The Fed and The World Wide Food Riots

With the Fed holding a two day meeting they have an opportunity to discuss things at length and topics that they may not have the time for when they hold a one day meeting. Which temporarily brings me to another point - that the Fed should hold two day meetings all the time as the one day meeting from my perspective seems to be a bit hurried. I will have to look at that another day as today I wanted to mention that the Fed may be able to discuss the food riots that have occurred during the past couple of months. What do the food riots have to do with the Fed? Well the Fed is the steward of the US dollar (even if the US dollar is officially the Treasury's territory) and since the Fed has slashed rates so much the dollar has been in rapid descent. The lower dollar has caused many commodities which are priced and traded in US dollars to march higher. These higher costs have been passed onto the consumer and often to the consumer in foreign countries whose populace receives low wages. This has caused food riots. A terrible situation and my heart does go out to those who are suffering. Amazing though how the Fed's lower interest rates have led to food riots half way around the world. We live in a very inter-related world, actions here can be felt around the world and vice versa. Members of the Fed are aware of the problems and some in recent days have turned rather hawkish. Today's meeting and the Fed's communique that follows will be all the more interesting because of these factors.

The Bouncing $ - Another Prop Removed From the Manhattan Housing Market

With the dollar taking off in recent days, albeit from extremely cheap levels, the high end of the Manhattan Real Estate market may experience a pull back from the foreign buyer, especially from the European buyer. The European high end purchaser has feasted on the Manhattan condo market for the past 4 years due to a combination of rising apartment prices and a sliding US dollar (especially vs the Euro where it has been killed during the past 5 years or so). With apartment prices in Manhattan already sliding and the dollar rallying, the European high end buyer will likely be giving second thoughts to buying any future Manhattan apartments.

Q1 2008 GDP - My Guess = -0.5

The Q1 GDP first estimate will be released this week. From Yahoo Finance I picked up the following:

Briefing Forecast: +0.7

Market Expects: +0.4

Prior #: +0.6

Important to note that these are annualized numbers (so they were multiplied by 4). I will throw my hat into the ring and say that the GDP Q1 2008 will have shown a decline.

My Guess: -0.5 (Made on Sunday April 27th)

I only am going off of the earnings reports that I have followed and the economic reports I have followed for the quarter also a ton of anecdotal information in the NYC tri state area. I talk to everyone when I buy something and here around New York City businesses all tell me that things have fallen off pretty hard. On the positive side there are the agricultural commodities and the boom in infrastructure related equipment related to commodities. Also the tech sector was very strong as Google, Intel and others said they have not any pull back. So a large propeller will be the exports. Starbucks has felt the consumer retrenchment though as the ultimate discretionary item moves lower on the list of consumer must haves. In combination with a weak dollar the exports really helped the economy out. Locally here in the US though the consumer was getting beaten around from all sides as the Bear Stearns storm hit, the employment picture sharply weakened and wage growth was weak.

The Fed's Bag Of Tricks

The Federal Reserve meets this coming week. The Fed's interest rate cuts may be only slightly helping the borrowing problems that exist in the economy. This is occurring because liquidity in the credit markets continues to dry up. This dried up liquidity has been caused by loss of confidence from the lenders. Who are the lenders that have loss confidence? And why are they snake bit? In this case the lenders are all of those entities all over the world that participated in the securitization process during the past 5 - 6 years or so. The lenders are snake bit because their loans that they owned decreased sharply in value and large losses were taken. So now they have become more careful. Also they have less capital to give because of the large losses they have sustained already. This brings me back to the Fed. The Fed sees the problems and they know that until the log jam from the credit markets breaks free that the system will not be able to be fully repaired. They know that further interest rate cuts may not help much if at all. Maybe the Fed will come up with some other weapon to work on the credit market problems or maybe the Fed will revert back to one of its other weapons that seem to have given it some traction. Those special auctions seemed to have helped get the Fed some traction. what will they come up with this time?

The WSJ on Friday mentioned that some credit spreads have come down. Notably the junk bond spread which had been up at 9 points fell back to the 7 - 7 1/2 points. They note though that this spread is still way above normal levels of 2 points or so. Another part of the credit markets that I have observed more closely is the Ted Spread. I have both the WSJ and Bloomberg TV to thank for pointing this out - that the Fed watches the TED Spread very very closely. The bottom line - TED under 0.50 is normal, TED above 2.0 is very worrisome, and in between is well in between. What is interesting is that the TED Spread has not stayed this elevated for this length of time since the 1987 crash. It currently is around 1.56.

Why Did An Institution Buy 10,000 Call Contracts on AMR

Today's Wall Street Journal had a blurb in their Option column on AMR. They reported that an institution purchased 10,000 contracts at about 2.60 on the January 2009 7.50s. This is a $2.6 million bet. For the purchaser to make money on these contracts the stock would have to get over 10.10. The big question is why did this institution make such a large bet?

I will put some possibilities out, but they are really guesses:

- The institution believes AMR will get taken over.

-This is not a bet but rather a hedge to offset a large short position in AMR.

- The institution believes the business is going to soar and that profits will follow.

- The institution believes that fuel prices will collapse.

Lets say for a second that this institution is not making this bet to hedge a position. In this case the belief that the stock would go up must be so strong that this size bet was deemed reasonable. Maybe a hedge fund who has come upon a thesis that seems likely to happen. Very interesting.

* Note I do not have a position in AMR but may take on at any point. I also may decide to not do anything. I am not aware of any position that the firm I work for has.

The Advantages and Disadvantages To A 130/30 Hedge Fund

Not long ago I attended a presentation at Columbia University that included a discussion on Equity Hedge funds and the percentage allocations that are popular. One of the popular allocations seems to be the 130% Long 30% Short fund. So what does this type of fund attempt to accomplish? A close examination brings to light some interesting observations.

First, what does this 130/30 break down mean? It may be easier to first look at a 100% Long only fund. A 100% Long fund means that every dollar of the assets is invested in equities. For example, if the fund had $10 million in assets, then the fund would own $10 million worth of equities (as close as reasonably possible, less commissions). Let's move from the 100% Long fund to the 130/30 fund. This fund would use leverage and would increase its Long exposure by 30% and initiate a Short position of 30%. If the fund had $10 million in assets, the fund would own $13 million in equities and simultaneously be short $3 million in equities. The leverage in this case would be 60%.

Another way to look at the 130/30 fund is to back out the leverage for a moment. In this case the fund would be 81.75% Long and 18.75% short. This is the same ratio as the 130/30 fund. The 130/30 fund is just an 81.75/18.75 fund on steroids. The important question is why do such an elaborate percentage as 130/30? If the fund is really an 81.75/18.75 fund in disguise why not just make the fund 81.75/18.75? The first reason is the potential for increased return. Instead of using only 100% of the assets, by using 160% of the funds assets the fund manager is levering the portfolio and therefor increasing potential returns. There is tremendous upside potential with this type of leverage. For example in a down market, the upside exists if the fund manager is able to pick longs that decrease less than the market and or pick shorts that go down more. If the fund managers wits exactly match the market then the fund will match the market exactly. The market and the fund will move identically.

However there is potential risk as well. The largest risk is that the extra 60% leverage goes against the manager. For instance in a worst case scenario lets say that the manager made poor picks. In this case the 130% Long positions decrease in value and simultaneously the 30% Short positions decrease in value (as the stocks the manager is short go up). Let's say that the longs go against the manager by 20% and the shorts go against the manager by 20%. The $10 million fund would drop to $6.8 million for a drop of 32%. If the fund had not used any leverage the fund would have only lost 20% and the assets would have been $8 million. In this case the manager would have been better without the leverage.

Tread carefully when using leverage. I have seen my fair share of problems arising from too much leverage and returns can definitely increase when used properly. Again it all comes down to risk management. Make the positions too big and your problems could cascade. Even if you think you are 100% Long via a 130/30 fund if there is a problem such that the extra 60% margin is really neutralized reality may be completely different if both the longs and the shorts go against you. In that case, action should be taken to lower the leverage and quickly.

The Dollar Strikes Back

Good to see the US dollar flex its muscles. In the short run the direction of the dollar will depend on the Fed. The strength of the economy and the rate of inflation will also factor in. Over the longer term the dollars position in the world will depend on the deficits it runs.

I am still a believer that the US is will be in the throes of a deflationary spiral and that the early stages of a deflationary spiral exist and can be seen through the housing market. However the deflationary run although deep in the housing market has not yet begun for either of two reasons. One: I am plain wrong and deflation will not spread from the housing market to the rest of the economy or two: My synopsis was just early and deflation has not made its way through yet. I am not sure of the answer but still believe deflation is coming and I was just very early. I think another sign to look out for will be the local and state governments and their budgets. If the state and local tax revenues fall off precipitously these local governments will be forced to do one of two things. They will either have to find a way to raise more revenues which likely means higher taxes or two they will have to make cuts to their budgets. Neither of these scenarios are of the pleasant variety. If deflation does take hold expect to see the dollar g on a tear and the model Giselle may then wish to rethink her wishes to getting paid in Euros.