Today I was invited back on Business News Network, Canada’s answer to CNBC. The presenters are charming and somehow always like to get me on when natural gas prices are plummeting - as if we haven’t noticed! But it did give me the opportunity to talk about Range Resources (RRC), one of our larger holdings in the sector. Last week RRC held an investor dinner to which I was invited. It was great to discuss their business in an informal setting, and while naturally nothing of a non-public nature was disclosed, it did reinforce my feeling that CEO Jeff Ventura leads a capable management team that’s hard-working and straight. Whether or not RRC really will ultimately access 60 Trillion Cubic Feet of natural gas, I assess that Jeff Ventura sincerely believes they have that much. It’s the upside case to be sure, but at $9BN in market cap with a solid, simple balance sheet they represent an attractive investment in the developing natural gas story.  We are long RRC.

Last night’s event organized by Catalyst Financial Partners was a great success. I was paired in a debate with an old friend Peter Fell, with whom I traded interest rate swaps back in the 80s when we were both at Manufacturers Hanover Trust (Manny Hanny). The question posed was “The Eroding Profitabilty of Hedge Funds”. Peter (now with Kenmar) gamely took what I felt to be the much harder side (i.e. defending the hedge fund industry) and it was capably moderated by Brenda Mauro of Trident Fund Services. Peter was not distracted by the autographed copy of my book that I shamelessly thrust into his hands moments before we began, and while there may be varying opinions on the future of hedge funds most would agree that investors will need better terms and results if the industry is to prosper.

Today KPMG released a report on hedge funds in partnership with AIMA, the UK-based hedge fund lobbying group. They evidently felt moved to set the record straight after the relentless battering hedge funds have received in the financial media of late. I am grateful that they have made such an effort – it’s given me something to write about.

On Monday I shall be taking part in a debate on this topic on Monday evening in NY with my friend Peter Fell, from Kenmar, at The Harvard Club. I am looking forward to the opportunity to discuss with other investors how hedge fund clients might improve upon the frankly abysmal results that the industry has delivered. Fees, lack of transparency, gates and other elements all combine to ensure that whatever profits hedge funds generate are taken up in fees.

Investors deserve far better than they have received, and I’m looking forward to an entertaining and lively discussion.

Chesapeake (CHK)  has long been the flag bearer for the natural gas industry. Aubrey McClendon has been front and center in making the case for shale drilling and the abundant natural gas reserves it is revealing. To many this is a game changer for U.S. energy consumption.

Aubrey McClendon has also shown a tendency to get over his skis in terms of his own risk profile, most notably in 2008 when personal loans he had taken out to buy CHK stock almost bankrupted him. In 2008 he was the highest paid CEO, earning $112MM which was intended to offset somewhat the $1.9BN he lost on leveraged holdings of CHK stock as it sank from $74 to $16.52 where he sold most of it to meet a margin call. For this reason, while we are bullish on certain natural gas E&P names, we long ago concluded that Mr. McClendon risk appetite wasn’t the same as ours.

There’s little doubt he’s a big believer in natural gas. But Aubrey’s not content with owning 3.25 million shares of stock; he also has an unusual deal that allows him to personally invest in individual wells that the company drills. It now turns out that he has taken out $1BN in personal loans top pay for these stakes. This is described by their general counsel as “aligning his interests with those of other investors” according to an article in the FT. Well, I guess so, but why not use that cash to buy more shares in CHK? By cherry picking amongst the assets CHK owns, he creates at least the potential for a conflict of interest and certainly the appearance of one.

It reflects on Mr. McClendon’s tendency to push risk to its limits. The fact that the company didn’t reveal the loans necessary to finance his purchases until reported by Reuters doesn’t help, and is contributing to today’s 5% drop in the stick price. But there are plenty of other companies to choose from that are run by less accident-prone managements. If CHK stock doubles because of positive developments in natural gas, other names in the sector will do well too. But CHK investors bear additional risks specific to the company for which they’re not obviously rewarded. Why provide capital to CHK by investing in their stock when their CEO shows such questionable judgment?

Managing tail risk is a constant worry for any investor using leverage, and many others who shouldn’t worry since they’re not levered also fret over the possibility of a market swoon. It’s a real dilemma; low risk assets such as government bonds offer no return at all unless a flight to quality drives prices temporarily higher. Risky assets such as equities are attractively priced as long as (take your pick) (1) housing doesn’t turn down, (2) Spain doesn’t need a bailout, (3) Israel doesn’t bomb Iran. As someone once said, you can have cheap markets and safe markets but not both at the same time.

Buying equity put options can afford some protection but of course the option premiums will eat into the return. Long stock with a put is equivalent to a long call, and buying call options isn’t generally a reliable way to build wealth. We started looking at using a short Euro position last year in combination with risky assets. The logic at the time was that most of the bad things that could derail the market were likely to begin in Europe. While that’s not as obviously the case today, it can still represent an attractive way to combine risky, yield generating assets (such as bank debt) with a market hedge.

The 90 day rolling correlation between the S&P500 and the Euro has moderated from its high levels in the Fall when the Euro crisis dominated the news. However, while day-to-day moves are fairly independent of one another, the Euro reliably drops when stocks are notably weak. Over the past year, the Euro fell 69% of the time when the S&P was down 0.25% or more. Falls of 0.5% or greater saw a weaker Euro 90% of the time.

The U.S. is likely to experience GDP growth of 2.5-3% greater than the Euro-zone this year. The focus on austerity as the solution to Europe’s excessive debt makes a weaker currency in their interests as a way to stimulate some demand for southern European exports. So a short Euro position is probably the path of least resistance barring another crisis, but in addition it provides some tail risk protection for holders of higher yielding assets.

 

Investors are living in a time of unprecedented openness by the Federal Reserve. Many readers are old enough to recall the days when “Fed-watchers” would seek to divine the central bank’s intentions on monetary policy through its open market operations. If managing reserves, and therefore indirectly the cost of short term financing through the Federal Funds rate, required that the NY Fed conduct a “System RP” and they instead provided somewhat less overnight funding through a “Customer RP”, bond traders would immediately interpret an intention by the Fed to raise interest rates and react accordingly. It was subject to all kinds of communication problems – sometimes the Fed wasn’t trying to say anything, but Wall Street analysts had got their reserve requirement Math wrong and thought they heard a warning of higher rates. Then the Fed might oversupply short term credit the next day, in order to correct the mis-communication. Somehow this obscure back and forth of action by the Fed followed by reaction from the markets was state of the art central bank communication back in the 80s and 90s. It all now seems so quaint and pointless at the same time. The Fed under Alan Greenspan, following custom, deemed plain English unsuited to its purpose. And Greenspan himself took evident pride at his ability to provide long Congressional testimony using tortured erudition that shrouded monetary policy in a fog and left senators befuddled.

Ben Bernanke has continued a new tradition begun in the latter Greenspan years of communicating quite plainly. Opinions are easily formed on this Fed, because their intentions are so clear. There’s no more hiding behind obfuscation. The conduct of monetary policy takes place right out in the open. FOMC minutes are released in a timely fashion; Bernanke holds “town halls” to discuss monetary policy, goes on “60 Minutes” and the Fed now actually tells you, with a fair degree of precision, where they think interest rates will be.

In January, the FOMC released short term interest rate forecasts from all 17 FOMC members. From the published data, it’s possible to construct the Fed’s own yield curve. A long term interest rate is simply the sum of all the short term interest rates from which it’s constructed. Libor rates are visible and can be hedged out to ten years through eurodollar futures. In aggregate they form the ten year swap rate. The ten year swap rate is closely tethered to the ten year treasury yield, which is largely set by the Fed’s Operation Twist and its predecessors, QE 1 and 2.

The chart overlays market forecasts of short term interest rates, derived from recent eurodollar futures prices less the typical 0.3% spread to the Fed Funds rate (the blue bars), and compares it with the FOMC’s own interest rate forecast (the red line). It assumes the FOMC expects to return to its equilibrium 4% interest rate in five years.

The Fed expects to raise short term rates by the end of 2014. They expect them to go up by 0.5% between the end of 2013 and 2014. Quite recently, the market forecast for Libor rates was that they’d increase by 0.3% during this time. Futures markets didn’t expect as sharp an increase as the Fed. Of course, the Fed is only making a forecast, and it’s based on GDP growth, inflation, unemployment and many other variables. Their forecast for these might be too optimistic. But when you ponder for a moment the actions of those bond investors who would accept market interest rates as the basis for their purchases, it’s quite bold to insist that buying bonds at yields below the Fed’s expected break-even is a sound move. They are telling you, if you’ll just listen, that short term rates between now and 2022 will average more than the current yield on a bond maturing at that time. The Fed’s forecast may be wrong, but their forecast is obviously a bit more important than yours or mine.

The long end of the yield curve is similarly fascinating. The FOMC’s long run equilibrium rate is 4%. This is where they believe short term rates will return when the Great Recession of 2008 is a distant memory and the economy is chugging along at whatever rate it can just short of causing inflationary pressures on wages and other inputs. The FOMC doesn’t say exactly when things will be back to “normal”. Of course, we’d all like to know. The chart above assumes five years. But the futures market has a different opinion on when that will be, and the answer is March 2022. This is how far out in to the future it’s necessary to go in order to reach a eurodollar futures contract that yields 4%. Everything prior to that date yields less, because investors in aggregate believe the economy won’t quite be back to normal. Or at least,
that’s what investors are saying by their decisions to invest, or not, at prevailing yields.

If Bernanke testified before Congress that we still have another ten years to go before the “extraordinarily accommodative” monetary policy was no longer needed, there would be outcry. He would probably be fired, or even impeached. Further fiscal stimulus not even imaginable would no doubt be contemplated. Big things would happen.

Except that he wouldn’t say that. Although he hasn’t put a date on normalcy’s return, everything about his actions and those of his colleagues on the FOMC strongly suggests they are not nearly that pessimistic. Futures markets are pricing in ten years because the Fed has put them there through their buying of treasuries. 61% of net U.S. Federal government debt issuance was bought by the Fed last year. The Fed is maintaining bond yields at levels far lower, perhaps 1-2% lower, than the likely break-even on short term rates over the same period.

This should be plain to anybody paying attention to the Fed’s communications. It doesn’t necessarily mean ten year treasuries at 2.2% and related corporate bonds at modestly higher yields are guaranteed to lose money. It may take us more than ten years to reinvigorate the economy, to fully repair all the damage excess debt has wrought over the years. But it is obvious that the Fed thinks today’s bond yields are a poor investment. That is a clearer expression of its opinion from the central bank than many of us are used to, and shows how far we’ve come since the old days of Fed watchers.

We continue to think equities are attractively priced, although obviously not as cheap as they were in the Fall. The Equity Risk Premium, the difference between the earnings yield on the S&P 500 and the yield on ten year treasuries, has narrowed modestly from where it was in September, mostly because the strong rally in stocks has driven multiples higher and earnings yields lower while treasury yields have drifted higher. However, this relationship is still historically wide.

But on interest rates, we believe in siding with the elephant in the room. If last year’s buyer of 61% of treasuries thinks yields are too low, that sounds like a view worth respecting. Investors can own a combination of equities and cash divided according to their risk appetite and outlook. But long term bonds, both government and investment grade corporate, are clearly at yields intended to lose you money. The world’s biggest buyer is telling you so.

One day, probably in the not so distant future, Spencer Jakab of the Wall Street Journal will probably regret suggesting that natural gas prices may go negative, as he did in today’s article “Why Natural-Gas Prices Could Fade to Red”. It’s an attention grabbing headline, but is likely to be better known some time in the future when natural gas has bounced and Mr. Jakab’s piece comes to be remembered as the time when the very last sellers showed up on the scene.

And of course natural gas fundamentals over the near term continue to look extremely poor, with a warm winter reducing the need to restock inventories during the shoulder months. Owning natural gas futures has been a terrible trade for anyone foolish enough to speculate that way, and there’s no near term bounce in sight.

But it’s not clear why anyone would pay to give away natural gas. It can be flared off or simply not produced if prices are unattractive. There’s also growing evidence that its cheap price is drawing utility demand for electricity generation while at the same time depressing demand for coal. In fact, the long term outlook is revealed by Kinder Morgan’s strategy (KMP). Their acquisition of El Paso (EP), expected to close in 2Q12, adds an extensive network of natural gas pipelines to KMP’s existing network as can be seen in the presentation they published when the acquisition was announced. Kinder Morgan expects increased movement of natural gas.

And KMP is expecting increased exports of coal as domestic demand wanes.

Meanwhile, investing in companies drilling for natural gas hasn’t been nearly as painful as being long the commodity itself. Range Resources (RRC) for example, over the past twelve months has matched the return on the S&P500 (although it’s been more volatile). In round numbers, 5 TCFE (Trillion Cubic Feet Equivalent) of proved reserves provides a solid base for its $9BN market cap (if they earn $1 per MCF that’s worth $5BN) and they have ten times that in potential reserves. Their manageable debt (less than $2BN net of cash, or 45% of their total balance sheet capitalization) and low production costs means that the equity holders are unlikely to lose the company to the debt holders. Their increased production of NGLs (natural gas liquids) generates cashflow from an area with more buoyant demand. Owning operating assets, or equity in operating companies such s RRC is far better than going long the futures.

So remember today’s WSJ story – although Mr. Jakab does point out that in the long run low natural gas prices will create their own demand and likely selfr-correct, the article’s headline will almost assuredly be worth revisiting at some point in the future.

I have been invited to give the Keynote Address at this industry gathering in June. I am looking forward to the opportunity to meet with hedge fund industry professionals and discuss how investors can achieve better results than they have in the past.

My thanks to Hank Greenberg for revealing an example of what’s wrong with some areas of Finance. The VelocityShares Daily 2X VIX Short-Term ETN (TVIX) is an exchange-traded note issued by Credit Suisse. Its travails and those of its investors are well covered elsewhere. It’s been a bust, as befits a vehicle designed to provide leveraged exposure to movements in the VIX (an index of S&P500 volatility). The idea that taking positions in the VIX has any utility to begin with is emblematic of the misplaced focus on using leverage to increase returns and then hedge temporary adverse market moves. It doesn’t help move savings to productive types of capital formation, but is instead part of a big casino.

But that is a point for another day. I am reading from the TVIX prospectus, as pointed out by Mr. Greenberg, the stunning disclosure language:

“The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.”

Now this is legal. The SEC apparently pointed out to Mr. Greenberg that they don’t approve the investment merits of securities issued. But what about Credit Suisse? How do they get comfortable issuing a security to the public that they believe will go to zero? Where’s the judgment? What is the point? If you sell a two-legged stool to customers with a warning that they’ll fall off, does that absolve you of responsibility? If you’re a private banking client of Credit Suisse and have entrusted your wealth to them, are you supposed to ignore this window into their values?

Credit Suisse has not broken the law. TVIX represents one element of their activities in the strange world of finance. It is part of their brand. They should be judged accordingly.

Today’s story in the NY Times about Marc Cohodes recounts a poignant tale of the fall of a formerly highly regarded hedge fund manager. I wrote about Marc Cohodes in my book, The Hedge Fund Mirage. A perennial bear and manager of a short-selling hedge fund, 2008 should have been the year he made a spectacular amount of money. Instead, as the NYTimes tells and as I wrote in my book, triumph quickly turned to disaster as the stocks he was short inexplicably rose strongly when everything not nailed down was being thrown overboard by panicked investors.

Copper River, his hedge fund, closed down. Reflecting what must be Marc’s complete disillusionment with all things finance, he is pictured tending to the chickens he raises on a chicken farm in northern California. It’s a sobering career shift, one of the more improbable stories to come out of 2008.