Defend & Advance

March 10, 2008


Two of the three were RDN and MTG; the other was Forest City Enterprises (NYSE: FCEA), which closed at $55.87 on the Fortune article’s release date. It closed March 4, 2008 at $36.30, while RDN closed at $6.07 and MTG closed at $14.19. The losses from these bargains are staggering. FCEA is down -35%, RDN has plunged -64% and MTG cratered -53%. Figure 18 graphs the performance of MBI along with RDN, MTG and the Financial Select SPDR ETF (XLF).

MBI’s fair value price is not knowable consequently, its freely traded price is not fair value, it is speculation, which is why Mr. Whitman has close to a 60% loss on MBI shares purchased in fall 2007. Yet Mr. Whitman, who has made a name by buying assets most other investors shun, in January increased his stake in MBIA, the largest bond insurer, at $12.15 a share, and now holds about 10 percent of its outstanding shares. Perhaps MBI is another home run like the one he hit with Sears years ago, when he paid $10 per share and then sold most of his shares near $130. I prefer not to seek speculative values with TAVFX.

Value investors can pick from a cadre of fine managers. One manager who is becoming one of my favorites is David Winters, who launched the Wintergreen Fund (WGRNX) on October 17, 2005, after departing the Mutual Series funds. This fund offers global diversification and concentrated sectors bets with a star manager that compares favorably with Marty Whitman’s long-term performance history. WGRNX’s current bets are less speculative than those of TAVFX.

Mr. Winters is gaining more favor because his fund is up over 4.5% since July 2007 when the credit problems became a crisis (Figure 19, black circles), while TAVFX is down over 12% (red circles), with the Russell 1000 Value Index down 12%. Figure 19 compares returns since WGRNX’s inception and each fund’s current two top sector bets. I am sorry Mr. Whitman, but 63% is too much of a wager on financials—or on any sector. Mr. Winters' 34% weighting to consumer goods is near my limits. TAVFX might score big on financials, but it will not be with my money.

Portfolio A is short The Rydex S&P 500 Equally Weighted ETF (RSP) and long PowerShares FTSE RAFI US 1000 (PRF). I also employ these equity samples as performance benchmarks for active managers. Since fall 2005, TAVFX has lagged both.

MBIA, Financials And The Minsky Moment

The Minsky Moment is named after the US economist Hyman Minsky. The idea holds that over long periods of economic stability, leverage tends to grow in predictable stages. This economic stability leads to a fertile environment sprouting trunks of easy credit access with little perceived risk. However, as the growth continues there seems to be a movement from moderate lending, risky lending, and finally outright irresponsible Ponzi-like lending.
Dr. Housing Bubble, July 26, 2007

Mr. Whitman might have avoided the value trap with an acceptance of Hyman Minsky’s thesis on induced business cycles. Mr. Minsky is a University of Chicago graduate who rejected the school’s almighty law of market efficiency (Modern Portfolio Theory, or MPT). According Minsky’s thesis, market prices are often driven (induced) by excessive debt creation (mal-investment) that divorces market prices from their true value. Please read Minsky’s 1992 "The Financial Instability Hypothesis."

Price distortions are common when bubbles are inflating and after bubbles bursts. During the late summer of 2007, MBI began its slide down the slippery slope of a debt-induced cycle. In 2007-2008, investors have seen many housing-related and financial stocks cascade below what Mr. Whitman saw as bargains. MBI and other monocline insurers are near the epicenter of the debt bubble, which is why investors should not bet the ranch on them. After doing some homework, speculators might spread their bets with a reasonable allocation to financials that comprises no more than 5%-10% of their portfolios (5% is in my zone).

Portfolio Implications

The Efficient Market Hypothesis assumes that market participants have access to enough information to establish a reasonable price and that on each trading day the market arbitrates fair value. However, how does the market know value when too many bidders are blinded by greed or when panic overcomes sellers? We witnessed blind greed in 1999 and fear in 2002. Now we are told that the market indexes were priced correctly during the summer and fall of 2007. At one time in 2007, the financials represented nearly 30% of the S&P 500, which is way above its historic representation. How could the market price the S&P correctly when nearly a third of its constituents had esoteric balance sheets and income statements polluted with ABS, CDOs, CLOs, SIVs and lately VIEs and auction rate securities? Did Standard & Poor's know what they were buying when they overweighted their index to financials? If not, maybe they should have asked their credit rating agency.

MPT is dependent upon transparency so the bidders and sellers can efficiently set fair prices; without it, prices might seem fair but they can be far from right. "Optimized portfolios that employ MPT often behave unexpectedly after bubbles deflate. Asset correlations that were historically weak become strong." Therefore, risk management requires investment managers to reduce leverage, reduce asset durations and overweight to high-quality securities.

Why did not more market players underweight and/or avoid financial and housing-related stocks prior to their price collapses? Those that thoroughly researched the credit bubble and restrained MPT urges did. For many others, peer pressure and career risk kept them from being active participants in the market.

MPT adherents reject Minsky’s thesis. They uphold views that all knowable information is included in daily security prices. They preach a gospel that says that the best we can do is to diversify, balance asset exposure and rebalance periodically to harvest efficient market returns.

Below is news from the Active Indexer to the MPT crowd.
"If we were all passive indexers, index values would not represent knowledge and accurate information. There would be no price discovery. Mr. Market would be an idiot! Active investors are the backbone of MPT. They are the inputs. If everyone were a passive investor, security prices would tell us nothing!"

Caution pays when risk is mispriced, which the Boys from Chicago claim as impossible. Since its first installment in July 2006, Active Indexer has been making that very claim. In the summer of 2006, we also identified May 8, 2006 as a pivot date for Mr. Market’s rotation from low-quality to high-quality assets. Thank God for Mr. Market and Mr. Minsky!

"Too Close Too The Fire To See The Smoke" Is Coming Soon

In the last issue, I promised readers that I would be offering them Too Close Too the Fire to See the Smoke. I am sorry to say that this report will not be available until sometime in April. I have uncovered more and more data/evidence that supports my view that potential losses from home values are likely to exceed $6 trillion, plus indirect losses from debt instruments and credit derivatives near $1 trillion. These losses will cause huge contractions in lending to home owners, businesses, students, and state and local governments. Hits from credit are striking blows to the economy that will knock it out (a severe recession looms).

Here Is A Preview

On Feb. 29, 2008, UBS, one of the world's biggest banks, reported banks might have to book as much as $600 billion of write-downs, in addition to the $165 billion reported to date. My research first reported in the summer of 2007 indicated that huge serial losses approaching $250 billion from banks and broker dealers were already baked into the cake. I also conducted a survey in 2006 that indicated indirect losses from debt instruments and credit derivatives would approach $500 billion if housing value losses exceeded -15% (cumulative from May 2006 price peaks). Participants at a fall 2007 Pension Plan conference were shocked at my presentation after it fostered their realization that there was a high probability for bank and brokerage losses in excess of $500 billion. They are now adjusting to a new comfort zone because $400 billion-$600 billion is the present consensus.

I am very indebted to Eric Janzen, the founder of, for encouraging me to initiate research on the credit bubble via the publication of Peak Risk in May 2006. He, Dean Baker at, Nouriel Roubini at and Chris Whalen at have all contributed to my research. Too Close Too the Fire to See the Smoke will first be published at with a link found in my next issue of Active Indexer.

Portfolio Adjustments

Now that I have irritated hedge fund managers, a star manager and the MPT crowd, it is time to turn to trades made in Portfolio A since November 26, 2007, which was our last report date. Twelve percent of our trades were annual rebalancing adjustments that are done during the first six weeks or so of each New Year. Twenty-one percent were newly established positions in the British pound (FXB, short), basic material shares (SMN, short) and the U.S. dollar (UUP, long). UUP was quickly sold within three weeks after it was purchased. Six percent were additions to existing shares in oil service companies (OIH) and health care (VHT). We also reduced exposure to short-term Treasury Notes (SHY) by 14%. Trades done since November 2007 have resulted in portfolio turnover of 53%. Gross exposures declined from 169% to 163% and have been 159%-169% over the past 12 months.

Figure 22 shows equity derived Beta exposure at 78% with Non-Beta exposure at 85% for a -7% net Portfolio Beta. Beta themes are played through high- and low-quality stocks. The portfolio expresses Non-Beta through Anti-Carry Trades and Weak/Strong Dollar positions. Our fundamental research and quantitative factor analysis drives all position weightings within the portfolio. Technical overlays on each position are employed tactically and for substituting one vehicle for another to express Beta and Non-Beta exposures.

A Tactical Fundamental And Technical Trade

UltraShort Basic Materials ProShares (SMN) was our latest trade made on February 29, 2008. It represents 6% of assets and 12% of gross portfolio exposures. We are very concerned about a severe correction in gold, gold stocks and energy sector positions because of their economic sensitivity. Rather than selling these shares, it is wise to employ SMN.

SMN is short 200% a basket that is 56% Chemicals and 8% Paper products, which are very negatively impacted by high energy costs. The profit margins in these industries are hurt badly by $100 + crude ($WTIC) prices (beta factors invert). The underlying stocks in SMN are also overvalued and overbought, so the timing is good on a fundamental and technical basis. We are using SMN to tactically hedge gold and inflation hedges, which are in secular advances but are subject to severe cyclical declines.

It is clear from Figure 20 that we reversed course quickly in UUP. Portfolio A’s positive return attribution has at times been dependent upon a weak dollar (not overly dependent). In early February, technical readings indicated that the greenback might reverse its downtrend with a sharp countertrend rally. However, near the end of the month, the dollar broke down again, and we sold UUP.

There is a lot to balancing Offense and Defense. Too much coverage does not help. It is time to end what never ends.



1 The Leuthold Core Investment Fund (LCORX) is one of the best strategic asset allocation funds in our industry. LCORX rates five stars by Morningstar.

2 Michael H. Steinhardt (born December 7, 1940 in Brooklyn, New York) was one of the first prominent hedge fund managers. He founded Steinhardt, Fine, Berkowitz & Co., a hedge fund, in 1967. Steinhardt averaged an annualized return for his clients of 24.5%, after a 1% management fee and a "performance fee" of 15% of all annual gains, realized and unrealized, nearly triple the annualized performance of the S&P 500 Index over the same time frame.

3 Victor Sperandeo, Trader Vic II, Principles of Professional Speculation, John Wiley & Sons, New York, NY, 1994.

4 Robert J. Shiller also employed this form of normalized earnings to account for the variance of earnings during business cycles in his book, Irrational Exuberance 1st and 2nd Editions, Princeton University Press, Princeton, NJ, 2000 and 2006.

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