Archive for October, 2016
I’ve been telling you for weeks that hedge funds have been bleeding cash – not just during 2016, but for the past 10 years or more.
And in our in-depth analysis of hedge fund performance – what historically made them extraordinary, and moreover, what they’re doing lately that’s undermining performance – yields an easy-to-follow roadmap leading to both investing and trading success.
That’s because these days, with markets being manipulated, being gamed, and being chased by too many hedge funds (and too many mutual funds) employing too many of the same strategies and getting into too many of the same stocks and getting out too late, means generating big returns requires a hybrid investing and trading strategy.
Employing both short-term trading and long-term investing strategies that incorporate what’s worked and what hasn’t worked, is the best way to make tons of money today.
But the news is better for some investors than others.
The truth is, today it’s easier for individual investors to make money running their own personal hedge funds than it is for the big boys to swing for the fences.
That’s because nimble investors who know what big hedge funds and sloth-like mutual funds are doing right (and wrong) can actually mimic, “fade,” and front-run funds into and out of positions.
It’s not hard, it just takes a little work.
Here’s why and how you should sometimes mimic, sometimes fade, which is a Wall Street insider term for “do the opposite” and always front-run funds in and out of trades.
It’s entertaining and enlightening work.
Making money has always been a passion of mine. Even though I retired from the hedge fund business, (frankly, because it’s a 24/7 job and because I don’t have to work anymore and like sharing my days with family and friends), I still exercise my passion every day for the business.
I read a lot. I follow what my hedge fund friends are doing. I talk to a lot of big investors.
That’s the kind of work I’m talking about. That’s how you research the trades you’re going to make in your own personal hedge fund.
Here’s how you exercise your own passion to make money.
Do Your Homework
The analysis I laid out here over the past couple of weeks shows that hedge funds are crowding into too many of the same positions. So knowing who’s in what, and how big their holdings are is a big part of your basic research.
Big institutional investors who oversee pools of $100 million or more in assets are required to file quarterly 13F forms with the SEC. All of those 13Fs are available for free on EDGAR, the SEC’s web search portal. Available in both HTML and XML form, the filings list all of the fund’s long equity and option positions.
While you can get all that information for free, it’s a slog to get through unless you set up your own spreadsheets with sifting mechanisms, which isn’t exactly easy. Luckily, there are web accessed “products” that distill the kind of data you’ll need. For instance, Whale Wisdom tracks hundreds of hedge funds and provides analysis on several years of 13Fs. It also provides 13F back testing and even scores funds based on performance. Either way, 13F information is required research.
While it’s true that 13Fs are filled out at the end of a quarter and managers could have already moved out of those positions, you can look back at trading volume and price action over the preceding quarter and make some assumptions about money flows in or out of stocks.
But that’s more granular. I do that, but you may not have time or the tools to calculate what could be net changes in hedge funds positions. Generally, what you don’t know doesn’t hurt you because you’ll be looking at positions held by a lot of funds and it’s not likely they’ve all already moved on.
Also, 13F filers don’t list their “short” positions. So it’s hard to tell if they are short as a hedge against the long positions you can see. While it would be great to see their short positions, there are other ways to zero in on shorting opportunities, not by the way to short them, to actually fade the shorts and buy them (I’ll tell you more about that soon).
Make Overcrowding Work For You
Basically, the overcrowding negative effect concentrated positions have on hedge funds is triggered when positions are exited.
It sounds simple, but it’s working beautifully these days. If you know hedge funds have big positions in the same securities, on the same side of a bet, all you have to do is check out the technicals and look for support and resistance levels.
Depending on how long funds have been holding those positions, and very often depending on which funds own what, both of which you can glean from 13Fs, you can front-run their exiting by placing orders to sell your own position, which you may have gotten into by mimicking the funds, or short the stock, when it breaks support levels.
For me, if a lot of funds are in the same position and I’ve got a good handle on who the players are, their trading and investing styles, risk tolerance, etc., all of which I learned because of my passion, and you can learn too by just reading a lot of articles about fund managers, their travails and successes, the markets and reading those 13Fs. That’s how I stage my trades.
I’ll watch the various support levels and see what happens volume-wise when they get broken. You can tell by watching block trades and volume metrics, if the selling is institutional or retail. Depending on the number and size of blocks and volume, I can tell if funds are dumping.
Then, if I’m not convinced they’re done, or if the stock is under more pressure, either from what’s bearing down on it or because of systemic market pressure, I’ll short more at lower levels if next levels of support get broken on bigger volume. That’s funds selling.
Of course, if you have a good handle on the players and their portfolio management styles, and how many are in the same positions, it’s not hard to figure there may be more heavy selling if another support level is broken.
The biggest problem hedge funds are facing when they are bunched together in the same long positions is getting out with profits, or at breakeven, ahead of the rest of the sellers.
That’s why this simple strategy is so powerful. It’s easy for small investors to do because they can be more nimble. Yes, big funds are aware of that, but they’re not worried about small investors front-running their selling. They worry about other big investors heading for the exits before they get out of harm’s way.
How to Play the Short Side
Playing the short side of hedge fund positions is pretty much the exact opposite.
When funds are short, they’re either long-term short position holders, or (far more often) very short-term short position holders.
It’s not that important to watch long-term short position holders (funds like Jim Chanos’ Kynikos Associates) because they aren’t generally who small investors should follow. However, they make waves when they call out a stock as a good short prospect. Pay attention to that.
The short-term short position holders are usually a nervous bunch who don’t like that they’re facing a long bull market and the prospect of unlimited losses, since stocks can technically go up forever – they’re the ones I watch.
Again, reading and keeping up on what the financial press is saying about funds positions is important. I also look at the number of shares shorted and the percentage of a stock’s float that’s been shorted. Both of those stats can easily be found on Yahoo Finance under “statistics.”
Especially if the market starts moving higher, quickly, those shorts are going to panic.
I love buying those stocks, doubly especially if I want to own them anyway, if there are large short positions on them. Up-moves will cause shorts to cover. The bigger the short position on a stock, the more of it I buy looking to front-run short-covering funds.
It’s really that simple.
Both playing from the long side and the short side, by nimbly front-running hedge funds, sometimes mimicking their going-in plays, but far more often front-running their exiting moves, can be extraordinarily profitable.
I’ll give you hedge fund positions in the future and tell you how to play them, that way you’ll see how easy it can be if you do your research and make sensible, nimble moves.
On a recent episode on Varney & Co., host Stuart Varney put the question to Shah: Is Apple Inc. (NASDAQ:AAPL) still an innovative company, or are they simply milking the legacy of Steve Jobs?Shah says no – there’s no reason to buy AAPL right now if you don’t own it… and if you do own it, you might want to consider taking profits.
Instead, for the stocks that Shah thinks are going to be the big innovators going forward… just click below:
For almost ten years now, hedge funds have been underperforming their benchmarks.
Even the biggest and historically best performing funds are underwhelming investors, who aren’t sticking around just because managers are lowering their exorbitant fees.
They’re fleeing in droves for passive investing strategies like index funds.
But don’t count the Masters of the Universe out just yet.
Not only are hedge fund managers figuring out what’s causing their underperformance, the headlong rush by investors into index funds and exchange-traded funds could backfire, making hedge fund escapees wish they’d stuck to their guns.
Here’s why passive strategies have become so popular, how much money has been moved into them, and why that trend could turn out to be devastating…
Most importantly, here’s how everyday investors can benefit from what amounts to a monumental industry upheaval…
Overcrowding Doomed Hedge Funds
Hedge funds have underperformed investor expectations and the benchmarks they’re supposed to beat since 2008. Only a handful of so-called hedge funds actually made money hedging the subprime mortgage meltdown in 2008, the rest of the industry took it on the chin.
Still, fund managers got a break from investors who stuck around expecting better results in what looked like a tough market going forward.
They bet the wrong way.
From 2009 through the first quarter of 2016, hedge funds underperformed the S&P 500 (the most widely watched U.S, equity market index and benchmark) by 51 percentage points, according to Standard & Poor’s.
As a result, hedge funds have been losing investors and closing up shop. In 2015, according to Hedge Fund Research Inc. (HFR), more hedge funds shut down than any time since 2009, while 2015 also saw the fewest start-ups since 2008, before the credit crisis hit.
Some 530 funds were liquidated in the first half of 2016, the most since 2008. And hundreds of billions of dollars of investor money has flown out of funds, with another $51.5 billion withdrawn in the first nine months of 2016, says HFR.
Fund managers point to extraordinary market conditions, market manipulation, and their own inability to understand how global market conditions have changed and upended their traditionally successful strategies.
There’s plenty of truth there.
The Federal Reserve in the U.S. and central banks across the globe have manipulated interest rates to unprecedented, impossibly low levels, even into negative territory for almost $13 trillion of European and Japanese government bonds. On top of that, high frequency traders move markets in mysterious, self-serving and dangerous ways. The strangling of free market price discovery has upended strategies employed to profit from the normal ebbs and flows of free markets.
But the deeper truth, that managers readily acknowledge, is that the industry has become almost “commoditized” as the number of funds plying a lot of the same strategies has exploded. And, that some of the same strategies that used to be successful are actually working in reverse and surprising traders in profound ways.
While overcrowding into the same strategies and the same stocks presents monumental event risk and liquidity issues for a wide swath of funds, some of the usual tried and true strategies funds employ are simply not working, and worse, backfiring.
The most recent example is so-called momentum trades, both long and short varieties.
It used to be managers who found good buying or shorting opportunities were followed into those trades as word got out about their research, their positions, or a significant enough move in the targeted stocks to draw other investors’ attention.
While medium to longer-term holding periods, from months to quarters and even years, were the norm, short-term traders, algorithmic traders, countertrend traders and trading desks trying to agitate stocks to trip stop orders, have all radically changed the game.
After buying and enjoying positive momentum, backed by central banks’ reassurances they were in no hurry to raise rates, funds got sideswiped by the August 2015 10% selloff. After taking their lumps and dumping positions, the market recovered and zoomed higher in the fall. But hedge funds were too scared to initially jump back in.
After solid gains, the momentum crowd came back onboard. Only to get mugged violently again in February 2016 by another 10% smack-down.
Meantime, funds looking to jump onto declining shares by shorting stocks that were headed south, in a bid to rake in profits as the market slid, got their heads chopped off.
Funds got short Wynn Resorts Ltd. (NASDAQ:WYNN) in 2015 which was off 55%, but remarkably rose 35% in the first quarter of 2016. Range Resources Corp. (NYSE:RRC), another big hedge fund position, was also down 55% in 2015, and jumped 33% in early 2016. The same is true for Kate Spade & Co. (NYSE:KATE), down 45% in 2015 and jumped 45% in 2016’s first quarter.
The list goes on, and includes Dick’s Sporting Goods Inc. (NYSE:DKS) and Urban Outfitters Inc. (NASDAQ:URBN), both hedge fund shorts that reversed unexpectedly in 2016. It was enough to make managers scream and investors flee.
Whether overcrowding is undermining hedge fund strategies or strategies themselves are backfiring, the net underperformance of funds with their high fees (relative to their indexed benchmarks with their negligible fees) is driving investors to passive investing strategies, namely indexed mutual funds and indexed ETF products.
The Flood Pushed Billions into Passive Strategies
Hedge fund investors fleeing to indexed mutual funds and ETFs already have lots of company.
In the three years ending August 31, 2016, according to Morningstar, investors of all stripes pumped slightly more than $1.3 trillion into passive mutual funds and ETFs. Of that amount, some $250 billion was stripped from “active” mutual fund managers trying to beat their benchmarks.
While 66% of mutual funds are still active funds, that’s down 84% over the past 10 years. Between 71% and 93% of mutual funds in the ten years (depending on the type of fund) closed or underperformed the indexes they were trying to beat, says Morningstar.
Passive investing is simply buying and tracking an index as opposed to paying a money manager to actively try and beat the market or an index. Over the past 40 years – since Vanguard Group’s John Bogle launched a passively managed S&P 500 index mutual fund – almost 30% of mutual and exchange-traded funds are now “index funds,” according to the Investment Company Institute. The ICI says that’s double their share a decade ago and eight times their share 20 years ago.
So… the trend’s your friend, right?
Sure it is. But the trend changes.
Passive indexing isn’t the answer a lot of its proponents want you to believe it is.
For one thing, stocks in any index can become overvalued relative to those outside it.
Index investors have little choice but to ride overvalued stocks down just like they did when hot technology indexes that drew in tons of money in the 1990s crashed violently in 2000.
Of course, most passive investing fans are huge fans of Warren Buffett because they consider him the ultimate passive investor.
But he’s not that at all.
While a dollar invested in Buffett’s Berkshire Hathaway Inc. between 1965 and 2015 grew an awesome 136 times as much as one dollar invested in the S&P 500, Buffett himself once admitted, “I’d be a bum on the street with a tin cup if markets were always efficient.”
In other words, he’s always trying to find value stocks and inefficiently priced shares, as opposed to just buying an index or the whole market.
The truth is, when active investing re-emerges and beats the pants off passive funds, probably starting right when the masses now rushing into indexed strategies head for the fire exits when investors not in those funds sell stocks, tanking passive funds whose managers have no choice but to go down with their ships.
Mass redemptions and a self-inflicted crash is going to make a lot of passive investors wish they followed a smart hedge fund manager.
On Friday, I’ll tell you what hedge fund managers have learned and what the smart ones are doing now.
As I told you Wednesday, investors are fleeing hedge funds in droves due to gross underperformance in the face of over-the-top fees.
In fact, the industry as a whole hasn’t seen anything like this since 2009 – maybe ever.
Ironically, the pain hedge funds are facing, based on the pain their trades have inflicted, holds the answer not only to their survival, but to an almost sure miraculous revival.
Understanding what’s gone wrong at hedge funds, how crowding into the same trades, staying too long in trades when cash registers should have been ringing, and how underperformance led to fee wars and investors fleeing for passive index funds, produces the roadmap funds have to follow to make a comeback.
And it shows average Joe investors how they can play the same profitable future.
Let me show you what I mean…
Exiting Sinking Ships
It’s not just 2016 that’s been tough for hedge funds. Investors in hedge funds and hedge fund managers would like to forget every year since 2008. But they can’t.
According to Bloomberg, the S&P 500 Index, sometimes referred to as “the market” which investors can invest in by buying an indexed mutual fund or a low cost ETF, outperformed the weighted-composite index of hedge funds every year since 2008.
From 2009 through the first quarter of 2016, hedge funds underperformed the S&P 500 by a whopping 51 percentage points.
In 2015, when The HRFI Fund Weighted Composite Index (and equal-weighted index of hedge funds) was down 1.1%, the S&P, with dividends included, had 1.2% gain.
Even in the full first half of 2016, with funds averaging a 1.6% gain, the S&P 500 posted a 3.8% gain.
It’s bad enough investors are underperforming basic indexes, adding insult to injury they’re also paying exorbitant fees to managers to be in the losing game.
Typically, hedge funds charge a 2% management fee. That annual fee, based on assets under management, which is usually collected on a quarterly basis, is paid to the manager regardless of gains or losses.
On top of the management fee, hedge funds take a healthy piece of the gains they generate.
Historically, the performance fee charged is 20% of profits.
The so-called “2 & 20” fee structure has been the standard for hedge funds for decades, though some very successful funds have charged a higher management and a higher performance fee. I’ve seen funds charge a 3% management fee and up to a 50% performance fee!
Investors have been aggressively negotiating down both management fees and performance fees in the face of pure ugliness. While 1% & 15% fee structures are becoming more prevalent, managers sometimes negotiate fees with different investors, providing they’re allowed to do that according to their fund disclosure documents.
But no matter how low a fund may be willing to drop its fees, investors have had enough.
The first giant institution to split from the hedge fund universe was the California Public Employees Retirement System, CalPERS, who is January 2104 started throwing in the towel. Over the past 20 months CalPERS exited 24 hedge funds and 6 fund of funds, withdrawing about $4 billion from the industry.
The giant New York State Common Retirement Fund, one half of a two fund complex that has $181 billion in assets, lost $3.8 billion as a result of hedge fund underperformance and exorbitant fees, according to a just released report from the New York Department of Financial Services. The system stopped investing in hedge funds last year and has withdrawn $1.5 billion this year.
So far in 2016, the Kentucky Retirement System has taken back $1.5 billion form hedge funds. The State of Massachusetts is cutting back all its alternative investments. College and university endowments are cutting back their hedge fund exposure on an almost daily basis.
According to the Credit Suisse Mid-Year Survey of Hedge Fund Investor Sentiment, a study of 200 hedge fund allocators directing $700 billion of investment capital, 84% of investors in hedge funds pulled money out in the first half of 2016. And 61% said they will probably make withdrawals later in the year.
Why Hedge Funds Aren’t Making Money
There are two basic problems hedge funds are having trying to make money. Today I’ll explain one and next week I’ll lay out the other, less obvious, busted strategy that’s killing performance.
The number one problem facing funds is they’re crowding into too many of the same stocks and creating massive correlation.
There are only so many stocks and so many trades to go around in the $3 trillion, 10,000 fund universe of hedge funds. As more funds ply the same trades and as big funds have gotten bigger, the need for scale increases.
That means more and more fund managers are crowding into positions that consume larger pieces of companies outstanding, floating shares.
That’s fine on the way into a trade if you’re early and other managers plow into those stocks creating momentum, that attracts momentum-driven funds, which attracts more investment capital. But, it’s exiting those positions, sometimes like rushing for the exit doors when someone yells fire, that crushes performance across a wide swath of funds.
According to Andrew Lo, acclaimed professor of finance at the MIT Sloan School of Management, “The whole hedge fund industry is a series of crowded trades.”
Back in a 2011 study Lo found that from 2006-2010 there was a roughly 79% chance “any randomly selected pair of hedge funds will move up and down in tandem in a given month.” That was up from 67% in the 2001-2005 period. It’s worse today says Lo.
In a speech on September 20, 2016 at the RiskHedge USA conference in New York, Mike Jemiolo, chief risk officer at Point72 Asset Management said, “The biggest challenge right now is crowding, the problem is that for many, many years crowding worked – if you loaded on that factor, you made money. But starting in mid-2015, long crowding stopped working pretty steadily and fairly catastrophically in January and February, and in late 2015 – December or so – short crowding stopped working too.”
Basically, investing in crowded stocks exposes investors to shocks and liquidity demands that are not always explicitly captured in risk models.
A perfect example of overcrowding in a trade and the pain a massive exit causes is Valeant Pharmaceuticals (VRX). After touting Valeant at several investor conferences and publicly, hedge fund manager Bill Ackman of Pershing Square Holdings found he had a lot of company in VRX.
According to Novus research on June 30, 2015 VRX was the most crowded position on a list of 10,000 funds from Novus’ Hedge Fund Universe. Novus, in its report pointed out that in spite of the overcrowding, not a single healthcare-focused fund was heavily invested in VRX.
In April 2015, when VRX got above $260 and was held by more than 106 hedge funds, accounting for 38% of its floating stock, as the stock began to tumble daily volume went from 1.8 million shares to 18 million on a 90-day rolling average.
Hedge funds were slaughtered all the way down to $22.27, where VRX trades today. None more so than Ackman’s Pershing Square.
Pershing Square was down 20.5% in 2015 and was down 21.1% in the first half of 2016. Assets under management at Pershing shrunk from $20 billion to $12 billion over the same period. Billions of dollars continue to be withdrawn from Ackman’s funds.
That’s the problem with overcrowding.
Next week I’ll explain what the other “strategy” hedge funds are following that’s killing them, and tell you where the exiting money is going and why.
Hedge funds look like they’re down for the count, having been beaten-up by self-inflicted underperformance in the face of over-the-top fees, high profile slip-ups, and investors stepping over them on their way to low-cost, passive investing strategies.
But don’t count Hedgies out just yet…
One reason hedge funds have been underperforming benchmarks has become abundantly clear and can be overcome (as you’ll see). They’re also knocking down fees to hold onto investors and attract new limited partners.
Not only that, the multi-trillion dollar trend towards passive investing could blow up spectacularly.
Today, I’m going tell you what’s going on with hedge fund underperformance, those exorbitant fees, and why the trend tooward indexing could be hell for the market and a godsend for hedge funds.
But first, let’s all get on the same page…
What Is a Hedge Fund, Anyway?
The first hedge fund, created in 1949 by Alfred Winslow Jones, was designed to hedge the ups and downs of the stock market. Jones figured he’d divide the money we was going to manage into two equal buckets. Half of his positions would be “long” positions (stocks he would buy) and the other half of his positions would be “short” positions (stocks he’d sell short, a bet prices would go down).
If the market went up his long positions would go up and make money, and if the market went down his short positions would go down and make money. Which makes sense – except the two opposing buckets would just cancel each other out.
But Jones had a plan. Because he was such a good stock picker, he explained to investors, when the market went up his long positions would go up more than the market. And because he could pick good shorts, they wouldn’t go up as much as the market, so he wouldn’t lose much on being short. And when the market went down, because he was a good stock picker his long positions wouldn’t go down as much as the market, and his short positions would go down more than the market dropped.
Jones sold his investors on the proposition that they were hedged against the market’s fluctuations and because he was able to generate “alpha” (a return better than the market) because of his stock-picking abilities, he would charge them a management fee and take a good percentage of the gains as a performance fee.
That’s how the term hedge fund came about, while the prospect of generating “alpha” is how managers justify performance fees.
The entity structure Jones used was a limited partnership. Jones was the “general partner” of the limited partnership, managing its portfolio and business, and investors came in with their money as “limited partners.” A limited partner has “limited liability” in a limited partnership. Because they aren’t involved in running the business they aren’t responsible for losses beyond the investment money they initially put at risk.
Today, “hedge fund” is a generic name for a limited partnership, a limited liability company or some other entity structure where investors fork over money to a manager to invest however he or she sees fit.
There are all kinds of “strategies” managers employ to make money, including: fundamental; technical; long/short; long bias, short bias; market neutral; relative value; value-oriented; multi-strategy, global-macro; special situations; event-driven; merger arbitrage; systemic; credit strategies; high yield credit; commodity-based; real estate-based; and on and on and on.
Today, a manager can invest in almost anything as long as they disclose to investors what they’re doing. However, some investor disclosure documents tell potential investors they’re not going to tell them what they’re going to do, or how they’re going to do whatever they do.
Good luck suing the manager of a fund for losing money if you sign off on giving them carte blanche.
In spite of the designation hedge fund, most hedge funds today don’t hedge against market moves.
That’s one reason funds too often underperform in down markets. But there’s another much bigger reason why so many funds have been underperforming for so long.
It wasn’t always that way…
Hedge Fund Performance Has Tanked Since the 90s
Though they’ve been around for decades, hedge funds exploded in the 1990s.
There have always been outstanding hedge fund managers, including legends Julian Robertson, George Soros, Stanley Druckenmiller, Ray Dalio, and Steve Cohen, whose long term track records are extraordinary, partly proven by the success of their investors and partly proven by the fact they are all multi-billionaires who eat their own pudding.
Based on the HRFI (Hedge Fund Research Index) Weighted Composite Index, an equal weighted index of hedge funds, which tracks funds back to 1990, the funds that make up the index collectively delivered 10% annually to investors from January 1990 to February 2016, with a standard deviation of 6.8% and a Sharpe ratio of 1.04.
At the same time, the S&P 500 Index had an annual 9% return with a standard deviation more than twice as high, at 14.6%, and a Sharpe Ratio less than half the HFRI Index, at 0.42.
Bloomberg, from which this data was gleaned, defines standard deviation as “the performance volatility of an investment, while the Sharpe Ratio is a gauge of risk-adjusted returns; a lower standard deviation indicates a less bumpy ride, and a higher Sharpe Ratio indicates that investors are more adequately compensated for the volatility they take on.”
As good as that hedge fund performance sounds, however, objects in the mirror are further away than they appear.
The actual rolling trend of the Index shows a significant decline in returns since tracking began.
The HRFI Index actually returned 18.3% annually from 1990 to 1999. But on a rolling basis returned just 3.4% annually over the past ten years. According to Bloomberg, it doesn’t matter what strategies are broken out – they all suffer diminishing returns.
By comparison, the HRFI Index fell behind the S&P 500 Index by 3% annually over the past 10 years and fell behind the Barclays Aggregate Bond Index by 1.3% annually over the same period.
As if that wasn’t bad enough, the Sharpe Ratio of the HRFI Index fell to 0.38, which was one third of the 1.13 Sharpe Ratio earned by the Barclays Aggregate Bond Index.
What’s going on?
In a word (or two), competition and overcrowding.
Too Many Funds, Not Enough Capital
Back in 1990, 610 hedge funds managed $38.9 billion of investor money. Today, there are more than 10,000 hedge funds globally, managing just shy of $3 trillion.
A lot of fund managers, competing rabidly against each other, are crowding into a lot of the same trades, no matter what the portfolio management strategy is.
Not only are managers clipping each other on the way into trades, bidding up prices of assets they’re all chasing, they collectively get killed when they all head for the exit doors as soon as news leaks out (which they are all privy to) that some big money somewhere is exiting positions.
On Friday I’ll give you some devastating examples of how fund managers followed other managers into and then out of trades, why, and what happened. Some of these stories made the front page news, and investors are still reeling from the devastation.
Not only will I cite specific examples and name names, I’ll tell you who’s doing what now and how that’s about to wreak havoc across the entire market.
Then next week, I’ll show you where the smart money’s headed, and how you can follow it.
So stay tuned.
On a recent episode of Varney & Co., Shah stopped by to talk about what the markets are indicating about the upcoming presidential election. Do the markets think a Hillary Clinton victory is in the offing? Would they prefer a government under the direction of President Trump?
Shah described it in simple terms: a battle between capitalism and socialism.
Here’s what else he had to say…
The big three American banks – JPMorgan Chase, Citigroup, and Wells Fargo – laid out their earnings today.
We’ve been following big bank earnings all year. Back in Q1, I told you that all was not what it seemed with their earnings numbers, and why they were once again a danger to the system. And in Q2, I told that you, while analysts were saying it was time to invest in the “too big to fail” banks, they were still a risky investment.
So has anything changed? Have the big banks gotten any better?
Here’s the skinny on the big three – whether you should buy, sell, or hold – and what to do at specific price levels…
Why Big Bank Earnings Matter
America’s “too big to fail” (TBTF) banks are all bigger now than they were before the credit crisis and after the Great Recession. And they’ll get bigger unless they’re broken up or implode to a point where they have to be unwound in the next crisis.
U.S. banks got bigger (and are in much better shape than their giant counterparts in Europe, Japan, and China) thanks to the Federal Reserve.
The bottom line is all the TBTF banks were in serious trouble as a result of the credit crisis, most bordering on insolvency, if not technically insolvent by honest measures of their capital ratios and reserve requirements.
The Federal Reserve had to rescue them because they were too big to fail, meaning if they did fail, there wouldn’t be enough money in the FDIC’s rescue pool to bail out depositors in any one bank, let alone all of them, who facing failure would have seen a run on each bank as depositors withdrew their money.
What the Fed did, besides initially provide unlimited liquidity to keep the banks afloat, and as their regulator help them hide their true state of borderline and actual insolvency, was come up with a grand experiment supposed to lower interest rates to stimulate economic growth called quantitative easing.
The real purpose of quantitative easing wasn’t to lower interest rates, they were already at zero. Quantitative easing was a program executed directly with the big banks whereby they could buy massive amounts of U.S. Treasuries and mortgage-backed bonds, bidding up their prices, and sell them to the Fed for a profit. QE continued for years to generate profits for the big banks and long enough to give them time to sequester bad assets in “bad bank” divisions and offload them to speculators.
European banks got initial help from the ECB, but their QE programs didn’t start until much later and the ECB didn’t force giant European banks to offload bad assets. That’s why American banks are in good (but not great) shape, and European banks are in trouble.
Here’s a closer look at the big three…
JP Morgan Chase
Of the big three American banks, mostly associated with retail banking on account of their retail bank branches and history as depository institutions, JPMorgan Chase has fared the best post-crisis and post-Great Recession.
JPMorgan, the largest U.S. bank by assets, posted better than expected third quarter results today, setting the tone in pre-market trading for a rally in bank stocks and index futures and the market’s big up-move this morning.
Profit for the quarter came in at $6.29 billion or $1.58 per share. Analysts had been expecting $1.39 a share. Surprisingly, profit in the bank’s corporate and investment banking unit doubled from a year ago to $2.91 billion, based on higher debt and equity underwriting fees and an increase in advisory fees. Commercial banking had a 50% gain over the year ago quarter, rising to $778 million, and the bank enjoyed higher deposit spreads. Costs continued to be pared down, falling 5.9% and gains came from reducing set-asides for legal and regulatory legacy issues.
But the news wasn’t really all that good when you dig deeper. The better than expected profit at $1.58 was 6% lower than a year ago. Return on equity, an important metric when gauging an investment in a bank, fell from 12% a year ago to 10% this quarter.
The bank acknowledged their trading, corporate and investment banking upticks were based on central bank action, money market reforms, and business resulting from Brexit.
Of the three big banks whose earnings came out this morning, JPM has by far the best performing stock which has risen strongly since February’s market selloff.
Still, it’s not a buy today. That’s because it’s had a good run and is up against overhead resistance. The 52-week high for JPM is $69.06, so even if the stocks makes a new high, which it easily could, there’s not a lot of upside ahead and buying in here would subject an investor to more downside risk than upside potential.
A falling ROE, lower profit than a year ago, the bulk of its earnings beat this quarter coming from corporate and investment banking based on central bank actions (that may change), money market reform (which will be behind us in November), and Brexit, which helped all the banks pick up some revenue (but now creates an uncertain future), means the ride may be over.
If you own JPM, hold it. But use stops to protect your profits. A tight stop on the way down to protect your profits close to the highs for the company, would be $66. Below that, I’d want out if JPM falls back to $64 on account of firm-specific issues or a market selloff.
If you’re a speculator, today’s pop creates a good spot to put on a short. If you sell JPM short here, a tight stop at $70 would be an excellent risk-reward play.
Wells Fargo’s earnings weren’t good, even though they beat analysts’ expectations. They beat because analysts have been ratcheting down their estimates for two months now thanks to its cross-selling scandal. Earnings per share came in at $1.03, better than consensus estimates of $1.01, but below last year’s same quarter of $1.05.
Wells’ return on equity fell to 11.3%, continuing a drop it hasn’t been able to arrest. The bank’s highly profitable Community Banking division produced profits of $3.23 billion, down a whopping 9.5% from a year ago. And expenses as a share of revenue increased to 59.4%, way above the bank’s goal of 55%.
As if that wasn’t bad enough, NIM (net interest margin, the spread banks make on loans) fell from 2.96% a year ago to 2.82% this quarter.
Wells set-aside $805 million for loan losses this quarter, but didn’t earmark any big set-asides for legal and regulatory issues the bank’s facing in the wake of its cross-selling scandal. That scandal is going to hurt Wells on all fronts and saddles it with legacy issues that will take years to overcome and work through.
Wells is only a buy here if you’re a bottom-fishing speculator. It’s a reasonable risk-reward play to buy the stock below $45 and use a $43 stop to get out if the trade doesn’t work. Buying here provides a good dividend yield and is a worthwhile play.
If you own Wells, you might as well hold it here, for the same reason it might be a buy after falling hard on the heels of the scandal. Still, depending on your comfort level, and your time horizon, if the stock goes lower, it’s only going to get more painful.
While Wells can go a good bit lower, especially if it faces state and federal investigations that could result in massive fines, it’s not going out of business and at some point will be a good turnaround story. I wouldn’t recommend shorting it here, only because there are better short plays to make if the market falters in the weeks ahead.
Citigroup is a similar story to Wells, in that it beat expectations but still had lower year over year revenues and profits.
Citi’s trading revenue rose 16% with the help of an accounting adjustment, meaning it may have been a one-time helping hand for trading. The bank also cited Brexit as a help in revenue, but looking back at Citi’s second quarter corporate and investment banking revenues, most of the Brexit gains came then, not in the current quarter.
The bank’s stock recently broke out of a sideways pattern, which some investors might see as a buy signal.
With the bank’s return on equity at a disturbingly low 6.8%, which is down considerably from last year’s paltry ROE of 8%, and revenue down at Citi Holdings, the division that holds the bank’s “bad assets” it doesn’t make sense to buy the stock here.
Its upside might be 10%, but the risk of backsliding outweighs the upside opportunity and the stock’s meager dividend yield of 1.31%.
If you own C then hold onto it. If you’re not a long-term holder – and I wouldn’t be with that ROE and tiny yield – then get out if it falls back below $45 and find a better place to park your capital.
I wouldn’t short Citi here. There’s a small play to the downside, but not enough for me to commit my capital to a slow moving stock with limited profit potential.
Welcome to insanity, which – by a definition commonly attributed to Albert Einstein – is doing the same thing over and over and expecting a different result.
Our insanity is actually a dangerously circuitous negative feedback loop.
It’s all about “Extraordinary Popular Delusions and the Madness of Crowds,” which happens to be the title of a brilliant book published in 1841 by Scottish journalist Charles Mackay. If you haven’t read this book, you should because it provides factual, granular evidence of what happened in the past when crowds – mostly crowds of investors – went mad following popular delusions of their day.
We’re there again. Only this time the popular delusions are exponentially more dangerous and the crowds – most of the global populous – aren’t just going to go mad, they’re going to go broke.
Here’s who’s deluding us, over what, why, how they’re doing it, and how it’s going to end… and how you can save yourself from going broke.
It seems that every few months, rumors surface that the poorly monetized (for now) social media network Twitter is a ripe takeover target.
But because of the company’s failure to capture and monetize its global audience the way its main competitor – Facebook – has, it’s hard to calculate Twitter’s value. Not only is it hard to nail down a decent price per share for a prospective buyer, but it’s hard to determine just what Twitter would bring to the table.
Here’s what Shah had to say…
Last week, I told you about how the banksters at Goldman Sachs lost $1.2 billion in Libyan sovereign wealth, and how the Libyan Investment Authority (LIA) subsequently sued the Vampire Squid, citing “undue influence.”
I asked for your input – whether you sided with the Goldman or the LIA – and the story elicited more than a few great comments. (Then again, most of my reporting on banksters – and Goldman Sachs, in particular – tends to stir the pot.)
Here are some of your best comments, and my replies…
Fallingman wrote: Why anybody would deal with Goldman is beyond me. The sucker at the table is YOU, by definition. I guess that’s why they try to find rubes… uh, I mean, muppets.
SG: If everybody knew that Goldman routinely takes advantage of its clients (I’m being polite), they wouldn’t have any. But Goldman Sachs’ underbelly, it’s history, and it’s incredibly self-centered nature unfortunately aren’t common knowledge.
In fact, Goldman’s “long-term greedy” mantra, which it openly articulates to its clients (who are supposed to agree that they too are greedy) is actually an endless series of “short-term greedy” moves made at the expense of a long line of clients over a long, long history.
Maybe prospective clients are seduced by the power of one of the greatest money-making machines the world has ever known – and believe they will partake in the magic moneymaking prowess of the Midas makers. Yes, that means YOU, if you’re not aware of what the Vampire Squid is known for, you are just a different kind of sucker.
Jlr wrote: Perhaps the blame and the judgment should cut both ways in the case at hand. The LIA may only be entitled to half in refund from GS. The high stupidity on the one part may just balance the high greed on the other.
SG: I agree judgement cuts both ways, on account of the LIA being incredibly stupid in how it bet billions of dollars in the most cutthroat casino in the world, and Goldman being… well, Goldman.
But I don’t know what the LIA can be blamed for in a legal sense, and if it makes its case, it should be entitled to all of what was lost. Why? For one reason: It would send a message to banksters that shearing sheep has a season, and it’s past.
There will always be high stupidity displayed by teed-up clients, sometimes because they’re actually stupid, sometimes because they don’t want to look and sound stupid, and sometimes because no matter how smart they are, they can be made to look stupid when dealing with the geniuses of gall and guise at Goldman.
Kent wrote: If Libya “lost” $1.2B (- $350M for fees, of course…), someone made $850M, no?! Any “bets” on how much the right hand of Goldman Sachs and/or close friends kept in their pockets (I’ll reserve the left hand for the salesperson)?
SG: Kent’s comment hits a bullseye. There isn’t enough space for me to lay out how Goldman could have taken the other side of these so-called trades that were supposed to be investments, and how they could have made close to 90% of the actual at-risk money put up by LIA after they hedged out their risk.
And believe me, that’s how the Squid does it. That’s how it makes so much money “making markets” (which isn’t proprietary trading, wink, wink) for clients like the LIA lambs.
James wrote: Goldman exerted undue influence. LIA entered trades without adequate advice or due diligence. This should be a classic set-up for a decision based on contributory negligence. For how much of the bad outcome was each party responsible? It is hard to predict the result without knowing the contributory negligence rules for the court with jurisdiction. However, since Goldman was clearly giving risky advice, it is hiding behind the fact that its agent was a salesman without any fiduciary duty to the client. LIA chose nepotism and cronyism over expert management. I believe Goldman will be held less responsible than LIA based on a stronger position in law. Since both sides were sleazy, it is a rare case where justice will be served regardless of the outcome. My bet is that the undue influence charge will fail but the unconscionable bargain charge will succeed. The payout will likely be tiny compared to $1.2 billion.
SG: James, I totally agree with your assessments, all of them. You’re dead-on right. Let’s see how right you are – and how little they pay.
Bob wrote: Fining corporations is totally meaningless. Jailing the banksters and all the other corporate gangsters for a minimum sentence of 50 years without parole is the only way to eradicate those seeking, and GETTING, “Golden Parachutes!” Lock ’em up! Throw away the key!
SG: And in the final analysis, Bob hits it out of the park. Well done, sir!
Though I’m not entirely “down” with blanket 50-year jail terms or throwing away the keys, I do believe that clawbacks, firings, personal fines, permanent disassociation from the industry, and – when appropriate – jail time, is the way to go, always.