Kyle Bass, who runs a hedge fund called Hayman Capital Management in Texas,  is gaining notoriety as an investor with the foresight to anticipate today’s growing sovereign debt crisis. If eurozone governments ultimately write down their debt because the weight of supporting their banks becomes too great, Kyle Bass will go down as one of the earliest to recognize and position for that. His worldview is dire, and it’s apparently prompted him to take some strange precautions such as acquiring $1 million nickels (20 million coins) because their 6.8 cents value as scrap metal exceeds their monetary worth. I listened to an interview yesterday on BBC Radio HardTalk in which he defended his views. The UK media tends to take a more populist stance with regard to hedge fund managers. It’s now 14 years since George Soros’s bet against Sterling preceded their leaving the European Monetary Union and ultimately declining to join the €. How fortunate that decision looks today, but at the time UK tabloids blared that George Soros had “broken the Bank of England” and financiers have never been fully trusted in the UK ever since. So the BBC’s interviewer adopted a combative stance, for instance accusing Bass of causing the collapse in Greek bonds through his bets on credit default swaps. Her attempts to portray him as a manipulating hedge fund manager exploiting opportunities for no benefit but his own were deftly handled with facts and figures. Kyle Bass has a point of view worth considering.

I went back and reread Bass’s investor letter from February, “The Cognitive Dissonance of it All”. He reaches a similar conclusion to Jim Millstein in Tuesday’s FT, although he focuses more on government revenues, debt and interest expense. Japan, given its shrinking and aging population combined with high levels of debt could not afford to borrow at the levels of other AAA-rated nations (such as France) because their total interest expense would exceed their revenue. As Bass says, “The ZIRP trap snaps shut.” (ZIRP is Zero Interest Rate Policy, pretty much what we have in the U.S. currently). I know people have been betting on a disaster in Japanese bonds for literally twenty years, and it has so far been a disastrous bet. But it does increasingly look as if it still is just a matter of time before we reach the tipping point. After reading what Kyle Bass has to say it’s hard to feel comfortable owning long-term government bonds issued anywhere in the world.

A perverse but totally understandable consequence of the current crisis is that even though it was an excess of debt that got us here, the cost of borrowing is about as low as it could get – at least in the U.S., thanks to the Fed’s confiscatory monetary policy. But in Europe, the cost of borrowing is rapidly reflecting the unfortunate reality that there’s just been altogether too much of it.

On Tuesday, the FT ran an Op-Ed piece by Jim Millstein, “Europe’s largest banks have become too big to save”. I can’t stop thinking about it. He makes the point that Europe’s biggest banks and governments are now so intertwined that one cannot fail without the other. Europe’s banking system is much larger relative to its economies than in the U.S., in part because European corporate debt markets are far less developed. Banks are also loaded with government bonds, an unfortunate consequence of the old BIS capital rules assigning no risk weighting to sovereign debt of any developed country. Bankers loaded up on peripheral European debt because it yielded more than German and French bonds but owning it didn’t require any greater capital. This is really the cause of today’s problems; the common currency simply eliminated the foreign exchange risk, but the capital rules made the build up of risk virtually free and bankers suspended critical judgment.

So what we have today is a symbiotic relationship. Europe’s governments sell bonds to their banks. Those banks, now sagging under the weight of mark to market losses on bonds are having to raise capital at a time of depressed equity prices. This creates the potential for Europe’s governments to need to support their own banks because they already own too much of their government’s debts. It’s a spiral, and the standard austerity prescription from the Germans may be starting to wear thin. The New York Times notes this in an article and wonders whether, as rising bond yields spread to northern Europe (France’s 10 year yields are currently 3.76%), the focus on deficit reduction may lose support. “All this underscores the ongoing nervousness about Europe generally and the banking sector specifically,” says my friend Barry Knapp from Barclays.

It’s not clear where it ends, and Jim Millstein’s piece leads quite logically to just about the worst outcome. So what’s an investor to do?

Well, as dire as things seem, timing equity markets is never easy and although the U.S. will inevitably be dragged down by Europe’s travails there is a world outside the eurozone and many stocks provide attractive return potential. We continue to be short the € in our hedge fund.

Within our Deep Value Equity Strategy we don’t invest in banks (too much leverage for my taste) and natural gas E&P names are no doubt cyclically exposed although it’s hard to see how much lower the price of domestic gas can drop than the $3.40 per MCF it’s at currently. Among the large E&P names we like Devon Energy, which is all domestic, has an attractive exposure to liquids and trades close to the value of its proved reserves. McMoran Exploration (MMR) is a smaller and highly speculative position that will likely resolve itself by the end of the year when it gets results from its Davy Jones Flow Test. MMR had some mildly positive news earlier in the week from their Lafitte Ultra-Deep Exploration Well but this company’s future will likely be driven by Davy Jones. MMR will move up and down with the European debt crisis but its value really has absolutely nothing to do with the price of Italian bonds.

We’re avoiding obvious risks such as financials, and using bottom-up analysis to manage top-down risks.

Disclosure: Author is Long EUO, DVN, MMR

Charles Evans, Federal Reserve Bank of Chicago President, was on CNBC yesterday and nicely illustrated why bond yields could stay low for a considerable time. At times sounding as if he was running in a Democratic primary campaign, Evans commented repeatedly on the pain out there in the economy and the chronic unemployment. Interestingly he maintains that the “natural” rate of unemployment remains at 6% even while the numbers of long-term unemployed remains high. The Pew Research Center recently reported that nearly 32% of those out of work haven’t worked for a year – over time leading to an atrophying of skills, reduced employability and ultimately less excess capacity in the labor force as the jobs market moves on. It is no doubt a terrible human tragedy – if only Washington could stumble on the right policies to fix it. But the familiar partisan gridlock remains.

Therefore, since low interest rates are the time-honored solution to economic distress, we face more of the same. It is a recurring irony of recessions that while excessive exuberance and debt generally precede if not cause a slump, much pain is also borne by those whose affairs were managed altogether more prudently. So it is that bond investors today are paying for the sins of their more profligate neighbors through miniscule interest rates that erode the purchasing power of their savings. The over-indebted are helped with a transfer of real wealth from the frugal. Managing your own affairs carefully carries less reward than it might.

A consequence is that dividend yields on a number of blue chip stocks are higher than the yields on their own bonds. This used to be far more common in the early 20th century when bond coupons were regarded much more favorably than uncertain dividends, and you can’t rule out that this state of affairs could persist for many months. It maybe even turn out that this yield advantage of stocks is appropriate for the risk, if we endure a period of protracted slow growth or recession that sees no dividend growth. High dividend yields can indicate corporate stress. Transocean’s stock  (RIG) currently yields 6.4%, but the market recognizes some risk this will be cut, either through continued poor execution by management or following a larger than expected settlement with BP on last year’s Macondo spill. On the other hand, Johnson & Johnson (JNJ) stock yields 3.5%, comfortably above its twelve year bond yield of 2.6%. JNJ is not a stressed company and has raised its dividend annually for 49 years. They’re likely to earn close to $5 per share this year and consensus expectations are for 5% EPS growth in 2012. There are numerous other examples in this article for instance. Pepsi (PEP) and Kimberly-Clark (KMB) probably belong in the same category – companies whose stock is highly likely to outperform its own debt.

Falling and low bond yields have so far not dulled retail investors’ appetite. Strong returns on fixed income in recent years, for those who buy securities because “the chart looks good” reduce their return potential as assuredly as night follows day. The most you can earn on JNJ 6.75% corporate bonds maturing 11/15/2023 and yielding 2.6% is, well, 2.6%. That doesn’t even cover inflation, never mind taxes for the eager, momentum-driven buyer. If that return beats stocks over the next ten years it’s unlikely that most types of corporate risk (credit or equity) will have been comfortable places to be. Is it possible the buyers are actually expecting still lower yields and therefore some capital appreciation? Ben Bernanke has surely demonstrated that yields can always go lower. But if you like JNJ bonds at 2.6%, surely treasury bills for a couple of years at 0% with the retained option to invest on better terms later on must be a viable alternative? With a modified duration of just under 9, if the yield rose to 2.9% the capital loss would eliminate the coupon income. A portfolio of reliably growing, dividend paying stocks either in combination with a beta-neutral hedge or cash is far more attractive than high-grade bonds.

Disclosure: Author is Long RIG, JNJ, KMB, PEP

While the troubles in the Euro-zone have clearly been a major source of uncertainty for U.S. equity investors, it’s beginning to appear as if negative consequences will be largely imposed on Europeans with manageable fallout elsewhere. No doubt there’s still plenty to worry about and this assessment could be wrong, but the economic data is starting to point that way. EU-zone GDP growth of 0.2% was meager but pretty much as expected – the FT’s headline announcing that “Germany and France drive eurozone growth” seemed at odds with the numbers. Europe doesn’t look as if anyone’s driving except towards a cliff. As a result. it’s increasingly looking as if U.S. and Euro-zone growth will diverge significantly with the tail risk being for an even greater difference. Base Case forecasts from JPMorgan are for 2012 real GDP growth of 1.7% in the U.S. versus -0.6% in the Euro-zone. This is why there’s still a case to be short the €. Even without a financial disaster, plausible baseline assumptions favor the U.S. economy over Europe’s. But before you conclude that all the unthinkable outcomes have already been contemplated, read the op-Ed in the FT by Jim Millstein, chairman of Millstein & Co. Mr. Millstein argues that Europe’s banks are beyond too big to fail – they’re too big to save. The size of Europe’s biggest banks relative to their economies is disproportionate and far larger than in the U.S. If his warning of wholesale sovereign debt writedowns and bank recapitalizations comes true, new sources of private capital will be needed beyond whatever the IMF can supply. It’s a sobering scenario.

At least savers in Italy, Spain and even France are being offered a positive real return on ten year government bonds (nominal yields of 7%, 6.3% and 3.6% respectively). Given the sorry state of developed country finances every where including the U.S., it’s hard to see why anybody would lend to anyone for ten years at low single digit yields. 2% in the U.S. is derisory, and every day the Federal Reserve drives thinking fixed income investors away – to senior loans (we continue to own BHL and PPR) and to MLPs . In fact the 1 year return through October on the Alerian MLP Index AMZ is +7& compared with just 1.1% % for the S&P500 and 2.3% for REITS. MLPs are best accessed through individual holdings in order to fully benefit from the 6% tax-deferred yields available.

Dividend paying stocks remain a valid alternative. Ten year treasuries represent such poor value that only $20 in dividend paying stocks can generate the same after-tax return as $100 in treasuries (assuming 4% annual dividend growth).  A barbell, made up of cash invested in treasury bills and dividend paying stocks, is a valid alternative to today’s overpriced high grade bond market.

60 Minutes ran a piece last night revealing that Congressmen are not only exempt from the insider trading laws that apply to everyone else but also routinely exploit inside information to which they have access. That’s right, members of Congress can and frequently do profit from inside information, and it’s perfectly legal. Further description hardly seems necessary – you just have to believe that the leadership will be sufficiently embarrassed by the report that they’ll correct this glaring abuse swiftly.

The challenges facing the Euro zone including most recently Italy seem so enormous and intractable that it’s easy to contemplate previously unimaginable outcomes. Der Spiegel reports that the German government is preparing for a possible Greek exit from the Euro. The currency was designed without an exit – it’s unclear how Greece could extricate itself. A weekend nationalization of banks with all deposits converted to drachma? The new currency would immediately collapse from its initial level as unwilling holders of drachma sold, and in any case the days and weeks leading up to such an event would no doubt see a sharp run on deposits from Greek banks. As it is there’s a tax on money leaving the country. And we read every day that supporting Italy will require the IMF and a reinforced EFSF. What will happen if Italy can’t refinance its debt, €250BN of which rolls over in 2012?

But you don’t need to bet on disasters to see downside for the Euro. Just muddling through and avoiding any of the crisis scenarios is going to involve slower growth. The Austerity Solution so favored by the EU and IMF is assuredly lowering GDP growth in the region as well as consumer confidence. The growth differential between the U.S. and the Euro-zone continues to widen. JPMorgan now forecasts +1.7% 2012 GDP growth in the U.S. versus -0.6% in the Euro-zone. Solutions and non-solutions seem to lead to the same place. The next 10% move in the exchange rate looks far more likely to be lower.

The Financial Times notes that Liquid Natural Gas (LNG) tanker ships are experiencing increased demand, one of the very few areas of shipping for which that is true. The rest of the shipping industry has shot itself in both feet as every operator positioned for a 10% increase in market share, which has crushed shipping rates through overcapacity and made the sector even less friendly than U.S. residential construction (if that’s possible). But the virtual shutdown of the Japanese nuclear energy industry following the earthquake has increased Japanese demand for LNG imports and is raising prices. Regrettably, producers of domestic natural gas in the U.S. are not direct beneficiaries because the U.S. currently has no facilities at which natural gas can be compressed for export, but greater global demand is a positive over the long term (i.e. 3-5 years).

Still on the subject of shipping, we continue to be invested in Aegean Marine Petroleum (ANW). They provide bunker fuel to the shipping industry and so operate a very different business model than their customers. Their stock price has been beaten down with their peers, although they continue to generate operating profits and just reported a third quarter of solid margins. If you can believe their book value (assets are ships and fuel inventory) the stock trades at a 40% discount. On their earnings call last week management asserted that market value for their ships was no lower than carrying value – much of the fleet is recently purchased so that ought to be true, although they did take a loss versus book value on the sale of one vessel in the third quarter. Even after rallying on last week’s earnings it still trades at less than 7 X ’12 estimated earings. We continue to hold a modest position in ANW.

Berkshire Hathaway (BRK) remains one of our biggest holdings, for reasons articulated the other day. Warren Buffett’s appearance on CNBC this morning was never boring, and he revealed an investment in IBM which is not a stock we would have bought ourselves. Many large cap U.S. stocks appear attractively priced, and the dividend yield on the S&P500 (SPY) remains more attractive than long-term government or high-grade bonds. The equity risk premium is not as wide as it was but remains nonetheless attractive in favoring equities over fixed income.

Disclosure: Author in Long EUO, BRK, ANW, SPY

A friend brought my attention to a recent article in the FT by James MacKintosh in which he noted how hedge funds have increasingly been delivering returns that are correlated with the S&P500. It looks as if increasingly the search for alpha includes trying to time beta. The media isn’t normally so negative on hedge funds – perhaps Mr. MacKintosh has looked at the website for my book.

One of the problems with selecting hedge funds is that so few of them consistently outperform their peers. Manager selection is really the only way to justify a hedge fund portfolio. If you can’t pick funds with skill then it’s best not to bother, because average hedge fund returns have trailed treasury bills . An investor can be a passive investor in equities through mutual funds and need not possess any security selection skill to justify exposure to the assets class. The same cannot be said for hedge fund investors.

But the challenge of picking good managers is compounded by the fact that returns mean revert. For the vast majority of funds, not every year is a good year. I did some analysis earlier this year for my book using data from BarclayHedge. Suppose your objective is to pick managers in the top 40% – seemingly not exactly a tall order you might think. However, of those managers that are ever in the top 40% only 7% are able to stay there for every year of their existence. The best managers have mediocre years. Whereas an equity investor can try and exploit mean reversion and sell his winners to reinvest in that year’s underperformers, such an option doesn’t easily exist for the hedge fund investor given the lengthy time involved in due diligence. And hedge fund managers who concluded this was their clients’ strategy would quickly tire of such a flighty investor, perhaps refusing to take them back.

It’s not that hedge funds are all bad – and indeed the hedge fund industry has generated fantastic results. It’s just that those results haven’t really made it back to the investors who provide the capital. Hedge fund investors need to do better than they have.

At least Italian savers are offered a decent return on their money. 7% on ten-year debt is a bit more like it – at least after taxes and inflation you stand a chance of being ahead of the game, unlike in the U.S. where government policy is hostile to savers and seeks to inflict real losses of purchasing power on anyone desperate enough to invest in government bonds. We could use some Italian yields here in the U.S. However, in Italy there’s just the non-trivial question about ultimate repayment. Meanwhile, Senior loans in the form of two closed end funds, PPR and BHL, yielding around 6% seem a much better bet. Diversified credit risk to leveraged corporate borrowers with short duration, versus concentrated sovereign credit risk with dysfunctional government and long duration. There’s no yield at which we’d invest in Italy; we did buy more of these two funds yesterday.

If the sellers of Italian bonds over the past few days have been banks, it would be wholly understandable. The “voluntary” 50% haircut they agreed to over Greece clearly sets a precedent rather than being unprecedented. Combined with the natural consequence that sovereign credit default swaps have questionable value (since the 50% write-down likely won’t trigger a default event) return of capital is trumping return on capital. Forecasting where the crisis will end remains a complex struggle, but by now we’re becoming trained to contemplate the unthinkable. Markets even seem to have moved beyond the EFSF and that leaves just the IMF to bail out with real money and strings attached, or ultimately the ECB to create money. What a surreal outcome that would be given that the ECB’s constitution was modelled on the Bundesbank’s and more or less dictated by Germany. And of course it may not happen. But with Italy now “in play” so to speak, yet another unthinkable is now a headline. German policymakers will have to wrestle with their deep-seated fear of inflation and their perhaps equally strong desire to maintain the Euro in is present form. We maintain a short € position (through being long EUO) as a hedge on some of our leveraged strategies. We reduced the position yesterday – it’s not that the crisis is over, but obviously everyone gets the joke by now so the $/€ exchange rate provides less protection than it used to.

Disclosure: Author is Long PPR, BHL, EUO

Of the many ways in which Silvio Berlusconi thought he could be forced from power, rising Italian bond yields was probably not high on his list. Even his titillating escapades seemed to have been insufficient to persuade the Italian electorate he should leave. But it turns out 7%+ bond yields, with €300Bn of new borrowing required in 2012, is the the breaking point. Less than a month ago the focus was on Greece and building a secure firewall with the EFSF to prevent contagion spreading to Spain or Italy. Now here we are, and we’re running out of unthinkable developments.

It’s not that Europe doesn’t possess the savings to fund profligate countries while they adopt the German fiscal model. It’s just that the money is in the wrong place – northern Europe not Southern.

So another test of equity investors’ fortitude looms. The S&P 500 (SPY) will once again shift from greed to fear. But it’s always worth looking at the fundamentals of the companies you own. For example, in our Hedged Dividend Capture Stategy, McDonalds (MCD) reported 5.5% Year-on-Year sales growth in restaurants open more than a year. Even in Europe sales grew 4.8%. It yields 3% (more than 1% over ten year U.S. treasuries) and could grow earnings at 10% next year. Kraft (KFT) just revised up their 2011 guidance from $2.25 to $2.27 and continues to exploit synergies from their Cadbury’s acquisition. KFT is also likely to grow at double digits as it prepares to break itself up into two companies and yields 3.3%, more than 1.3% over ten-year U.S. treasuries. The Federal government wants your tax dollars, but really doesn’t want your savings. That’s the message of today’s bond yields.

The near term is usually uncertain, and especially so right now. But the prospects of these and other companies remain solid.

In yesterday’s election the voters of Ohio rejected by 62% to 38% a state law that limited the ability of public sector workers to collectively bargain and to strike. It’s a remarkable reflection of how Ohio voters feel about their government – I mean, who do state employees work for if not the people of the state? Ohio employs 769,000 people in government which represents only 13% of the labor force, substantially less public sector employment than in other states. Union membership as a percentage of the labor force in Ohio is less than 14%, although modestly above the national average of 11.9%.

The law that the Republican-controlled legislature had passed included limits on the ability of public sector workers to collectively bargaining or strike and required greater contributions to their retirement and health plans. The average voter in Ohio must think that all these public sector workers work for some foreign government. I think they’re emulating the Greeks. Perhaps it’s because I grew up in Britain during the 70s when unions periodically held the country to ransom. At times in Europe they still do.

But as an investor you take the world as you find it. I don’t have any plans to invest in Ohio, nor live there. Democracy allows people to vote for concepts that are not obviously good for them. Ohio is adopting some of the values of Europe that have created the current Euro sovereign debt crisis.