MarketThoughts' Road Map for the Next 12 to 24 Months

[HenryTo]

This board seemed to be very active today - so I just thought I'd pitch in with my "2 cents" tonight. While I am not writing for the website or sleeping, I have usually been reading some research piece or book over the last week or so. I hardly read the WSJ or the FT unless they are writing about a particular sector or stock I am interested in.

Anyway, I digress. Over the last week or so, all I have been thinking about is the hedge fund industry and what they have been doing vs. what we should be doing. To a lesser extent, I have also been thinking about what retail investors have been doing (investing in global equities and to a lesser extent, commodities and precious metals) and when they will stop what they have been doing. In a way, I am thinking out loud here so please bear with me for a couple of minutes.

The evidence suggests that the global market rally over the last few years has been driven on the margin by the following:

* Global equities by U.S. retail investors
* U.S. equities by company buybacks, private equity, and to a lesser extent, hedge funds. The retail investor has been OUT OF THE PICTURE (at least directly) since early 2004.
* Commodities: Hedge funds, pension funds, and CTAs - and China (since 2003)
* ETF industry: hedge funds and professional investors
* Bonds: UK, European, and US pension funds, etc.
* Gold: Indian and Chinese consumers and U.S. retail investors (since 2003)

Back in the late 1990s, we all did not know any better and piled into technology just like what everyone else was doing. The mantra was "to buy the dips" and to forget about valuations. Whoever did well were the ones that anticipated what the retail investors did next - and to a lesser extent, mutual and pension funds and what the S&P will do in their indexing methodologies, etc. Folks who stuck to valuations did okay up until 1997 ( e.g. Julian Robertson of Tiger Management had a 40% return as late as 1997) - but from thereon, the inmates took over and overran the asylum.

The key to outperformance in today's environment is not to only anticipate what retail investors will do next, but what hedge funds will be doing next as well. In retrospect, we all know what they did over the last few years - and especially over the last six months as many of them "capitulated" and just rode either the MSCI World Index and the S&P 500. In other words, they were really increasing their betas and disguising them as alphas. They had to - since many "absolute return strategies" were not working out. Spreads were at all-time lows. The carry trade was getting very dangerous, as the Yen were at all-time lows against the Euro and against the dollar on a purchasing power parity basis. The huge increase in exposure to both the S&P 500 and to the MSCI World index by hedge funds over the last six months has been well-documented by Goldman, Lehman, and GaveKal.

Make no mistake: The "bubble" in hedge funds is here to stay. CalPERS just announced that they will invest an additional $1 billion into hedge funds last week. Global hedge fund assets are now at $1.8 trillion. Sure, there will be washouts - such as Amaranth, but other guys like Red Kite are getting reprieves. And you have to wonder: What would this do to global capital movements and the world's financial markets going forward? What will be the best sectors to invest in and what would this do to the stock market? How about the world's equity markets? Or the U.S. Dollar?

I think I have at least one answer. Almost by mandate, the returns of hedge funds in general cannot resemble the S&P 500. In fact, the primary goal of investing in hedge funds is to find investment strategies that have no correlation with the return of the S&P 500. To the extent hedge funds will invest in U.S. equities, they will seek out high beta plays or stocks that do not have a meaningful representation of the S&P 500. For long-short hedge funds, that means you better find stuff to short and not turn yourself into a long-only fund.

Of course, this mandate has been with us since a few years ago but this will continue to get more powerful as more assets flow into hedge funds over the next few years.

In the event that absolute return strategies and carry trades have a low probability of turning out well (this is still the case even though the Yen has bounced somewhat over the last week or so). hedge funds will have to make directional bets that are either 1) not correlated with the S&P 500, or 2) if they are correlated, make sure they are either high-beta plays or do not have a meaningful representation in the S&P 500.

This - almost by definition - tells us that the speculation in steel, mining, precious metals, energy, construction stocks, etc. will continue over the next 12 to 24 months. Whereas in the 1970s the commodity boom was driven by high inflation and the emergence of OPEC as a power force, this one is being driven by a lack of infrastructure investments during hte 1980s and 1990s (which was obvious) and investment demand coming from investment partnerships (hedge funds) that not only want to beat the return of the S&P 500 but who also want to do it with zero correlation and lower volatility. This latter emergence is not as obvious - especially given that hedge funds just have not been that powerful in shaking up the markets from 2003 to 2005.

Basically, what started out as more of a play on a general underinvestment theme will turn out to be a theme driven mostly by hedge funds in the coming months. An example: Given a choice between buying a "high beta" stock like CAT or a "deflationary boom play" like PFE (which is trading now at a P/E and P/CF ratio of around 10 - probably one of the cheapest valuations since since the last full-blown recession in 1990), what should you buy?

Remember, valuation is now only a secondary concern. On the other hand, CAT is generating lots of cash and has a higher ROE but are trading at valuations similar to late 1997 and early 1998 - right at the last secular top. CAT would make a slightly higher high in early 2000 but that was primarily due to the indexing effect coming in from the S&P funds and to a lesser extent, the Diamonds. However, the tailwind that is working for CAT is that it remains a high beta play relative to the S&P 500 - as well as a great infrastructure story trading at a relatively attractive valuation. Moreover, it is one of the blue chips among infrastructure plays in the world, and its businesses are also relatively diverse. This is not unlike buying "blue chips" such as Microsoft or Cisco back in the late 1990s. As long as they can continue growing their earnings, valuations will not matter too much going forward.

Put another way: As long as the Chinese and Indians keep on buying more gold (on a US$ basis, not a volume basis) year-in and year-out, it really doesn't matter what the gold price is trading at - as long as supplies do not increase substantially going forward. At some point, supply will catch up (e.g. investors who bought technology and internet stocks didn't know that a supply of these type of shares is effectively infinite) - but mining for gold or copper is still not an easy endeavor - at least not compared to setting up your own website and selling paper during the late 1990s. Moreover, rising energy prices and labor costs will also raise marginal costs of production going forward. In other words, the secular bull market in commodities and infrastructure plays are not dead yet - and are still awaiting for their "blowoffs."

As retail investors awaken from their "shell shocks" in the housing and subprime industry, my guess is that more of their money will flow into these infrastructure plays going forward - including commodities and precious metals as opposed to deflationary boom plays or consistent, stable stocks like PFE, MRK or KO. These latter stocks won't come of age until the consumer in China and India really start to take hold, and it won't happen in the next 12 to 24 months.

[rffrydr]

Aluminium was a marginal down sector today, with mining.

Uranium has surpassed the 100dollars/pound "shrink" level.
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Today is the Tomorrow you worried about Yesterday!

[rffrydr]

Somewhere around 1/3 of deliverable Cocoa is in Hedge Fund hands.

General taste shift to dark chocolate, and decline in milk variety. Hot air in Ivory Coast--but first peace prospects in half-decade. 1300 used to be sky-high for this stuff. And european powdercontent has finally been "liberalized."
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Today is the Tomorrow you worried about Yesterday!

[HenryTo]

I am not too sure at this point. For example, the both the Chinese "real" and "financial" economy already have plenty of liquidity. The government is trying to actively curb that liquidity, so I seriously doubt any money in this (at least initially) would be used for domestic investment projects. The spending in infrastructure will come, but not from this fund (as this fund is strictly for return-maximizing/risk minimizing purposes).

Unlike many Middle Eastern investors, the Chinese are probably more welcomed as investors - although maybe only slightly so. However, whatever financial investments they make here in the US, the Chinese government is definitely certain that its assets will not be frozen in the name of the Patriot Act.

[rffrydr]

Roach's ideas concerning the reycling of petrodollars applies here:

[HenryTo]

John Mauldin's latest:

http://www.2000wave.com/article.asp?id=mwo030907

Note that he is also starting a Chinese version of his letter. I am suprised that a guy like Marc Faber hasn't done the same already - although he definitely has garnered much of an audience already.

The National Social Security Fund of China brought in Mercer Investment Consulting late last year to advise them on where they should invest the $1 billion (of the total $29 billion in the fund) they have set aside for global investments:

http://online.wsj.com/article/SB116480510849835670.html?mod=todays_us_money_and_investing

I imagine they will go this route initially (investing mostly in financial assets such as stocks/bonds/currency strategies and so forth). As always, the Chinese government (unless Chinese retail investors) will take it slowly and only slowly shift to investments in other areas - such as specific infrastructure projects, social safety nets, etc.

Assuming that this occurs over the next five years, $250 to $350 billion is still a good-sized amount ($4.17 to $5.83 billion on a monthly basis) - and this doesn't include the money that is continuously coming in. Taking that into account (an additional $100 billion a year), monthly inflows to the world's "risker assets" will be approximately $12.50 billion to $15.83 billion - at least over the next five years anyway. This is a huge chunk of change - more than half of what U.S. retail investors were dumping into U.S. mutual funds during the 1999 to 2000 period.

[rffrydr]

Maybe Merrill is blinded by the fact that the correlation burns very brightly right now. Forget about Large Caps, how about that ultimate and most ancient "hedges," AU? The business cycle is being denied. There are historical forces in play as "developing country" investment finds its way back West magnified many times in (leveraged) wealth. Is this an "asset class" in terms of a conventional business cycle? Or should we just call it, "the monied class"?

If you accept such valuations on US Steel, for example, you either endorse some concept of "supercycle," which is really a denial of the business cycle altogether, or you admit to a valuation based upon something else altogether. And steel, though a dramatic one, is hardly a special case.

High yields pressed up moderately last week in reaction to the subprime crash-and-burn. What links the two? Nothing--and everything: and you won't find the answer in economics but literature. Metaphor!

[rffrydr]

Mauldin's current letter talks about this, the greatest "Private Equity" fund the world has ever seen.

I suspect their newfound colonial empire will occupy much of this--stocks are lottery tickets. But can they (all of them) resist??? Hard assets, money in the ground, both minerals and food, taking big commitments in money, years and manpower, infrastructure will absord much; foreign direct DISinvestment in the context of a western recession, foundering bank debt, FALLING yuan should should take care of much of the remainder
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Today is the Tomorrow you worried about Yesterday!

[HenryTo]

Besides anticipating what hedge funds will do going forward - another play is to anticipate what this Chinese government "slush fund" will doing going forward as well. It is still up in the air, but no doubt this will have more of a "global bent" than its predecessor which has nearly 75% of its assets invested in U.S. Treasuries. Going forward, having a global/multi-market asset allocation perspective is essential for outperformance.
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China Forming Fund to Invest Reserves
Friday March 9, 2:24 pm ET
By Joe Mcdonald, AP Business Writer
China Creating Company to Invest a Portion of Its $1 Trillion in Reserves


BEIJING (AP) -- China will soon create one of the world's largest investment funds, with ramifications for global stock, bond and commodities markets and for how the U.S. finances its trade deficits.
Finance Minister Jin Renqing said on Friday the aim is to make more profitable use of its $1 trillion in foreign currency reserves that have piled up as it posted huge trade surpluses year after year. Most of those funds are now parked in safe, but relatively low-yielding U.S. Treasury securities and other dollar-denominated assets.

"We can achieve more profit from the investments," Jin said at a news conference. "We are now preparing the organization of this new corporation."

Jin said Beijing may follow the lead of Singapore's Temasek Holdings, which manages nearly $90 billion in government pension funds and other assets. It owns stakes in Singapore Airlines and Singapore Telecom, as well as in banks, real estate, shipping, energy and other industries in India, China, South Korea and elsewhere.

Analysts have speculated for some time that China would create an investment company, and officials have said repeatedly they want to make better use of the country's reserves.

Economists have suggested Beijing might allocate as much as $200 billion to $400 billion to the new company, which in a single move could create one of the world's richest investment funds.

"They want to be more aggressive than what they do with current reserves," said economist Mingchun Sun at Lehman Brothers in Hong Kong.

"They could invest in higher-yield products -- stocks, corporate bonds, maybe even commodities," Sun said. "Basically, the returns would be higher because the risk is higher."

A shift in China's investment strategy could change its purchases of Treasuries, affecting a market that Washington relies on to help finance multibillion-dollar budget deficits, and perhaps eventually push up U.S. interest rates.

But Lehman Brothers' Sun played down that risk. He said that with its reserves growing by as much as $20 billion a month, Beijing could afford to keep buying U.S. government bonds while also channeling billions into new investments.

Even so, news of the Chinese announcement -- along with an upbeat jobs report, which reduced expectations the Federal Reserve will need to cut U.S. interest rates -- came on the same day of a big drop in the price of the benchmark 10-year Treasury note Friday. That pushed up its yield to 4.58 percent from 4.51 percent late Thursday.

The Commerce Department also reported on Friday that the U.S. trade deficit with China soared 12 percent to $21.3 billion, even as the overall gap between what America sells abroad and what it imports slimmed slightly in January to $59.1 billion from a December deficit of $61.5 billion.

Jin gave no details of how the Cabinet-level company might invest the reserves, nor did he say what portion of the reserves might be channeled through the company or when it would start to operate. Spokespeople for Jin's ministry and the central bank and foreign currency regulator declined to give any other details.

U.S. Treasury Secretary Henry Paulson, in an interview this week on the U.S. television network ABC, rejected suggestions that changes in Chinese bond purchases could affect the United States.

Paulson said Beijing's entire holdings represent the equivalent of less than a single day's trading in Treasuries on global bond markets.

Chinese economists and media reports have suggested China might adopt more unusual investment approaches, ranging from stockpiling oil and other raw materials to spending more on social programs in order to encourage Chinese consumers to spend more and reduce dependence on exports.

The growth in China's reserves is driven by the rapid growth of its exports, which brings in dollars, euros and other foreign currency, and by the billions of investment dollars being poured into the country.

The surge in money flooding in from abroad forces the central bank to drain billions of dollars from the economy every month by selling bonds in order to reduce inflationary pressures.

The precise composition of China's foreign currency reserves is a secret. But economists believe that as much as 75 percent is believed to be in U.S. dollar-denominated instruments, mostly Treasuries, with the rest in euros and a small amount in yen.

Stephen Green, chief economist at Standard Chartered Bank in Shanghai, calculated that last year the central bank made a $29 billion profit on its Treasury holdings after paying interest on its own bonds and other expenses.

But even that represents a return of less than 3 percent on the $1 trillion in holdings.

By contrast, Singapore's Temasek says it has averaged an 18 percent annual return since it was created in 1974.

[HenryTo]

Examples of high beta plays: Homebuilders back in July 2006. Still reporting bad results but they bottomed anyway and just kept on rising throughout the year. Hedge funds most probably had something to do with it.

Today, a prime example is the subprime lenders. Hedge funds have been very active in this area and for those companies that have staying power (i.e. their business models hold and they are not going into bankruptcy), I think they will be snapped up by hedge funds sooner or later.

[rffrydr]

Check out the journal graphic today if you wanna see it in black and white: the countries with the best economies, esp. ireland, have sold off the most. Long suffering Italy, hardly at all. The picture is of one thing, money--lots and lots of leveraged money.

While you're at Aluminum don't forget uranium. That they can never touch the stuff themselves, that they are not allowed control over what they own, is no deterrent. Here hedge funds take on the old military-industrial complex. Should be interesting now, in light of a oilman Republican of a president--and peak oil.

WSJ March 5.

In a new type of nuclear-arms race, hedge funds and other institutional investors in search of higher returns are competing with energy companies to amass scarce fuel-grade uranium, hoping to profit from revived interest in nuclear power.

The intense quest for uranium by speculators has sparked a debate over private investors driving up the price and increasing the scarcity of the world's most sensitive natural resource.

Since investors first delved into the market two years ago, the price of processed uranium yellowcake powder -- the most commonly traded form of processed uranium -- has skyrocketed more than fourfold, from about $21 a pound, traders say. They say uranium prices climbed to $85 from $75 in February due to bidding for supplies offered by a tiny mining company in Corpus Christi, Texas, Mestena Uranium LLC. The privately held company regularly includes hedge funds and other speculators in sales.

Uranium isn't traded on any exchanges. The somewhat infrequent sales of the commodity in the open market are private, so the price depends on the terms of any given transaction.

Financial investors aren't licensed to possess the radioactive mineral, which is subject to tight government controls aimed at keeping it out of the hands of terrorists and rogue states. Instead, several of those investors have secured access to ownership rights of material stored at licensed repositories in North America and Europe, exploiting legal channels previously used only by utilities and suppliers.

But even with only paper rights to the material, hedge funds are exacerbating what was already the biggest nuclear-fuel supply crunch in decades, according to utilities, miners and large traders. The market represents the latest corner in which hedge funds -- private partnerships that cater to wealthy investors and large institutions -- are seeking outsize returns, an increasingly challenging task as the number of funds multiplies.

Many funds say they are holding their uranium off the market because they expect the price to climb.

"They sweep the market clean. Every pound they can find," said nuclear-fuel broker Kevin Smith, who connects buyers and sellers of uranium for White Plains, N.Y., commodities-brokerage Evolution Markets.

Adit Capital, a small hedge fund in Portland, Ore., was an early uranium investor, buying millions of pounds for as little as $20 a pound beginning in December 2004, said Bob Mitchell, its founder.

It jumped into the uranium market after Mr. Mitchell noticed nuclear utilities allowing inventories to dwindle when the material was cheap, to avoid the cost of storing it. Meanwhile, some mining companies had been selling more future production than Mr. Mitchell figured they would be able to produce, and mines were closed when prices were depressed in the 1990s -- all evidence of a coming shortage.

QVT Financial LP, a $5 billion-plus New York hedge fund that was spun out of Deutsche Bank AG in 2003, won a big portion of a U.S. government stockpile of uranium gas at auction last August for $42.1 million, people familiar with the sale said. Uranium gas is refined from yellowcake as part of the multistep process that produces fuel for nuclear power plants. (Making weapons-grade uranium involves a much more complicated process.)

Two new publicly traded uranium investment funds are adding to the competition. The funds are similar to gold and silver exchange-traded funds, raising money from investors in initial public offerings of shares to buy uranium.

Unlike other fuels and metals, there is no futures market for uranium, but the mined supply is so scarce that some utilities now are striking deals to buy it on future dates at whatever the prevailing market price is on delivery, said Mr. Smith. It's a perilous bargain: The uranium market hasn't had a down week since June 2003, according to Ux Consulting Co., a Roswell, Ga., price-reporting service.

Production shortfalls at uranium mines around the world are helping drive up the price, says Jim Cornell, president of Connecticut nuclear-fuel trading firm NUKEM Inc. Production fell last year, in part because a flood this past October collapsed the underground infrastructure of Cameco Corp.'s Cigar Lake project, a major mine in Canada, soon before it was to begin production.

The investors' arrival has spurred questions about the economic viability of nuclear energy as an alternative to fossil fuels, including coal, that produce global-warming greenhouse gases. About a quarter of the cost of producing nuclear power goes toward uranium fuel, and prices are skyrocketing just as safety concerns over reactors are ebbing. Although uranium is abundant in the earth's crust, bulls see prices climbing to $200 a pound before supply can catch up to push them back down.

Currently, some of the fuel used in reactors comes from U.S. Department of Energy stockpiles and a program run for the U.S. government by USEC Inc., a publicly traded Bethesda, Md., energy company originally formed as a government corporation, to convert old Soviet warheads back into fuel. The rest comes from private mining companies and other suppliers.

When selling uranium, the Energy Department makes no distinction between financial investors and end users, so long as it's held in authorized storage facilities. Bidders must disclose their identity and the nature of their business.

The Nuclear Energy Institute in Washington, which represents utilities and fuel processors and producers, asked the Energy Department on Feb. 5 to exclude anyone but end users from federal auctions. In a letter, the institute asked the government to "protect utilities that cannot procure sufficient uranium in the open market."

Marvin Fertel, senior vice president of the NEI, said in an interview that investor stockpiling isn't in the industry's best interest: "All it does is take what's somewhat scarce and make it a little bit scarcer," he said.

Financial investors say they are just seizing on buying opportunities that the nuclear industry missed. Moreover, industry players say, high prices are encouraging hedge funds and others to invest in mining companies, which will help finance increased production and possibly drive down prices.

The NEI's Mr. Fertel conceded as much. In the long run, "I think we're going to end up with a much better situation than we even had before," he said.

The market began taking off about two years ago. In May 2005, several months after Adit entered the market, Uranium Participation Corp. raised about $80 million for a uranium investment fund via an initial public offering on the Toronto Stock Exchange, and has raised roughly twice as much since. Managed by executives of the Canadian mining concern Denison Mines Corp., UPC controls more than 6.8 million pounds of uranium yellowcake or gas. It says its average yellowcake acquisition cost was $31.75 a pound.

A similar fund, Nufcor Uranium Ltd., went public last July on the London Stock Exchange's AIM small-stock market and now controls 2.3 million pounds, the company says. Regulatory filings show that hedge funds invested in that IPO, including GLG Partners, Citadel Investment Group and QVT Financial LP.

Shares of both funds are trading at about 20% more than the current market price of their uranium, suggesting that investors see prices continuing to climb.

Ux says financial funds have purchased about 20 million pounds of yellowcake since entering the market in late 2004. That is roughly a fifth of the supply being mined each year. Such funds bought about 25% of the uranium sold on the spot market in 2005 and 2006. They are husbanding most of their supplies, having sold only two million pounds so far, Ux officials say.

Today, while the value of some funds' uranium has quadrupled, Cameco and other large miners are stuck with commitments to sell future production for a small fraction of today's prices. In the last three months of 2006, Cameco got an average of just $22.35 a pound for its uranium.

Tension over the issue was evident at a February energy conference in Houston. After John Rowe, nuclear-power producer Exelon Corp.'s chief executive, addressed the gathering, a man in a rainbow-hued jacket rushed up to introduce himself as a potential seller of uranium.

The man was Mitchell Dong, a Cambridge, Mass., entrepreneur who last September launched the Solios Uranium Fund, which recently reported having assets worth $46 million.

"I know who you are!" Mr. Rowe shot back with a laugh. "Are you the biggest villain in the energy industry?" Mr. Rowe later explained in an interview that he believes hedge funds are helping run up uranium's price.

Mr. Dong declined to discuss his fund's recent activities. He told a newsletter last fall that he expected demand to exceed supply for five years. "We're going to buy it, hold it, and when the price is right we'll liquidate a position," he said.

Indeed, eventually "the price of uranium will collapse," said Adit's Mr. Mitchell. "I don't know when, but the mining companies of the world will get their act together. The guts of the trade was getting into it before anybody even knew you could. But the art of the trade will be getting out before the price turns over."
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Today is the Tomorrow you worried about Yesterday!

[Prospero]

Thanks for posting the Merrill link, dash.

However, I am very sceptical about their methodology. It seems to me that using a rolling 5 year correlation to 'smooth out the business cycle' might have the effect of hiding most of the real information in the data.

To give an example from page 8:

[HenryTo]

My initial reaction to that is that it won't until we see a huge shakeout in the hedge fund industry - which will probably correlate with a meltdown in the emerging markets and a significant sell off in cheap, domestic equities.

But let me think more about that in the coming days...

Appreciate the input, guys! rffrydr, I will look more into aluminum over the next few days.

Best regards,

Henry

[dash]

[rffrydr]

Here's your hedge fund commodity play in action. This short-squeeze better work soon. That is the Chinese post newyear pull better kick in right now. Graphic shows parabolic increase in stocks--fueled in large part by china itself! (despite disincentives by Govt.)


China giveth and China taketh away. That certainly resonates with those taking a punt on aluminium. The metals market is focused on one huge long position built up recently. It is thought to be equivalent to between 50 and 80 per cent of all the aluminium sitting in London Metal Exchange's warehouses, just over 800,000 tonnes. There is also an unusually large number of March 2007 aluminium calls at strike prices of Dollars 3,000 a tonne or more outstanding.

Yet in spite of several runs up towards Dollars 3,000, spot aluminium has not breached that level and now sits at less than Dollars 2,800. The squeeze means even high-cost producers can keep their smelters running, and metal has been flooding into LME warehouses, with inventories rising by almost 70,000 tonnes in the past month alone. Producer stocks, held outside the LME, have also seen a big increase across the world.

The hopes and fears of aluminium traders largely rest on China. The view that tight supplies of raw materials and high energy prices would crimp Chinese production has proved unfounded. China continues to export aluminium. In January, the country imported more than 1.6m tonnes of critical raw material bauxite - more than five times the amount landed in January 2006. Beijing's efforts to curb rampant production offer little comfort. Export taxes have so far proved ineffective. China now accounts for more than 40 per cent of global aluminium production. If taxes did lead to lower output, world prices would rise, incentivising Chinese producers to export regardless. Yet if the authorities did manage to slow the economy's expansion, that would hit all manner of risky asset classes, with commodities in the front line.

Commodities bulls have long trumpeted the fact that China is simply too big to ignore, but its impact is not a one-way street.

Source Citation: "Helter smelter THE LEX COLUMN.(LEX COLUMN)(Column)." The Financial Times (March 5, 2007)
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Today is the Tomorrow you worried about Yesterday!