Ireland & India {An Update}

Earlier this year I posted some positive comments on Ireland (March 15-17, 2006) and was cautious on India (see March 3, 2006 and May 22, 2006). The proxy I use for Ireland is the New Ireland Fund {IRL}. It has gained 13% since March. The proxy I use for India is the India Fund {IFN}. IFN has lost 24% of its value since we first wrote about it and it is 33% off of its May highs. India was widely over-hyped as an investment early in the year and nobody talked about Ireland. Enough said.

*Lumen Capital Management has no positions in the New Ireland Fund. One client owns shares in the India Fund.

Sell In May

An old Wall Street dictate is "Sell In May & Go Away". Actually most years it has paid to sell in the March-April time period. A seasonal period of spring weakness is a well documented part of the yearly market cycle and if anything has become more pronounced in recent years.

I bring this up today because all of a sudden the world seems to be discovering that the market has had a pretty good August (albeit on lower than normal volume). However a simple glance at most charts show that stocks have rallied from their summer lows and have basically made it all the way back to where they traded in early May.

Above is a chart of the proxy I use for the S&P 500 (the SPY ETF). From it's May highs to it's mid-June lows the S&P 500 fell close to 8%. It has spent most of the past 6 weeks in rally mode and is now is now only slightly below its May 10 close. At this point stocks are very overbought. We are also now about to enter a statistical period (September-October) that has traditionally been the worst part of the market year. As such my opinion is that a more cautious approach is warranted for the next several weeks.

Caution does not necessarily mean to head for the hills. The market might fool us all and go straight up this year. It could be for example that investors' belief that the Fed is done raising interest rates will trump seasonal patterns in 2006. Or the possibilty of significantly lower oil prices might cushion any autumn decline this year. Both examples would show a stock market doing what it has to do to prove the most amount of people wrong.

However given the recent rally in stocks and the overbought current state of the market, prudence dictates a more cautious approach for the time being.

*Long SPY in various client accounts.

The Great PE Compression

The folks at "Chart of the Day" do a great job reducing statistical concepts to pictures. Every Friday they publish a free chart to the public. Today they discuss a theme familiar to our clients about Price to Earnings multiple compression.

"Today's chart illustrates that the recent growth in earnings has led to a significantly lower PE ratio. In fact, the PE ratio is currently within the confines of a tight and very steep downtrend. So while the significant earnings growth of late is a plus, the market does not appear willing to pay more for each dollar of earnings."

You can see the illustration of this posted at http://www.chartoftheday.com/20060825.htm?T

Late August Market Recap {Summer Rally}

With nothing on the economic front, investors seemed this week to focus less on if the economy will slow down and more about the ramifications for stocks if the Federal Reserve is finished raising interest rates. The Market's response was to stage a sudden and dramatic rally over the past three days, albeit on less than stellar volume. Stocks are currently very short term overbought.

I expect the markets to become basically a snoozefest until after labor day as most of the East Coast investment community will take most of the next two weeks off.

There may be some fireworks after Labor Day. Should be interesting either way.

One More Thing About Summer

One last thing to keep in mind is that we are entering statistically one of the seasonally weakest periods for stocks. I ran a quick screen today using Worden and the data shows that the average return for the S&P 500 over the last 4 years August-September was -2.48%. Thought you'd like to know.

Summer Doldrums

Not only do stocks have to contend with the issues described in my last post but they also have to deal with perhaps their greatest summer enemy-inertia. The markets traditionally make less headway between now and Labor Day as much of the investment community flees en-mass to their various watering holes throughout the nation. I too will be flying tomorrow away tomorrow to Rhode Island for the next week. I will be working via my laptop but expect posting to be light during this time.

Fed Reaction

Well the market sold off yesterday after the Fed pause. No surprise there. After a good start to the trading morning investors seem to have second thoughts on the double impact of rising energy costs and slowing economic growth.

Persistent interest rate hikes have had a choke hold on equity valuations for almost two years. The reason for the pause, slowing economic growth, means that the Fed feels pricing pressure will ease even without more rate hikes. A slow growth environment helps with the inflation issue but stocks will continue to be pressured if companies start to report lower than expected arnings growth.

A slowing economy has the potential to present plenty of obstacles for stock price appreciation and it will be particularly important to focus on sectors that are less susceptible to the business cycle.

Going into yesterday the market was short term overbought by my indicators so some of what we are seeing should not be all that surprising.

Fed Day-Interest Rate Pause?

Today is Federal Reserve Interest Rate Decision Day! (D-Day). By an overwealming majority, market pundits think the Fed. is going to pause today. Stocks may have already anticipated this in their run up over the past several weeks. Indeed by our analysis the market is near term overbought. This could generate a "sell the news" reaction later today. Meanwhile in the be careful what you wish for the folks over at "Ticker Sense have analysed what happens after the Fed. signals the all clear in the rising rate department. I reprint their analysis below.

Re-Post - Fed Pause Good For Stocks?

In our newly released study, The Inverted Yield Curve ~ The End of The Cycle, we analyzed prior Fed rate tightening cycles since 1962. Among our findings was that in the period spanning the Fed's last rate hike to its first cut (average span of six months), the market has an average decline of nearly 7%, and has only risen during two of the nine periods. In the chart below, we created a composite chart of the S&P 500's performance during the 'limbo' period of Fed tightening cycles.

You can find the link here. http://tickersense.typepad.com/ticker_sense/.

Hedge Funds-Two Other Things.

On Hedge Funds a couple of clarifications. I actually like the hedge fund approach if it is set up in a proper manner, particularly if it has a well thought out investment methodology, pays strict attention to not losing money and uses a limited amount of leverage. I also like hedge funds when I know something about the principals of the firm. The reason I like this type of investing is that when it is performed in its intended form it does align investors and their managers. Investors want to care more about absolute performance and most investment models (read mutual funds) are not set up with this metric in mind.

Also I want to stress that I was not trying to pick on Mr. Healey in my post of yesterday. Like I said then I have no idea what kind of investor he is nor do I know anything about his firm. I used that part of the story to illustrate the risk and rewards of that business. Again I will stress that from what has been reported most of what it cost to bring Sting to Narragansett went to charity.

Hedge funds however can be disastrous when attention is not paid to risk. Doug Kass over at Street Insight discussed this particular subject today. I will share some of what he wrote.

"I have long felt that the hedge fund industry is taking uncommon risks for common returns. In its extreme was Long Term Capital Management, a hedge fund that routinely leveraged its capital over 50 times and failed in 1998. Today, many of the largest hedge funds (and some not so large!) leverage their capital in order to compete in a market that, although it is displaying increased volatility, shows little net progress. The hedge fund industry's dirty little secret is that it has morphed away from its origin of stock picking (A.W. Jones) in favor of becoming nothing more than levered capital pools, or mini Long Term Capital Managements. As such, with so many hedge funds searching for the same alpha (excess returns) and correlated to the same markets, a rapid decline in worldwide equity prices could snowball in the same way that portfolio insurance exacerbated the stock market debacle of nearly 20 years ago." *

Kass should know of what he speaks as he is a Hedge Fund Manager himself. Kass also believes that massive hedge fund redemption will be the third and final leg of a bear market which he believes we are already in. I do not believe that we are in a bear market and see no evidence of massive redemption from hedge funds.

*Profiling the 2006-2007 Bear Market, Doug Kass, Street Insight, 8/7/2006 8:16 AM EDT.

The "Sting" of Hedge Funds.

Two events got me to thinking about the hedge fund Industry over the weekend. The 1st was a party thrown in Narragansett, Rhode Island by hedge fund manager Joseph Healey who had the British musician Sting play for his guests for his 40th birthday party. Mr. Healey invited over 200 guests to the party but he also fixed the stage so that Sting played to a sizeable free crowd out on the Narragansett beach. One of the folks soaking in the free music on the beach was me. You can read about the concert here: http://www.projo.com/news/content/projo_20060806_sting6.1eede32.html. Sting was great by the way. He played many of his well known songs as well as some old Police tunes.

The 2nd event was the closing of a well known and well respected energy hedge fund at the end of last week. Motherrock Energy Fund was run by an ex-Nymex president who by all accounts was well regarded in his business. Bloomberg broke the news on this here http://www.bloomberg.com/apps/news?pid=20601109&sid=a2RV_7_smzJ4&refer=home at the end of last week.

Now first for disclosure Lumen Capital Management, LLC runs a small private fund which is not open to new investors. Also this is not an article set to bash Mr. Healey or the Hedge Fund business. I don't know Mr. Healey, cannot say what kind of investor he is or what kind of returns he has generated for his clients. I will also note that most of the money Mr. Healey shelled out for this concert is reported to have gone to charity and he certainly made an effort to enable the beach goers to hear the concert. The only comment I want to make is that most 40 year olds in this country do not have the money to have Sting come sing at their birthday parties.

But that is the nature of the Hedge Fund business where the potential to take what is a standard 20-40% of the profits of the fund has the potential to force its principals to take exponential risk. Often the way these funds are set up so that it is head the principals of the fund win, tails the investor lose.

Take Motherrock for example. Bloomberg reports that the fund had more than 400 million dollars in customer assets earlier in the year and made 23% on it's customers money last year. If say for example the fund had average assets of 300 million dollars all of last year it's principles earned almost 14 million dollars . Here's the math ($300 million X 23%= $69,000,000. Assuming the principal's of the funds take is 20% of the profits that means they split $13,800,000.) In case you are wondering the expenses of the fund would have been charged against the 1% management fee that the fund would have charged its investors in this case another $3,000,000.

Now to further the Motherrock example, Bloomberg also states that this year the company is shutting down its doors because it has lost 23% this year. The investors who made 20% last year on their money have given all of that back plus more. Also in case you are wondering, unless there is something atypical in Motherrock's documents, the principals of the firm aren't required to give back any of what they earned from the fund last year unless they do so voluntarily or can be forced to do so by a court which is a very hard proposition to attain.

Now in theory what is supposed to keep a hedge fund working for its investors is something called a "Highwater Mark". The highwater mark usually states that once the fund suffers a drawdown-that is once a fund declines below last year's close- the principals do not get paid again until the fund gets back above last years reported amount. So if on the $300 million above stated example Motherrock had lost 23% or roughly 69 million dollars then the principals could not be paid again until they had again moved above their "highwater mark. This in theory should keep the manager's interests aligned with the limited partners. It often doesn't. The math works against the fund. A fund down 23% like Motherrock has to earn back 30% just to get back to break even. Often when faced with these sort of odds the principals of the fund just close up shop.

Now here is one of the dirty secrets of the investment business. If as a principal of a fund I have an investment structure that absolves me of most liability from loss via an offering memorandum, if I'm pretty smart in the risk assessment area, if I am willing to use leverage (sometimes a lot of it via margin), if I get lucky and if my markets treat me right I might be able to generate those 20+% returns. I might be able to do it for a couple of years. But I might not be able to do it forever. If I can't and particularly if I'm using leverage the losses can be overwhelming. Often many years of gains evaporate in a matter of months.

Sting quit playing the other night to a thunderous applause from us on the beach. Investors in hedge funds when things go brutally wrong often don't feel like clapping.

July Scorecard

Market Results for the month of July, 2006. (Results do not include dividends.)

Dow Jones Industrials .32%
S&P 500 .58%
Nasdaq Composite -3.71%
Russell 2000 -3.32%

Source: Data courtesy of Q-Charts. Lumen Capital Management, LLC reports this information as a courtesy and is therefore not responsible for the accuracy of this content.