Barron’s has a couple of interesting articles this weekend. They lead with “Buckle Up”, and make the case for equities by highlighting the very wide equity risk premium (the S&P500 earnings yield of 8% minus the yield on ten-year treasuries of 2%) something we’ve also noted in the past. This spread is historically wide and, it can be argued, makes a compelling case for stocks. What seems more clear is that the spread will narrow but that could just as easily be through bond yields rising. We do think equities represent an attractive long-term investment but we are more sure that bonds do not. Public policy in the U.S. is to effect a transfer of real wealth from savers to borrowers, so while stocks look attractive bonds look positively ugly.

Of course noting that bond yields are low and can only really move up is scarcely a contrarian view. Randall Forsyth notes in Barron’s a solid agreement among forecasters that bond yields will be higher a year from now. While it makes a great deal of sense, presumably the Federal Reserve will respond to higher yields by increasing its purchases unless rising yields are accompanied by an upside surprise in GDP growth. They’re likely to maintain negative real rates of return for a considerable time.

A hedge fund, QB Asset Management, forecasts “face-ripping inflation”, a term likely to catch your attention. The output gap (such as the difference between current unemployment and the natural rate) seems too high for that – there still appears to be plenty of excess capacity in the labor force. It’s hard to see how inflation (at least as measured by the Bureau of Labor Statistics) can take off when so many people are available to be employed. QB could be right, but it hasn’t happened so far and without an increase in money velocity the jump in money supply isn’t likely to become inflationary. But similar to the wide equity risk premium, while low current inflation may persist it’s not worth betting on a continuation of the status quo.

Shorting Euros is another crowded trade. It’s just hard to see how any of the solutions on offer will promote growth within the region. The Real GDP differential is likely to be 2.5% next year in favor of the U.S. European governments are following pro-cyclical policies during a time of slowing growth. The Euro has weakened in recent weeks but really ought to be far lower. However, we run this risk in our hedge fund in combination with long equities from a number of different trades. We think the Euro will depreciate, but if we’re wrong it’ll most likely be in a scenario that is good for stocks. Borrowing Euros to buy U.S. equities represents an attractive  opportunity. Mike Platt, co-founder of BlueCrest, a global macro hedge fund, offered a most dire outlook on Europe and its banks. BlueCrest is one of the most successful hedge funds around, and the TV interview is worth a look. Platt is frustratingly vague about how he’s positioning for what he expects will be a continued deterioration but leaves little doubt about his overall view. If European banks valued their positions the way hedge funds have to they’d all be declared insolvent. I can’t really see why anyone would lend anybody in Europe any money, except perhaps in Germany and the UK.

Finally, I’d note that JPMorgan issued revised valuation estimates for large cap E&P names. Devon Energy (DVN) remains one of the  largest positions in our Deep Value Equity Strategy, trading at close to the value of its proved reserves. The continued shift from natural gas to oil production in the U.S. in response to relative pricing should work to Devon’s advantage given its asset mix.

Disclosure: Author in Long SPY, EUO, DVN

My book, The Hedge Fund Mirage, is finally in print and making its way up the Amazon Best Sellers list (currently in the top 3%). The hedge fund industry has co-operated in its launch by delivering the second worst year in history. Not all hedge funds are bad though, and since some of the most talented managers will always be found running hedge funds it’s worth figuring out how to be a hedge fund investor in the good ones, on fair economic terms so that the steady transfer of wealth from clients to managers isn’t perpetuated. In my book I’ve tried to show hedge fund investors how they might do that.

The New York Times today has a piece on Richard Kinder, founder of Kinder Morgan (KMP) the largest publicly traded partnership in the U.S. KMP recently agreed to acquire El Paso Corporation to create an entity controlling 80,000 miles of pipeline crisscrossing the U.S. KMP is a Master Limited Partnership (MLP), which is to say that owners of LP units (as their shares are known) own a proportional stake in the underlying assets rather than shares in a corporation. The big advantage of this structure is that there is no 35% corporate income tax, so the profits flow straight through to the unitholders without the double taxation that occurs when corporations use after tax profits to pay dividends that are themselves taxable. MLPs and KMP in particular also represent an investment in the growth of natural gas as a source of America’s energy production. Cheap shale gas is increasingly being used to produce residential electricity. From 2005-2010 consumption for this purpose grew from 5.9TCFE (Trillion Cubic Feet Equivalent) to 7.4TCFE, more than 70% of the increase in total natural consumption to 24TCFE last year (according to the EIA). A shifting mix of energy sources requires new infrastructure to transport, store and refine it, which is what KMP recognizes. JPMorgan initiated coverage on the sector in October and expects $130BN in infrastructure spending over the next 10 years.

KMP pays a $4.64 distribution, giving a current yield of 5.9%. They’ve grown this distribution at a compound annual rate of 14%. This is high for an MLP, but 6% annual distributions with likely growth of 4-6% over the next 2-3 years is a reasonable assumption, offering the potential for 10-12% total return (assuming multiples are unchanged). Distributions are also largely tax-deferred, since much of the cash received by unitholders is classified on their K-1 as a return of capital, rather than income. Ah yes, you have to deal with a K-1 instead of a 1099. They’re not for everybody, and unless you use a tax accountant and can afford to invest at least $250K in a diversified portfolio of individual names this sector is probably not for you. But for high net worth investors interested in a 6% tax deferred distribution yield with likely 4-6% growth and tolerant of K-1s, this is a sector that belongs in most portfolios. In fact, I think MLPs are a great substitute for high yield bonds. They exhibit similar levels of price volatility (in a weak equity market they can fall farther than you’d like) but offer better return prospects. While unitholders do own equity interests, the overall risk/return characteristics are more bond-like than equity-like.

MLPs are putting in another solid year, with the Alerian MLP Index returning 7.7% for the year through November. That’s ahead of both high-grade bonds (the Dow Jones Corporate Bond Index is +6%) and the S&P 500 (+1.1%) over the same period.

Government policy is to transfer real wealth from savers to borrowers. Policy rates and bond yields are being maintained at levels so low that, after taxes and inflation savers are virtually guaranteed to lose purchasing power. Bonds have their place in a portfolio, and no doubt there are plenty of issues facing markets right now starting with the Eurozone. But given the guaranteed poor long-term outlook for bonds, we think investors should be reducing their overall fixed income weighting in favor of alternative sources of income (such as MLPs) and dividend paying stocks. Retail investors have been steadily increasing their holdings of corporate debt. For example, the  iShares iBoxx Investment Grade Corporate Bond Fund (LQD) has seen steady growth in outstandings all year. Corporate bonds have been strong performers for the past couple of years, but with yields on high grade bonds currently around 4%, you can only make 4% and after 2.5% inflation there’s about enough to pay taxes and that’s it. The Federal Reserve is causing this distortion in the fixed income markets. They can keep it up for a long time. Today’s fixed income investors are competing with the world’s deepest pocket – it’s probably time to look elsewhere.

Disclosure: Author is Long KMP

As the reality sets in of guiding 26 countries (i.e. the EU less Britain) towards agreement on a common set of revisions to the Treaty, the smug satisfaction of the tabloid press and at least a substantial minority of the British population is almost palpable even here on the U.S. side of the Atlantic. One by one, other member nations are commenting on the challenges of not only finding agreement but then achieving ratification through 26 parliamentary processes. The FT has a good synopsis of the growing acknowledgment of challenges ahead. The UK has to avoid any overtly self-congratulatory behavior, but the truth is that for those afforded the luxury of expressing opinions unburdened by the reins of government, seeing any project related to the French founder is never dull. And there’s many decades of suspicion of German power, even though the competition nowadays is thankfully economic and on the football pitch. I must confess I share many of these sentiments myself.

Michael Cembalest, CIO of JPMorgan’s Private Bank and an eloquent, insightful observer, put it well in a recent newsletter. Likening the ongoing Euro debt crisis to Bergman’s “Scenes from a Marriage”, Cembalest observed that, “Holding assets of countries suffocating themselves is not something that sounds very rewarding, unless prices get extremely cheap.” That’s the point. The prescription of austerity may be the right solution, but the widening differential in Real GDP growth between the U.S. and the Euro zone (2.5-3% in 2012) is scarcely likely to make Euro zone assets attractive. The € is becoming a funding currency – a currency with reliably low interest rates for the creditworthy (or those with good collateral). Borrowing in € and investing in U.S. assets – even risky assets like U.S. equities – has been the right position in recent weeks and events are unfolding in a way that’s likely to continue current trends. It’s hard to see why the € should rally much other than on the back of short-covering – and if it does, equities will surely move up as well.  As a result, we continue to be long U.S. equities. We like Microsoft (MSFT) in our Deep Value Equities Strategy, at 7X earnings after adjusting for cash on balance sheet. You’re unlikely to wake up worrying about their future, although there is always the risk of an over-priced acquisition with all that cash sitting around. And we are still short € through owning EUO.

Several weeks ago we switched our investment in Range Resources (RRC) into Devon Energy (DVN). We had liked RRC for a long time, but it had been looking less like a value stock as its price eventually doubled in a year. Shale drilling for natural gas is an area to which we’ve had some exposure for almost two years. Natural gas is likely to represent an increasing share of the means of power generation in the U.S. It is (1) far cheaper than crude oil on a BTU equivalent basis, (2) cleaner than other fossil fuels, and (3) here in the U.S., as opposed to having to be shipped through the Straits of Hormuz past Iran. RRC represents a concentrated bet on the Marcellus Shale, an enormous area that stretches from New York State to Tennessee. RRC strikes us as a well-run company, and we like the management. However, challenges to the shale gas story seem to be multiplying. In August, the EIA sharply reduced its estimate of the Estimated Ultimately Recoverable (EUR) amounts of shale gas in the Marcellus, causing a huge difference between the aggregate potential reserves from all the companies drilling there and the EIA’s estimate.

Recently the New York Times highlighted growing concern about the legality surrounding the transfer of certain drilling leases in Pennsylvania. Fracking, the technique by which drillers pump fluids (mostly water) into deep rock formations, imposing stress on rock formations that then frees up trapped natural gas, continues to be the target of environmental criticism. It has long been blamed for contaminating local drinking water (a movie “Gasland” was made to focus on this) and there have also been questions about how the fracking fluids (which are almost all water but do contain tiny amounts of very nasty chemicals) are disposed of. Just the other day the EPA blamed fracking fluids as the likely source of water contamination in Wyoming. And there’s even suggestions that fracking and the disposal of fluids deep under ground can cause minor earthquakes. Added together, there’s a growing source of potential problems for shale gas. Tighter environmental regulations around drilling would be fine – natural gas prices are so cheap that increased production costs across the industry would simply reduce some of the price advantage, so there shouldn’t be much problem with that. But the risk remains of some environmental disaster requiring expensive remediation. Not the most likely outcome, but a concern nonetheless.

As a result, in Energy our biggest holding is Devon Energy (DVN), which while focused on natural gas has a significant exposure to liquids and crude oil as well. They are all domestic and trade at around the value of their proved reserves (i.e. unproved and possible are thrown in for nothing). We switched our RRC holding into DVN some 2-3 months ago, and while we could have chosen better timing it’s currently looking like a good move.  We also own Comstock Resources (CRK), whose recent acquisition in West Texas was greeted positively by the market since it’s in an area where the company is already active with continued success. And most speculatively, we own McMoran Exploration (MMR), which has nothing to do with shale gas but which is pursuing shallow water deep drilling for natural gas in the Gulf of Mexico. Results from their Davy Jones flow test will be available soon and the stock will no doubt move sharply in one direction or another. The stock trades with a high beta which is not that meaningful since its ultimate value is a binary outcome based on the abovementioned flow test.

Disclosure: Author is Long MSFT, DVN, CRK, MMR, EUO

I spent a few days in London last week, meeting with investors and discussing my book. I also managed three separate TV appearances. I can tell you that if the € sovereign debt crisis appears to dominate the news in the U.S., it is an all-consuming obsession for the financial media in the UK. It is naturally more impactful on Britain, and the jingoistic response of the popular media to Prime Minister Cameron’s exercise of his veto over Treaty changes showed how shallow is the support in Britain for the European project. I’m sure if there was a way to shift Britain 1,500 miles to the west it would more accurately reflect the country’s center of gravity between European liberalism and U.S. mercantilism.

But wherever you sit, Friday’s EU summit was yet another all-too-small step towards finding solutions to the problems of too much European sovereign debt. The markets are now left to wait and see if the ECB will find enough to like in the commitments of the other 26 nations towards fiscal discipline so that it can become a significant buyer of high yielding sovereign debt. One has to assume they will do so if needed – sufficient private buyers are not yet there, although over the next 2-3 years the Carry Trade could become a source of recapitalization for European banks desperately in need of such. 7% Italian yields funded at 1% could replenish the retained equity of banks for a considerable time. It’s not a trade we would do ourselves, but it could plausibly draw substantial capital in the months ahead.

Indeed, the growing differential in Real GDP between the U.S. and the € zone looks set to be 2.5% in 2012 and could easily reach 3% if Europeans follow through on promised austerity while the U.S. delays such and extends the payroll tax deduction. The € is becoming a “funding currency”, the disrespectful moniker attached to a currency facing an extended period of low rates and little prospect of moving higher. Borrowing in € is looking increasingly like a cheap source of funding – after all, European sovereigns have been doing so for years with reckless abandon (hence the present crisis). The ECB is likely to keep rates low and in considering the solutions, whether they stay on the present course of  employing fiscal drag, utilize an increase in inflation or stumble into a disaster, it would seem that most plausible paths for the € are lower. It’s frankly part of the solution, to further stimulate exports and devalue the real value of debt owned by non-€ investors.

We think it’s one of the better trades available, but in combination with a long equities portfolio is becomes quite compelling. Stocks are reasonable long-term value and are compelling versus fixed income. A higher € would almost certainly be accompanied by higher equities and an altogether more friendly investment outlook. It’s not obvious how we’ll get there, but it’s certainly possible. The big issue restraining equities is the €. So borrow the € and buy US stocks.

As a result we remain invested in U.S. equities. Our biggest position is Kraft (KFT) an attractively priced name that provide exposure to global GDP in combination with their own positive story. KFT has seen almost 7% organic revenue growth through the first 9 months of 2011 and more than 5% of that has come from pricing, so they’re clearly able to push increases through the pipeline. They continue to enjoy operating margins of 12-14%. The Cadbury synergies are coming through, both in sales of Oreo cookies in India across Cadbury’s existing distribution infrastructure and through sales of Cadbury’s chocolate in South America where it had relatively small penetration. KFT’s break-up next year into a global snack business and U.S. grocery business should unlock additional value for investors, and at 14X next year’s consensus earnings with 11% YOY EPS growth we think valuation is not excessive.

We continue to like Aspen Insurance (AHL), trading at 60% of book value in an industry with reduced capacity given a series of reinsurance payouts over the past year (Japanese earthquake and so on).

We are long stocks such as these in our Deep Value Equity strategy, and in our hedge fund maintain long equities with a short € (long EUO).

Disclosure: Author is Long KFT, AHL, EUO

I spent a most enjoyable lunchtime at a roundtable sponsored by the Centre for the Study of Financial Innovation (CSFI). The topic of debate was my book, and more specifically my assertions that hedge fund investors have not done very well. It was a spirited and informed debate, with lively interchange among the participants. Hopefully I left the audience with a few thought-provoking ideas about hedge funds and the contrasting fortunes of the managers compared with their clients. I should also thank the CSFI organizers for making the event possible. It was very well organized and the room was filled with well-qualified, articulate finance professionals (hopefully my presence didn’t render that less true).

I was also on Bloomberg TV this morning.

I have arrived in London and am therefore physically closer to the Eurozone crisis than normal. Tomorrow I’ll be spending a lot of time promoting my book – Bloomberg at 7am, a roundtable debate at the Center for the Study of Financial Innovation over lunch and Jeff Randall on Sky in the evening. Hedge funds are having their second worst year in history. Even a skeptic like me didn’t expect the industry to deliver such a poor year.

Betting against a crisis is almost always the right approach. If you invest without leverage, you’re afforded the luxury of waiting to see how events play out without caring too much about the path equity prices take. It might very well be that the latest round of negotiations will result in the ultimately more stable Euro the whole world now desires. While being long equities reflects a belief that things will work out, borrowing money to do so would reflect more conviction than is warranted. A big question is precisely what mechanism will be used to enforce budgetary discipline in the future, since the Maastricht Criteria (limits on deficits at 3% of GDP; debt at 60% of GDP) were as much use as the Maginot Line against the German panzers in 1940. In fact, Germany and France were among the first countries to violate this law, and consequently the fines (set at implausibly high levels such as 1% of a country’s GDP) were never imposed. It’s unclear how such fines could ever be imposed, and a key element supporting the imposition of fiscal discipline remains to be defined.

It occurred to me that one solution might be to limit each country’s banking exposure to profligate nations. Instead of emphasizing rules for the borrowers, impose rules on the lenders. Germany could pass a law preventing its own banks from incurring country risk to, say, Spain in excess of 5% of a bank’s tier one capital. All the current measures impose penalties on the debt addicts, but the dealers who provide the fix are part of the problem too. This would seem to be a solution well within the ability of each creditor country to impose unilaterally without requiring a treaty overhaul, and would also limit creditor nations’ exposure to rule-breaking profligacy in the south. It seems a simple measure, I’m not sure why it’s not part of the solution.

The Economist magazine noted on the weekend that Sweden (an EU but non-Euro member) has imposed 12% Tier 1 Capital to Risk Weighted Assets requirements on its own banking system. Overleveraged banks are no doubt a substantial part of the problem. Sweden has prospered outside the Euro zone (though its export-driven economy is expected to suffer next year given a likely Eurozone recession). More countries should follow the model of Sweden and adopt more realistic leverage rules in their banking systems.

Meanwhile, long $100 of SPY and long $40 of EUO provides exposure to attractively priced stocks in combination with a short € position since most disaster scenarios for the stock market start in Europe. The relationship between the two has tightened in recent weeks – Eurozone sovereign debt solutions promote austerity and are negative for growth; a melt-down clearly is; muddling through with neither of the above should be (in fact, has already been) positive for equities and only mildly bullish for the €.

Disclosure: Author is Long SPY, Long EUO

Many years ago, when hedge funds managed far fewer assets and returns were generally good, they were described as Absolute Return strategies. Perhaps the best industry magazine covering the sector is called AR Magazine. An Absolute Return suggests that it should be positive in most circumstances, which to most people sounds like an attractive proposition. But in 2008 hedge funds delivered a very definitely Not Absolute Return by losing 23% (as defined by the HFRX Global Hedge Fund Index) and thoughtful industry promoters concluded that a different adjective was needed to characterize their performance. Some settled on Uncorrelated Returns, suggesting that while they could no longer deliver consistently profitable results, they could promise that whatever they delivered would be uncorrelated with traditional assets. This can also be a worthy objective, assuming that over an appropriately long period of time the returns are positive. However, uncorrelated returns are not as easy to generate as you might think, and Felix Salmon noted just the other day that hedge fund industry returns were in fact becoming more correlated with equities.

And yet, CNBC reported on Wednesday that hedge funds were “dumping stocks” and hoping for a better year next year. Their report noted that hedge fund exposures to equities are the lowest since 2008. And so they ought to be. Because the HFRX is down 8.5% for the year, on track for its second worst year in history (handily eclipsed by 2008). Through November, the S&P500 (including dividends) is +1.1% for the year; the Dow Jones Corporate Bond Index is +6%. Clearly using the moniker “Absolute Return” more sparingly was a smart move. 2011 will mark the 9th consecutive year in which a 60/40 split between stocks and bonds has outperformed hedge funds. But the (sort of) good news is that hedge funds have shown that they can deliver uncorrelated returns. In fact, for many hedge fund clients they’ll be hard pressed to find other segments of their portfolio that have done as badly. There’s been a great deal of manic buying and selling, of risk on followed by risk off, of deleveraging and releveraging, and it looks as if for the average investor it’s burned up time, fees and capital.

If you’re not a hedge fund investor, you’ve probably done better in 2011 than those who are. Hedge funds are making my book appear more insightful than I might have hoped.

You don’t need a degree in Psychology to know that investors are nervous. Pick up any newspaper, or just take your own pulse. Macro issues dominate almost every investing decision, and it’s therefore not surprising that the safety of bonds remains attractive. No doubt fixed income has had a great run. The Dow Jones Corporate Bond Index, a benchmark of long duration investment grade debt, has returned 7.9% p.a. since the beginning of the millennium. The S&P500 has managed 0.5% p.a. over the same period. Investing by looking backwards can be reassuring – generally if something has happened before, it can happen again. Bonds look better than stocks in the rear-view mirror and they can appear pretty compelling looking forward too. If the Euro collapses then for stocks, so goes the conventional wisdom, down is a long way. And so it might be. But here’s the Math. High grade bonds (as defined by the relevant iShares ETF, LQD) yield 4.4%. That is what the hold-to-maturity investor in long-term corporate debt can hope for. Factor in a 40% tax rate on interest payments with 2.5% inflation and it will be hard to maintain purchasing power. Stocks were roughly 2.5 times as volatile as bonds over the last decade – selling those bonds and putting 40% of the proceeds in large cap, dividend paying stocks that yield 3.5% (with the rest, for now, in cash) maintains the same overall portfolio volatility and only requires 3.8% dividend growth to beat bonds (compared with a fifty year growth rate of 5%). The 60% in cash provides a useful option to invest at a later date when prospects are clearer – and who knows, maybe one day interest rates with an integer could return to the money markets. Ben Bernanke is steadily raising the stakes for those bond investors who wish to invest alongside him. The Fed’s QE2 program has created a large and non-commercial buyer for debt that is not motivated by profit. Indeed, the Fed’s objective is to create an environment in which bond investors wish they owned something else. Real returns on investment grade and government debt are likely to remain negative for an extended period of time. The Fed has the ability to ensure this state of affairs persists indefinitely should they so desire. “I promise you negative real returns for many years” may not be a catchy soundbite, but if Chairman Bernanke said those words they would not require any change in monetary policy. While it’s usually good to follow the smart money, in this case it may be academic smarts rather than street smarts that are on display. The most significant long-term challenge facing investors must surely be identifying alternatives to traditional fixed income.