Volatility (as defined by the VIX) has been trending lower, as the many sources of bad news fail to get any worse and confiscatory interest rates relentlessly push investors into the water. Investors are searching for ways to bet on it rising again – a tricky concept to get right. As investors climb the wall of worry through buying stocks they push down levels of implied volatility in the process.

Bonds are without doubt guaranteed both to return your money and to reduce its purchasing power. It’s a Faustian bargain readily accepted by many, and yet the pessimist would say you can lose money quickly (in stocks) or slowly (in Bonds). Without dismissing such fears, I’d simply say that figuring out how much of the bad news in the the overall level of the market isn’t something that we spend an inordinate amount of time on. Better to focus on companies that can survive the bad things that may come and can prosper if everything turns out not quite so awful.

In our Deep Value Equity Strategy we’ve made a few modest changes over the past couple of weeks. We have net raised a bit of cash, mostly through trimming positions that had grown too big rather than through any darkening top-down view of the world. We reduced our position modestly in Comstock Resources (CRK). We still like the natural gas theme and CRK is making the right moves, repaying their revolver with $300MM of long term debt maturing in 2020 (incurred following their purchase of properties in west Texas) and continuing to shift their capex to oil while natural gas prices remain weak. They also announced a partnership with KKR sharing their development risk in their Eagle Ford shale. About a year ago BHP Billiton acquired Petrohawk (HK), in whom we were invested, at a 60% premium but more recently had to take a writedown on the shale gas assets then acquired. Floyd Wilson, then Petrohawk’s CEO, always said he wanted to sell the company and showed timing of a similar order to Steve Case (AOL to Time Warner) or brother Dan Case (H&Q to JPMorgan) with that move.

But it’ll be a while before CRK realizes the value in its portfolio through being acquired, and daily volatility of 5 times or more the equity market caused us to trim this back somewhat. We maintained our energy exposure with an investment in Kinder Morgan Inc., (KMI), which owns most of the GP for Kinder Morgan Partners (KMP).

We invested in Leukadia (LUK), a holding company with a fairly eclectic portfolio of businesses that has been trading at a discount to book value for some time and recently dipped when Knight Trading (KCG) almost bankrupted themselves through a poorly debugged trading program. LUK owns a portion of Jefferies (JEF), and no doubt traded down in sympathy at that time.

We’ve also invested in Burger King (BKW), which recently started trading in the U.S. following an investment by a UK SPAC called Justice Holdings and controlled by Bill Ackman. BKW is in the midst of a turnaround, and generates about $1.1MM per year from its restaurants, far less than its peers in the Quick Serve Restaurant (QSR) industry such as Wendy’s (WEN) at $1.4MM or McDonalds (MCD) at 2.4MM! We also own MCD in our Hedged Dividend Capture strategy.

Finally, we sold some of our position in Kraft (KFT) as it broke through $40. Kraft will split into two in October and we still think it’s a good investment but no longer worthy of a maximum position at current prices.

We watched the JCPenney earnings webcast with interest last week. We have around a 4% position in JCP – although we began accumulating the position over a year ago (after CEO Ron Johnson had joined the company but before he assumed his high profile CEO role). In a spectacularly wrongheaded move earlier this year we neglected to take profits when it reached $40, so convincing was the smooth yet inspiring Ron Johnson in his investor presentation. It was a missed opportunity as the stock proceeded to lose half its value through collapsing sales as the transformation of JCP proceeded not altogether smoothly. We’ve neither bought or sold JCP for several months, and will likely do nothing for quite a long while. If they can truly pull off the change they’re projecting then the company will be worth substantially more, and in the meantime they have enough cash and cash generating capability to provide time. We’re going to wait this one out.

From Felix Salmon’s examination of AIMA’s latest attempt to counter the criticisms of the hedge fund industry in my book. Felix is far more eloquent than I ever could be in assessing AIMA’s report. It’s well worth reading his analysis.

The title isn’t my creation, but is rather the work of Michael Edesess, PhD, CIO of Fair Advisors (an investment firm) and author of The Big Investment Lie (which I am currently reading). Michael just posted a review of my book, and he does an excellent job of summarizing the highlights and adding his own commentary. I had a most interesting chat with him a couple of weeks ago when he was writing the review from his office in Hong Kong.

Last week’s Knight Trading (KCG) disaster marked the first time that I can recall when a software glitch actually threatened the surivival of a public company. In recent years computer technology has played an increasing role in the functioning of the equity markets, and KCG’s mis-hap was preceded by the Facebook (FB) IPO mess and the Flash Crash in May 2010. And based on the terms of the $400MM in new capital KCG raised, such that the new investors will own 70% of the company at $1.50 a share, prior KCG investors are all but wiped out compared with the $12 price of recent weeks.

We’ve never considered investing in KCG, but investors might be forgiven for not having contemplated their exposure to bad implementation of a new trading system. KCG’s most recent 10-K is lighter than most in its list of Risk Factors, containing seven although they’re all important. Operational Risk is the relevant disclosure, “…from major systems failures.” which would seem to incorporate what happened. As well as raising further questions for regulators about how well they monitor the increasingly automated activities of the public markets, it also highlights the need for investors in such business to achieve greater comfort around “IT competence” when they invest in such companies.

In late July I had the opportunity to present the ideas in my book, The Hedge Fund Mirage, at the CFA Institute’s Financial Analysts Seminar in Chicago. Flying to Chicago for the day afforded me time to catch up on some reading, and some new ideas.

From time to time we’ve written about the Equity Risk Premium and how it makes stocks a far better investment than bonds. The earnings yield on the S&P500 (which is the inverse of its P/E) is around 7.6% (consensus earnings of $105 divided by current S&P500 level of 1,385). Ten year treasury yields are 1.5%, so the resulting 6.1% gap was last this wide in 1974 following the Yom Kippur War, OPEC oil embargo and rampant inflation. Or to put it another way, as we’ve written before, it only takes $22 invested in the S&P 500 (yielding around 1.9%) to generate the same after-tax ten year return as putting $100 in ten year treasuries (all assuming unchanged dividend yields and 4% annual dividend growth compared with a 50 year average of 5%). The remaining $78 of the $100 could be left in 0% yielding cash and the Math still works. This is how expensive is the relative safety of fixed income. To describe bonds as being for wimps would risk provoking the Market Gods to swiftly prove otherwise, so I won’t go that far. But they are for those willing to accept a guaranteed loss of real wealth after taxes and inflation.

However, the Equity Risk Premium has remained more or less historically wide for some time, and it’s not exactly a secret. Martin Brookes and Ziad Daoud of Fulcrum Asset Management, recently offered a possible explanation. In a paper titled “Disastrous Bond Yields” reported in the Financial Times, they construct a risk/return framework for investors that extends the more normal economic state of two scenarios (expanding or contracting economy) to include a third (“disaster”, a “large decline” in GDP). Such disasters were far more common prior to World War II, and the authors theorize that the subsequent 60 years of comparative serenity caused investors to undervalue the safety of government bonds in such cases, an oversight we might now conclude has been corrected. To the layman, people are scared. Or, as a retired bond trader and friend of mine observed recently, investors are not buying ten year treasuries because they think they’re a great long term investment. I won’t do the paper justice here and it’s worth reading, for the authors go on to show that at a certain tipping point of economic distress the credit risk in government bonds overwhelms their safety. Empirically, when the default probability of a country exceeds 3% its bonds and stocks start behaving far more alike as correlations flip from negative to positive. Greece, Spain, Italy and (interestingly) France have all crossed this threshold.

At the CFA event in Chicago my presentation directly followed that of Professor Robert Shiller, author, Yale professor and co-creator of the S&P/Case-Shiller Home Price Indices. Clearly my inclusion showed the organizers’ flexible standards on speaker selection. Professor Shiller spoke about his recent book, “Finance and the Good Society”, a review of which I had coincidentally just read on my flight. The book makes the case for the benefits of financial innovation to broader society, a lonely position given recent history. One novel idea was that the Federal government should borrow money by issuing securities whose coupons are directly linked to GDP. Specifically, one such bond would pay annual interest equal to one trillionth of GDP, or about $15.09, hence the name “Trills”. I thought it was a clever idea; many investors would surely find use for a security tracking nominal GDP, and while the government’s cost would be pro-cyclical (i.e. fall when the economy’s contracting) it would be less volatile than if the Treasury issued exclusively short term treasury bills and would also provide an inflation hedge to investors. Of course, Professor Shiller noted that TIPS (Treasury Inflation-Protected Securities) were first suggested about 100 years before they became reality so we shouldn’t expect to see these novel securities soon. But I thought it was an intelligent suggestion.

One new idea would be for Congress to resolve the looming “fiscal cliff” before the election, thus acknowledging the supremacy of the economy compared with their respective campaign plans. But any new idea I suggest here will be too dripping in sarcasm to be serious. Suffice it to say that, as we sit here watching the weeks tick by to November with no pre-election solution in sight, it is with a feeling of stunned amazement that we regard the oblivious disregard of Congress for the private sector. Planning for 2013 hiring and capital spending decisions takes place well before the lame duck Congress will limp back to Washington DC in mid-November. Anecdotally, companies are increasingly curbing their long-term commitments until fiscal policy becomes clearer. While we don’t try and time the markets, many companies’ quarterly earnings have shown very weak European demand across varied products and services and a cautious outlook globally. In our Deep Value Equity Strategy cash is a relatively high 10% as a few names have reached price targets we felt fairly reflected their value.

MLPs had a nice month in July following six months of zero total return. The sector had become steadily more attractive as we noted last month, and July’s results made up some lost ground. We think MLPs  remain attractively priced with distribution yields still above 6%.

As we head towards another deadline for Greece, during which they must convince the troika that austerity is on track, there is growing speculation that Greece may be forced out of the Euro. A “Grexit” to use a popular term.

Well, maybe, but here’s why it’s not inevitable. First, from Germany’s point of view, Greece’s presence in the Euro isn’t the real problem; it’s the money Greece owes. In fact, Greece’s recession is if anything creating downward pressure on the Euro which helps Germany’s exporters. The notion that Germany may force Greece to leave the Euro is based on the flawed assumption that this would be in Germany’s interests. No doubt popular opinion in Germany may be moving in that direction, choosing to “punish” the profligate Greeks for their poor budgeting skills. But leaders in Germany must know that such a move would be their “Lehman moment”. The risk of contagion swiftly moving to Spain and Italy would be such that perhaps as much as 1 trillion Euros might need to be available to support those countries’ ongoing borrowing needs. Untold additional dominoes might fall. It’d be a foolhardy German government that contemplated such a move.

Moreover, the instant Greek default on their cross border debts which would immediately follow their ejection would hurt their Euro-zone creditors including Germany. Indeed, the ECB itself might need to be bailed out. So there seems little point in kicking Greece out of the Euro while they still owe any significant sums to other Europeans.

For Greece, while a New Drachma may appear an appealing way to generate inflation and allow a drop in living standards to create a more competitive economy, introducing a new currency over even an extended bank holiday is a daunting task. A well run government bureaucracy like Germany’s would be hard pressed to pull that off. Greece is not Germany. It would be a disaster. In fact, for Greece their interests are best served by continuing to negotiate for an ever decreasing debt burden. Regular brinkmanship around austerity targets and the next release of EU/IMF funds is becoming their strategy. It can continue to work as long as the promise of some ultimate repayment is sufficient to outweigh the risks to Germany of kicking them out.

But Greece has an additional option, which is a stealth devaluation. The government could start paying its bills in IOUs, as California has done in the past. The IOUs would promise to repay the holder in full in five years in the then prevailing currency. These IOUs would of course trade at a discount to face value, but over time the Greek private sector’s holdings of these would grow as their government issued more of them. Their discount to par would no doubt fluctuate with the odds of Greece staying or leaving, but over time as the discount stabilized and their volumes grew the “New Drachma Notes” as they might be dubbed, would provide visibility around the type of depreciation the New Drachma might suffer if it replaced the Euro. In fact, it could co-exist with the Euro, but by creating a plausible alternative currency that was slowly introduced over 2-3 years through the Greek government paying its bills, it would improve Greece’s negotiating stance with the troika and perhaps allow them to achieve greater debt forgiveness than would otherwise be possible.

The Greeks have played a weak hand pretty well so far. Their forced exit from the Euro needn’t be as inevitable as it might appear.

Modern financial theory holds that a diversified portfolio of securities is the most efficient way for an investor to access an asset class. Idiosyncratic risk, the risk associated with an individual stock say, can be diversified away and therefore theory holds that investors don’t achieve any additional return for holding concentrated portfolios of their favorite stocks. It’s an idea that makes a lot of intuitive sense. Consequently, you can invest in equities and possess no particular stock-picking skill by using an index fund. Hundreds of billions of dollars are invested passively in this way. Based on many decades of performance from public equities (although admittedly the last decade was no walk in the park) this is a sound strategy.

Using the same construct with hedge funds produces a different result. A key underlying assumption in the “diversification is good” approach is that the underlying asset class has a positive return. However, as I show in my book The Hedge Fund Mirage, if all the money ever invested in hedge funds had been in treasury bills instead, the investors would have been better off. The average hedge fund $ generated a negative return with respect to the risk-free rate. There are great hedge funds and happy clients, but these are not the norm. Since I wrote my book hedge funds have continued to provide empirical support for my findings. YTD performance for the HFRX Global Hedge Fund Index is 1.2% through June – actually outpacing treasury bills (which yield approximately 0%) but for the tenth straight year lagging a simple 60/40 stocks/bonds portfolio.

Since hedge funds in aggregate have been a bad investment, the only way to win as an investor is to be better than average at picking managers. Some people are. But since diversification is intended to draw you towards the average return, and the average return is in this case not something you want, the rational use of hedge funds in an investment portfolio is to select only two or three where you have insight and high conviction. Adding more funds creates more diversification, which for a hedge fund investor is a bad thing.

Some of the smartest people in the hedge fund industry are the hedge fund managers themselves. You’ll rarely hear them advocating a diverse portfolio of hedge funds. They already understand the mediocrity and lack of return persistence so prevalent amongst their peers. And often the happiest clients are those who don’t have many hedge funds, but made a few good choices with a small part of their portfolio. For if a diversified hedge fund portfolio is bad, so is a large allocation to hedge funds. A 1-2% allocation to two or three funds takes the best of what hedge funds have to offer. Hedge fund returns have steadily deteriorated as assets have grown, just as is the case with individual funds.

But the consultants and advisors who promote a diversified portfolio of hedge funds as an important component of an institution’s overall portfolio are misusing the Capital Asset Pricing Model. A diversified hedge fund portfolio is The Dumbest Idea in Finance.

The Energy Information Agency (EIA) is a rich source of data on everything related to energy production, consumption and storage in the U.S. This chart caught my attention, showing that coal use for electricity generation continues to fall sharply, with the result that in April for the first time natural gas was used to produce as much power as coal. The price advantage and environmental issues are both helping drive natural gas consumption higher, and the EIA even project that the U.S. will eventually become a natural gas exporter (though that time is 5-10 years away).

Meanwhile, Patriot Coal (PCX) filed for bankruptcy yesterday as the deteriorating economics of the coal industry proved insurmountable.

We continue to hold positions in three E&P names: Range Resources (RRC), which stands to benefit over the long term from greater natural gas consumption since they have such large potential reserves (50-60 Trillion Cubic Feet Equivalent). Their current market cap of $9.7BN is far less than the cash they can generate if even half of this potential is realized. We also like Comstock Resources (CRK) which we think will ultimately be acquired, although its daily volatility is multiples of the broader equity market so it’s not for the faint of heart.

Back in April some were forecasting that natural gas prices might go negative, such was the excess supply and shortage of available storage. That was around the time prices hit their low.

I am once again indebted to The Economist for writing about my book and noting some of the points I made about hedge funds’ poor performance. On January 7 they covered it in the Buttonwood column, and this weekend they once again discussed the issues I raised. They are performing a public service by highlighting some important concerns for investors.

Last week Coeur d’Alene (CDE) announced plans to issue debt, even though they have no obvious need of any extra cash. It looked very much as if the company was planning to make an acquisition rather than focus on returning value to shareholders, and we commented as such on this blog. It seems the bond market reached a similar conclusion since today CDE announced that unfavorable market conditions had prompted them to withdraw the bond offering.

Of course it’s not hard for any creditworthy borrower to raise funds at today’s rock-bottom interest rates, but evidently the long history of value destruction by prior management combined with CEO Mitch Krebs’ very small personal investment in CDE equity persuaded bond buyers that CDE debt was not an investment the market needed. The irony is that pulling the issue has boosted their stock price by 5% today. What a pity CEO Krebs doesn’t believe more fervently in his company’s ability to create shareholder value, otherwise he’d have a bigger stake and would be benefitting from the bond market’s rejection of their acquisition plans.