years. India’s central bank estimates growth will slow to 7.5% this year and next, from an annual average of 8.9% in the past four years. Emerging markets will expand at an average of 5% in 2009, compared with 1% in developed countries, Mobius forecast on October 21.

“The global economic downturn may not be as long or severe as expected because of the coordinated fiscal and monetary stimulus put forth by policy makers worldwide, the 72-year-old investor said today.

“The slowdown ‘will be rather short-lived and, of course, the markets will anticipate this’, Singapore-based Mobius said. ‘There will be some deceleration, but these are still fast- growing countries.’”

Source: Fabio Alves and Monica Bertran, Bloomberg, November 17, 2008.

David Powell (Bank of America): Is the dollar’s recent rally coming to an end?
“David Powell, currency strategist at Bank of America, believes the dollar has lost several important sources of support.

“The global shortage of dollar liquidity – one of the primary reasons for the US currency’s strength as the financial crisis escalated in September – has been sharply reduced by the extraordinary measures introduced by central banks to ease money market stress, he says.

“Furthermore, the repatriation of the dollar, which prevented its retracement as tensions in the wholesale funding markets were reduced, may no longer provide the currency with much support moving forward. Private sector flow data indicate the repatriation of foreign investments to the US is slowing sharply, Mr Powell says.

“‘A third factor behind the resilience of the dollar seems to have been the steady return offered by longer-dated US Treasuries, when compared with the sharp drop in German Bund yields. However, the fall in the euro against the dollar appears excessive even when compared to drop in the 10-year Bund-Treasury yield spread.

“‘In addition, a dollar retracement is likely to gain momentum from the pattern of seasonal weakness normally seen in December. As such, we affirm our year-end euro/dollar forecast of $1.38 and outlook for a return to $1.44 by the first quarter of 2009 before the pair resumes a more gradual sell-off.’”

Source: David Powell, Bank of America (via Financial Times), November 19, 2008.

Financial Times: Jim Rogers – the dollar is a flawed currency
The following is an excerpt from an online interview with Jim Rogers.

“FT: It’s a year since we last interviewed you. You were aggressively bearish about the dollar, but you thought there would probably be a rebound and you would take that as an opportunity to further get out of the dollar. Have you made a further exit from the dollar?

“JR: Not yet, no. And the reason I haven’t is because we’re in a period of forced liquidation of everything. We’ve only had eight or nine periods like this in the past 150 years, where everybody has to reverse their positions on everything. There is a gigantic short position in the dollar and they’re all having to cover as they reverse their positions, so this rout is going to go on much further than I would have expected, to my delight, because then I’ll get to sell at higher prices. I don’t know whether I’ll get out this month or this year even, maybe next year, but I do plan to get out of the rest of my US dollars, because this is an artificial rally caused purely by short covering.

“FT: How will you tell when that deleveraging is finally over?

“JR: I’m sure I won’t get it right, but I do hope that when there’s a lot of euphoria about the dollar and everybody’s saying, well, see, there’s no problem with the dollar … I hope I’m smart enough to recognise it and finally get out of the dollar, because it is a flawed and maybe, even, doomed currency.

“FT: Do you see the sell-offs we’ve seen in commodities as a drastic correction?

“JR: Well, we’re in a period of forced liquidation of all assets … we’re getting the business cycle effect on demand right now, certainly, but unless the world’s in perpetual economic decline, commodities are the only thing going to come out of this okay.

“FT: Does this mean you’re actually buying back into commodities at the moment, or is this an area you’re standing clear of?

“JR: No, no. In October when I started covering my shorts in the US stock market, I started buying Chinese shares, Taiwan shares, I started buying commodities again. No, no, I’ve added to those positions.

“FT: What’s your strategy towards emerging market stocks?

“JR: My hope is that I’m smart enough and brave enough at some point along the line to buy some of them back. But I’m not even thinking about it right now … The world’s financial situation is in a mess, and there are a lot of people who have to liquidate. I mean, we must have had 30,000 MBAs flying around the world looking for emerging markets. All of that money has got to come home.

“FT: How do you think the world should go about redesigning the regulatory system, and are you worried that we’re going to end up with a swing towards over-regulation?

“JR: Well, we probably will, The problem is that people like Alan Greenspan would never let the market work … For 15 years, under Greenspan, and now Bernanke, they would not let the market work. Had they let Long-Term Capital Management fail back in 1998, we wouldn’t have these problems now, I assure you. Lehman Brothers would have been smashed. Goldman Sachs, Bear Stearns, would have been smashed. We wouldn’t have these problems now. That only happened because every time they turned around they propped these guys up, gave them more money, and that’s why we have the problem … But now, of course, they’re going to blame it on other people and cause more regulations.

“FT: You’re arguing we need to allow some more big institutions to fail?

“JR: One failed. Why didn’t they let Fannie Mae and Freddie Mac? I mean, I was short Fannie Mae, and they should have let it fail, go to zero. AIG, they should have let it fail, they should have let all of these guys fail, and we would clean out the system … What they’re doing is they’re taking the assets away from the competent people, giving them to the incompetent people and saying to the incompetent: ‘Okay, now you can compete with the competent people, with their money.’ I mean this is terrible economics. This is outrageous economics.”

Source: Jim Rogers, Financial Times, November 17, 2008.

Bloomberg: China should buy gold for reserves, Association says
“China, the second-biggest overseas holder of US Treasuries, should increase its bullion holding to diversify its reserves because the dollar may decline, the country’s gold association said.

“‘China should have at least several thousand tons of gold in its reserves, five to six times the officially announced 600 tons,’ Hou Huimin, vice chairman of the China Gold Association said from Beijing. The group represents producers, traders and retailers.

“The US budget deficit climbed to a record in October, and some investors are betting the dollar may weaken as the Treasury would need to sell more debt to finance its $700 billion financial-rescue package. Gold has tumbled 29% from its March record.

“‘There’s no doubt that gold would be attractive, as US debt is likely to swell,’ said Kenichiro Ikezawa, who oversees about $3 billion as a fund manager at Daiwa SB Investments in Tokyo. ‘In the long term, both the dollar and Treasuries will probably weaken. It’s possible that China will buy more gold, though the country is likely to do so gradually.’”

Source: Xiao Yu and Ron Harui, Bloomberg, November 14, 2008.

Reuters: Iran switches reserves to gold
“Iran has converted financial reserves into gold to avoid future problems, an adviser to President Mahmoud Ahmadinejad said in comments published on Saturday, after the price of oil fell more than 60% from a peak in July.

“Iran, the world’s fourth-largest oil producer, is under UN and US sanctions over its disputed nuclear programme and is now also facing declining revenue from its oil exports after crude prices tumbled.

“‘With the plans of the presidency … the country’s money reserves were changed into gold so that we wouldn’t be faced with many problems in the future,’ presidential adviser Mojtaba Samareh-Hashemi was quoted as saying by business daily Poul.

“Iranian officials in July denied reports that Iranian banks were moving funds from Europe, with one report suggesting as much as $75 billion had been withdrawn and converted into gold or placed in Asian banks, because of a threat of tightening sanctions.”

Source: Zahra Hosseinian, Reuters, November 15, 2008.

The New York Post: Global run on gold coins
“There’s a worldwide run on gold coins. Even as the price of the precious metal itself comes under pressure along with commodities like oil and copper, people around the world are demanding so many of the valuable coins that government mints are having difficulty filling orders.

“A spokesperson for the US Mint tells me that gold coins in this country, for the past month, ‘are being allocated because of an increased demand’.

“And the price that the government charges coin dealers has recently been increased by as much as 10% for a 10-ounce coin.

“And even when gold coins are available, dealers report that customers are paying a bigger premium than they would have just a few months ago.

“In one sense, the attraction for gold coins isn’t surprising. Since ancient times, gold has been considered the safest investment to hold in times of uncertainty.

“With fears of future inflation rising and concern about the value of paper currency and government-debt increasing with each new recovery plan announced in Washington and in foreign capitals, the desire to hold gold grows.

“That part makes perfect sense. But there’s another more puzzling aspect to the recent gold rush. Even as the demand for gold coins such as the Canadian Maple Leaf or the Krugerrand of South Africa has grown, the market price of the precious metal itself is off its highs.

“Bill Murphy, chairman of the Gold Anti-Trust Action Committee, says the price of spot gold is even more perplexing given the demand for coins and the fact that central banks in Europe have stopped selling gold into the open market.

“‘Gold should be moving up,’ Murphy says. ‘How could there be such a dichotomy between the historic high premium for coins all over the world and the low Comex price?’

“His answer? ‘Today the public is buying gold like crazy, but the US government and the banks that hold bullion are intentionally keeping the price down.’”

Source: John Crudele, New York Post, November 18, 2008.

James Pressler (Northern Trust): Japan enters first recession in 7 years
“Today’s indicators out of Japan confirmed what we had expected – that Japan is in recession, though the consensus believed there were enough one-offs to growth to keep the headline figure on the positive side of zero. Real GDP contracted by 0.1% from the previous quarter after a sharper fall of 0.9% in Q2 (originally -0.7%), with Q3 consumption rising by 0.3% after a fall of 0.6%. True, there were factors that perked up private consumption, but they were not enough to overcome a weak net exports figure that will only get worse in the coming quarters.”

Source: James Pressler, Northern Trust – Daily Global Commentary, November 17, 2008.

YouTube: Bloomberg Voices – Japan enters recession

Source: YouTube, November 17, 2008.

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Homan, Tokyo, Trading, Treasury Bill Rate, Treasury Inflation Protected Securities, Treasury Note, Treasury Secretaries Lawrence Summers, Trillion, troubled car sector, Turkey, U.S. Congress, UK, ukw, unbalanced media, Unemployment Insurance, Unemployment Insurance Benefits, United Kingdom, United Nations, United States, US, US central bank, US Dollar, Us Federal Reserve, Us Government, US Stocks, Us Treasury, usd, Valuations, Value, Vice Chairman, Video, Wachovia, Wall Street, Wall Street Journal, Warren Buffett, Washington, Wells Fargo, Western Europe, WestLB, White House, William Hague, Xiao Yu, yellow metal found support, Youtube, Zahra Hosseinian
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Hendry: Short Selling Ban a Fiasco

Friday, October 10th, 2008

Hugh Hendry, the eloquent, brash, and outspoken CIO at UK-based Eclectica Asset Management, comments on the today’s worsening selloff in markets, appearing this morning on CNBC European Squawk Box with Geoff Cutmore.

“It feels like the blackest morning,” Hugh Hendry, CIO & partner at Eclectica said Friday (today). “We’ve never really experienced a matter as grave as this.”

Conditions like these are unmatched, except with 1930-32. He “slakes” regulators for this, making the following points.

• The short selling ban has been a fiasco, as it has removed an entire constituency of buyers from the market, so that on weak days there is no profit incentive to buy the market.
• The tremedous slide of the last two weeks has made the market completely oversold, therefore nobody is willing short sell the market.
• The VIX index is very high, so one can’t (afford to) buy puts to protect their holdings
• Fundamentals have become an intellectual curiosity, and an outrageous luxury
• The only defense left to investors is to sell their assets, this is a liquidation
• People watch the market all day and are averaging their trades,
• and that’s why in the final hour of trading you see a cascading of orders, and the market runs out in panic trying to fulfill those orders.

So far in the month of October, Hendry’s hedge fund is up 40% on account of his levered positions in long-term government bonds.

Tags: Cio, Eclectica, Eclectica Asset Management, Euro, Geoff Cutmore, Government Bonds, Hedge Fund, Hugh Hendry, Markets, outspoken CIO, risk, Short Selling, Trading, UK, United Kingdom, Video
Posted in Bonds, Markets | Comments Off

James Montier: Unusually Clear-Eyed Analysis

Saturday, July 26th, 2008

James is an unusually clear eyed analyst:

“In good times, few focus on such ‘mundane’ issues as earnings quality and footnotes. However, this lack of attention to ‘detail’ tends to come back and bite investors in the arse during bad times. There are notable exceptions to this generalization…

Contrary to the silly populist backlash which sees short sellers as rumor mongers and conspirators, they are actually amongst the most fundamentally driven of all the investors I interact with. Rather than being some malignant force within the markets, in my experience short sellers are closer to the accounting police (something the SEC once purported to do!).

Whilst companies often accuse short sellers of lying and conspiracy, it turns out that the accusers are often the guilty party. Owen Lamont from Chicago University has examined the battles between corporates and short sellers in the U.S. between 1977-2002. He found that ultimately it was the shorts that were right; the stocks underperformed the market by a cumulative 42% over three years after the start of the battle.”

-James Montier, Mind Matters: Cooking the books, or, More sailing under the black flag, June 30, 2008

Tags: Chicago University, Earnings, Focus, James Montier, Markets, Owen Lamont, Short Sellers, Short Selling, SocGen, Societe Generale, U.S. Securities and Exchange Commission, United States, unusually clear eyed analyst
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More volatility coming and more ETF options

Friday, January 25th, 2008

Jan. 25, 2008 – Watch out below. There is sure to be more volatility to the downside in the coming weeks, as the carry trade and proprietary traders continue to unwind profitable trades.

Finding themselves unable to collect on credit default swaps vis-a-vis AMBAC, MBIA, ACA, large institutions (banks) and hedge funds are finding themselves under pressure from a substantial cash call.

An example of this danger came to light when a little-known firm called ACA Financial Guaranty caused some of Wall Street’s biggest banks to write down billions of dollars in holdings, restating their value on corporate balance sheets. ACA revealed last month that it had promised to cover $60 billion worth of mortgage and corporate debt, but had enough cash to cover only a fraction of that. Merrill Lynch, Citigroup and financial institutions in Canada and France, which had all sold swaps to ACA, set aside billions in case the firm collapsed.

Most of the strength that the market is witnessing is due to short covering and this will manifest itself over and over during the next two to four weeks.

Institutions are still unwinding their profitable trades to raise cash. The market goes down. Then short covering occurs, and you get what appears to be a bounce or recovery in stock prices. The problem is that as long as the cash call remains larger than the outstanding short positions the market will continue to trend lower.

Don Coxe, in January’s Basic Points, puts it in these terms:

Sadly, the central bankers have been forced into injections of all-time record amounts of liquidity. Jim Cramer and some other prominent apologists for Wall Street glitterati screamed, “The Fed doesn’t get it,” and demanded bailouts for their buddies who faced demotion from Croesus status to morally cretinous status. The biggest benefi ciaries from these bailouts were not overstressed homeowners, but the biggest, baddest, borrowers who had made the biggest, baddest, bets through use of complex derivatives.

Despite strong openings today, both the Dow and TSX look unable to hang on to gains. You also have to look at trading volume for clues about the weakness of the recovery. Volumes are down 20% at the NYSE and 15% at NASDAQ.

Assuming you agree with the idea that there is more downside in the market, there are some relatively new and interesting ways that you can take positions on the short side to reduce downside that do not involve derivatives or short positions. In particular there are a new breed of ETFs that provide short exposure to various sectors and country bets. These are aptly referred to as ’short’ and ’double-short’ ETFs.

ProShares has created ETF’s that trade inversely with the markets. These allow investors and traders to hedge against market downturns or that want to bet against the market. These ETFs are very liquid and actively traded and are designed to go up when indexes go down. As a reminder, the SHORT funds use no leverage, but the UltraShort funds employ leverage. Here is partial list by Fund (Ticker):

• UltraShort QQQ (AMEX: QID)
• UltraShort Dow30 (AMEX: DXD)
• UltraShort S&P500 (AMEX: SDS)
• UltraShort MidCap400 (AMEX: MZZ)
• UltraShort SmallCap600 (AMEX: SDD)
• UltraShort Russell2000 (AMEX: TWM)
• UltraShort MSCI EAFE (AMEX: EFU)
• UltraShort FTSE/Xinhua China 25 (AMEX: FXP)… short selling FTSE Xinhua 25 index (FXI).
• UltraShort Basic Materials (AMEX: SMN)
• UltraShort Consumer Goods (AMEX: SZK)
• UltraShort Consumer Services (AMEX: SCC)
• UltraShort Financials (AMEX: SKF)
• UltraShort Health Care (AMEX: RXD)
• UltraShort Industrials (AMEX: SIJ)
• UltraShort Oil & Gas (AMEX: DUG)
• UltraShort Real Estate (AMEX: SRS)
• UltraShort Semiconductors (AMEX: SSG)
• UltraShort Technology (AMEX: REW)
• UltraShort Utilities (AMEX: SDP)
• Short MSCI Emerging Markets (AMEX:EUM)
• Short MSCI EAFE (AMEX: EFZ)
• Short QQQ (AMEX: PSQ)
• Short Dow30 (AMEX: DOG)
• Short S&P500 (AMEX: SH)
• Short MidCap400 (AMEX: MYY)
• Short SmallCap600 (AMEX: SBB)
• Short Russell2000 (AMEX: RWM)

On the TSX in Canada, Horizons BetaPro Funds have launched ‘double-short’ ETFs that trade inversely with the market (they also have corresponding ‘double-bull’ versions of these). Canadian investors and traders can use these to protect against downturns or simply bet against the market.

• Horizons BetaPro COMEX® Gold Bullion Bear Plus ETF (TSX: HBD)
• Horizons BetaPro S&P/TSX Global Mining® Bear Plus ETF (TSX: HMD)
• Horizons BetaPro DJ-AIGSM Agricultural Grains Bear Plus (TSX: ETF HAD)
• Horizons BetaPro S&P/TSX 60® Bear Plus ETF (TSX: HXD)
• Horizons BetaPro S&P/TSX Capped Financials® Bear Plus ETF (TSX: HFD)
• Horizons BetaPro S&P/TSX Capped Energy® Bear Plus ETF (TSX: HED)
• Horizons BetaPro S&P/TSX Global Gold® Bear Plus ETF (TSX: HGD)
• Horizons BetaPro NYMEX® Natural Gas Bear Plus ETF (TSX: HND)
• Horizons BetaPro NYMEX® Crude Oil Bear Plus ETF (TSX: HOD)
• Horizons BetaPro COMEX® Gold Bullion Bear Plus ETF (TSX: HBD)
• Horizons BetaPro S&P/TSX Global Mining® Bear Plus ETF (TSX: HMD)

Look at it this way; if you already have long positions that have appreciated, but you’ve got a longer term holding period in mind that is not determined by market conditions, this may a viable option to capture some of the potential downside.

Tags: Agricultural Grains, Amex, Apologists, Bailout, Banks, Basic Points, Bear Plus, Bear Plus ETF, Benefi, Biggest Banks, Bullion, Canadian Market, Carry Trade, China, Citigroup, Collapse, Corporate Balance Sheets, Corporate Debt, Credit, Credit Default Swap, Credit Default Swaps, Crude Oil, Crude Oil Bear Plus ETF, Derivatives, DOG, Dollar, Don Coxe, Dow 30, DUG, DXD, EFZ, Emerging Market, Emerging Markets, energy, ETF, EUM, Fed, Fed Doesn, Financial Guaranty, Financial Institutions In Canada, Financials, France, FTSE, FTSE Xinhua 25, FTSE/Xinhua China 25, FXP, Glitterati, Gold, Gold Bullion, Gold Bullion Bear Plus ETF, Grain, Hedge Fund, Hedge Funds, Horizons BetaPro, Horizons BetaPro Funds, Investment, Jim Cramer, liquidity, Markets, Mbia, Merrill Lynch, Mining, Miscellaneous, Mortgage, Msci Eafe, MYY, MZZ, Natural Gas, Natural Gas Bear Plus ETF, Nymex, oil, pence, Plus ETF, Profitable Trades, Proprietary Traders, Proshares, PSQ, QID, Rally, Real Estate, REW, risk, RWM, RXD, S&P/TSX 60, SBB, SCC, SDD, SDP, SDS, Short Covering, Short Dow30, Short MidCap400, Short MSCI Emerging Markets, Short QQQ, Short Russell2000, Short Selling, Short SmallCap600, SIJ, SKF, SMN, SRS, SSG, Stock Prices, Substantial Cash, SZK, Trading, Tsx, TSX 60, TWM, ultrashort, UltraShort Basic Materials, UltraShort Consumer Goods, UltraShort Consumer Services, UltraShort Dow30, UltraShort Financials, UltraShort Health Care, UltraShort Industrials, UltraShort MidCap400, UltraShort MSCI EAFE, UltraShort Oil & Gas, UltraShort QQQ, UltraShort Real Estate, UltraShort Russell2000, UltraShort Semiconductors, UltraShort SmallCap600, UltraShort Technology, UltraShort Utilities, Us Federal Reserve, usd, Value, Wall Street
Posted in Canadian Market, Commodities, Credit Markets, Emerging Markets, ETFs, Gold, Markets, Oil and Gas, Outlook, US Stocks | Comments Off