More recently, Uncorrelated Returns has gained favor. This was another smart move just in time for 2011′s results, because while returns were definitely not positive (i.e. Absolute Return wouldn’t have been an appropriate moniker) or even relatively good (since they were worse than virtually anything else you could invest in) they were definitely uncorrelated. This could be a good long term choice, because uncorrelated just means they don’t have to look like anything else you own, which could encompass quite wide set of investment outcomes.

I just came across another term though, Smart Beta. This was used (for example) in an article from last year and although there is no photo of the author’s face when he wrote it I believe it is intended to be taken seriously. Perhaps it is meant to evoke Smart Bombs, which unerringly reach their target through computer driven guidance. In fact, bombs is a useful if unfortunate connection to use in this context.

But then everything was cleared up by Zilch Capital, a hedge fund that is evidently moving quickly from relative obscurity to complete oblivion and whose latest marketing letter was kindly reproduced in the Economist. Ah well, the hedge fund industry is a soft target. As Warren Buffet once said, if you don’t kick a man when he’s down when will you kick him? They’ve tried Absolute, Relative and Uncorrelated. Perhaps it should be the Zilch Return industry.

AIMA’s opportunity now is to acknowledge the embarrassingly poor past economic outcomes for clients of the industry they promote, and to lead the discussion of how hedge fund investors might access the undoubted talents of many managers on far more equal terms than in the past. Will they be up to the challenge?

On August 8, 2011 Andrew Baker, CEO of AIMA, proudly noted on FTfm that, “Far from being disappointing, hedge fund performance has been impressive.” This was in response to an article by Jonathan Davis whom Mr. Baker accused of promoting “hoary old myths about the hedge fund industry.” Jonathan Davis was on to something, and Mr. Baker’s vigorous defence of his industry (albeit at odds with the facts) happily did not deflect Mr. Davis from shining a spotlight where it was sorely needed. Fortunately for investors he followed up a few months later with the pointed, “Do hedge funds offer value for their fees? No.”

Six months after Mr. Baker’s “…performance has been impressive” comment, AIMA is still avoiding a response that includes numbers and now lamely speculates that, “The main problem with Lack’s whole thesis is that no serious investor would tolerate for long a situation in which nearly all the returns were going to the manager and not them.” I think I shall start wearing AIMA’s criticisms as a badge of honor. Somebody ought to be promoting the interests of the clients – there doesn’t seem to be much competition for the job.

Another piece from UBS makes the case that as the U.S. reaches energy independence this will increasingly provide support for the US$. The U.S. has been an importer of crude oil for as long as any of us can remember (currently estimated at $300BN), but that is changing as new domestic discoveries are reducing the need for imports. The revolution in shale gas as well as new discoveries of oil (North Dakota now produces more oil than OPEC member Ecuador). This will eventually reduce the drag on our trade deficit of being an energy importer, and could well be supportive for the US$. Over time it will reduce U.S. reliance on the Middle East, and by reducing global trade imbalances could slow the growth of sovereign wealth funds.

Devon Energy (DVN) is squarely in the middle of this (and incidentally just reported strong earnings this morning). We also continue to like being long US$ versus the Euro. Short the Euro is a nice form of tail risk insurance. While a Greek default is still unlikely, some European finance ministers are reportedly more sanguine at that prospect should Athens fail to sign up to the latest austerity plan. Neither outcome makes the Euro attractive.

Disclosure: Author is Long DVN, EUO

So the news is mildly positive for some of those with low costs of production, such as Devon Energy (DVN), Southwestern Energy (SWN) and Comstock Resources (CRK). However, CHK is weak, since the prospect of shedding around a third of its assets when natural gas is trading at $2.50 reveals some poor financial planning by Aubrey McClendon and his team. The expectation that CHK may have to sell more liquids-focused properties is further disappointment for owners of CHK. It shows that debt is bad and low production costs vital if you’re going to earn a decent return on investment in this sector. CHK’s actions are helpful for just those types of company, but not for CHK itself.

Disclosure: Author is Long DVN, CRK, SWN

So although many commentators repeat the mantra that too much borrowing by a few profligate countries is endangering the entire Euro-zone, and this sounds as if it makes sense, I’ve never fully comprehended the precise linkage. Why shouldn’t countries in a common currency (or even cities for that matter) be allowed to borrow whatever they wish at prevailing market rates? Municipalities do go bankrupt in the U.S. (though far less frequently than Meredith Whitney once forecast). Orange County defaulted in the 1994 because of speculative interest rate bets gone awry, and nobody questioned the viability of the US$.  In 1975 the Federal government was willing to let New York City go bankrupt (although President Ford did not tell NY to “drop dead“, as is popularly believed). But at no time was there any question about the viability of the US$ or the single currency area.

So I’ve been somewhat uncomfortable with the accepted wisdom that a fiscal union is necessary for a currency union to work. Fiscal transfers do take place in the U.S. on a far greater scale than in Europe, but not in response to local deficits but to growth shocks.

Then I came across an academic paper called “Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility“. It’s quite technical and I can’t claim to fully grasp its many nuances. However, the main insight is in the following example: an Italian buying a BMW car from Germany writes a check in Euros drawn on an Italian bank. This results in a series of transactions from the Italian bank to the Bank of Italy, ECB, Bundesbank, German bank and BMW. The Italian buyer obtains his car. The Bank of Italy has a liability with the ECB, and the Bundesbank has an asset. The key point is that these balances, while they offset at the ECB, never have to be settled. Italy has been running a growing trade deficit (hence the discussion of improving southern European competitiveness) while Germany has been running a surplus (because it is already an exporting powerhouse).

Germany, through its Bundesbank, has an “asset” or claim with the ECB of 450BN Euros (as of September 2011). All the Eurozone members net out, but the imbalances have soared since the 2008 debt crisis. They are called “Target” balances, and according to the paper are obscurely reported by the ECB, only disclosed in footnotes. Germany’s loan to the ECB is guaranteed by the other Eurozone countries, but if one was to leave (say, Greece) they may default on their pro-rata share. In this way, Germany is already on the hook to its Eurozone partners for 450BN Euros (and presumably growing).

These imbalances are caused by the fiscal deficits southern European countries have been running, which is why the Maastricht Treaty imposed a 3% deficit:GDP limit and a 60% debt:GDP limit. The architects of the Eurozone payments system understood this. But the debt owed Germany by the ECB is substantial, not widely reported, and fundamental to the crisis.

In the U.S., a Texan buying a Caterpillar earth mover from a California factory would trigger the analogous payments sequence through his regional Federal Reserve bank. However, the Dallas Fed would have to settle its deficit with the San Francisco Fed within a year by transferring government securities. This critical “true-up” doesn’t exist in the Eurozone.

It’s a complex topic, but I found  Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility helpful. It helps show why Germany doesn’t necessarily want Greece to leave the Euro, and how its break-up could uncover some substantial debts. So the risk of a Euro disaster is extremely low, since it’s not in anyone’s interests. But the growth outlook is correspondingly extremely poor, which should cause the Euro to depreciate. We continue to own EUO so as to be short the Euro in combination with being long risky assets such as equities (SPY).

There were a couple of interesting articles about energy over the past 24 hours. The WSJ noted that natural gas is eating into demand for coal. Over the past three years natural gas has gone from producing 21.4% of U.S. electricity to 24.4% (coal has dropped from 48.2% to 42.8%). It’s a slow process and don’t expect near month natural gas to trade at $4 anytime soon. But it does illustrate market forces at work. In another article, Bloomberg notes that the U.S. is on its way to achieving energy independence . By way of illustration, they report that Methanex, the world’s biggest producer of methanol, is dismantling a factory in Chile and moving it to Louisiana to take advantage of cheap natural gas. We continue to own Comstock Resources (CRK), which reported earnings yesterday and expects production to be 20% oil by the end of 2012. They have minimal debt, low operating costs and while today’s low natural gas prices don’t help the company does control its own destiny and trades at a healthy discount to book value (even after taking a reserve writedown in 4Q11).

Finally, Bill Gross wrote an interesting piece on the problem with low interest rates in yesterday’s FT. He suggests that QE2 and Operation Twist are keeping long term rates so low that banks don’t see much upside in lending there. This slows down the recapitalization of the banking system that a steeper yield curve would provide. Whether he’s right that this is slowing growth or not, he’s certainly right that long term rates provide little incentive to lend. Long term high grade and government bonds are a safe way to lose purchasing power. An obscure but interesting trade can be found in the eurodollar futures curve. The spread between Sept 2013 and Sept 2014 is 35 or so basis points. The market is pricing for an increase in three month Libor of only 35 bps between 2013 (when a majority of FOMC members expect short term rates to be unchanged) and 2014 (when a majority expects them to be rising). This spread is unlikely to narrow much beyond 25-30 under those circumstances, and an upside surprise in GDP growth (perhaps led by housing?) could cause a substantial steepening in this part of the curve, straddling as it does the point at which the Fed has indicated it will start raising rates. We think it’s an interesting trade, there’s probably no need to rush into it though.

Disclosure: Author is Long PPR, BHL, CRK, EUO

It supports the case for equities over bonds. The Equity Risk Premium is wide but this type of data will cause it to narrow somewhat, as stocks rise and bonds fall. In addition, the utility of holding a short Euro position in combination with long stocks is highlighted. The U.S. economy is likely to grow 3% faster than the Eurozone this year. The $ can draw support just from the relatively better prospects here, as well as providing tail risk insurance against an economic or geopolitical surprise. Leon Panetta probably isn’t using the Washington Post to communicate policy, but the article draws attention to the closing window Israel has to set Iran’s nuclear plans back several years. While the more likely outcome is that EU-led sanctions will be allowed more time to play out, an Israeli attack on Iran is just the type of event that could derail the recovery. The US$ would undoubtedly offer some protection in that type of environment.

We continue to like Microsoft (MSFT) which has quietly broken above $30 following a solid earnings report in January. Corrections Corp (CXW) is also attractively priced – California’s state budget included no cuts in funding for private prisons which has helped the stock price of the largest private prison operator. We’ve added to a couple of natural gas E&P names lately – most notably Comstock Resources (CRK) which has $1.5BN in reserves based on its PV-10 (albeit using early 2011 natural gas prices), net debt of $700MM and is valued at $560BN. They recently announced reduced 2012 capex and expect revenues will be 20% oil by year-end. We expect them to be acquired if valuation doesn’t improve soon.

Discclosure: Author is Long SPY, MSFT, CXW, CRK, EUO

We own JCP in our Deep Value Strategy. Reading through prior investor presentations, after Ron Johnson joined but before he’d begun to communicate his vision, was underwhelming. Buying JCP back then represented an act of faith that the man who led AAPL’s retail strategy, hand-picked by Bill Ackman, could perform some magic on a dowdy retailer. Looking like the late Steve Jobs without his trademark black jeans, Ron Johnson provided plenty of reasons to get excited about owning JCP.

Transforming the company will take several quarters to even begin to show financial results. No doubt there are enormous differences between selling AAPL’s proprietary products, and changing retailing while your competitors watch and quickly emulate your best ideas. But in the meantime, the bear case will have to survive without the benefit of disappointing financial results to shake out the bulls. And it’s not hard to imagine hope and a little reflected stardust from Ron Johnson’s prior employer adding some rocket fuel. Our JCP holding is an investment, and the upside is sufficient that we’ll likely hold it for a long time to see how the story plays out. Although JCP’s earnings multiple is high, it trades at 0.5 X next year’s consensus revenues compared with 0.55 for Macy’s (M) and 0.64 for Kohl’s (KSS). There seems little point in being short JCP at anything less than industry revenue multiples. Nordstrom (JWN) trades at 0.97X. As of Dec 30,  20% of the float was short, and those must be weaker hands than many of the longs. For now, the bulls are in charge at JCP.

Disclosure: Author is long JCP

The industry kept 98%. Bloomberg presented a version of this chart on TV this morning. Hopefully the message is getting across. It’s not that there aren’t some great hedge fund managers out there – of course there are. But investors need to do a far better job of negotiating terms that allow them to share in that success.