PERHAPS ONE OF THE greatest failings in the run-up to the financial meltdown was a lack of perspective — an inability by many market participants to see the big picture. Not so with Kevin Duffy and Bill Laggner, principals of the Dallas-based hedge fund Bearing Asset Management. With the help of their proprietary credit-bubble index, developed in 2004, the managers sounded early warnings on housing and credit excesses, and capitalized handsomely on their forecasts by shorting Fannie Mae, Freddie Mac, money-center banks and brokers, builders, mortgage insurers and the like.
Students of the Austrian school of economics, which espouses a free-market philosophy that ascribes business-cycle booms and busts to government meddling with interest rates, the pair is solidly in the contrarian camp, believing that the worst for the markets may be yet to come.
Students of the Austrian school of economics, which espouses a free-market philosophy that ascribes business-cycle booms and busts to government meddling with interest rates, the pair is solidly in the contrarian camp, believing that the worst for the markets may be yet to come.
The two established Bearing in June 2002 after running their own money and, before that, a stint by Duffy at Lighthouse Capital Management and by Laggner at Fidelity. Bearing now has about $60 million under management, and they have returned on average an impressive 18.28% annually since setting up shop. They hold refreshingly against-the-grain views on what's ahead.
Barron's: You've said that perhaps the most redeeming feature of capitalism is failure. Please explain.
Duffy: Any healthy system needs a way to correct error and remove waste. Nature has extinction, the economy has loss, bankruptcy, liquidation. Interfering in this process lengthens feedback loops. Error and waste are allowed to accumulate, and you ultimately get a massive collapse.
Capitalism is primarily attacked by two groups: utopians who wish to impose a more "compassionate" system, and political capitalists who want to enjoy the fruits of success without bearing the pain of failure. They use the coercion of the state to gain privileges, at the expense of everyone else.
As a country we've become less tolerant of economic failure. The result has been a series of interventions, such as meddling in the credit markets, promoting homeownership and creating a variety of safety nets for investors. Each crisis leads to an even greater crisis. The solution is always greater doses of intervention. So the system becomes increasingly unstable. The interventionists never see the bust coming, then blame it on "capitalism."
Do you see the S&P 500 retesting its lows of this year?
Duffy: It's difficult to know. It depends on how much money gets printed. In real terms, can we get cut in half from here? We think so. S&P earnings are distorted because of accounting changes for banks and brokers; if banks were marked to market, S&P earnings next year could fall to $45 a share. Bullish sentiment is rivaling the 2007 top, and volatility has fallen dramatically. We like the VXX, an exchange-traded note that's based on S&P 500 short-term volatility as measured by the VIX index. It's down 67% this year, and fits into the whole idea that complacency is very high.
Indeed. Are there any sectors of the market that you do find attractive?
Duffy: We are long consumer staples, discount retailers and pharmaceuticals. One way to participate is through the Gabelli Healthcare & Wellness Trust
What are your other themes?
Laggner: We are heavily short Japanese and U.S. government long-term bonds. Greece's deficit to GDP is approaching 15%. If you look at the proposed debt-ceiling increase in the U.S. [the Senate voted Thursday on a near-term increase to $12.4 trillion from $12.1 trillion] and at the current administration's planned spending, we are probably going to be at roughly 13% deficit to GDP this fiscal year, so basically we are Greece, where 10-year-bond yields rose 160, 170 basis points. [A basis point is a hundredth of a percentage point.] U.S. bonds are down about 20% this year, so we see a process in which creditors just shy away from funding our long-term obligations, and long-term rates keep creeping higher.
The Fed has controlled the long end by monetizing Treasuries and mortgage-backed securities. If they see the long end getting away and decide to come back into the market and buy, that will result in a much lower dollar and higher gold prices. Gold is reflecting not just inflation but instability around the world related to these business models that have been adopted by governments.
What about the big banks? When do we see the denouement?
Laggner: There is some deleveraging in the consumer space, but little or none in the professional-speculator space, the bank money-center space. Credit Suisse is apparently allowing its hedge-fund clients to return nearly to the leverage levels at the peak, in '07. Assuming financial-accounting regulators reinstate off-balance-sheet rules on securitizations early next year, Barclays estimates it will bring roughly $500 billion in off-balance-sheet assets back onto bank balance sheets in 2010. That is going to force the banks to raise capital. A lot of structured finance is carried on the books of banks at close to par.
The FDIC [Federal Deposit Insurance Corp.] took over Corus Bank and Guaranty Bank and liquidated their books, and that debt is going for anywhere from 33 to 37 cents on the dollar. Until the regulators force banks to realize these losses, it's like the entire financial sphere is in suspended animation. A large chunk of CMBS [commercial-mortgage-backed securities] aren't being serviced. The same with residential mortgages, whether in the loan-modification-market program or not: Banks are able to carry a lot of these loans as performing loans, even though they are not performing. Japan tried the same thing, and it just lengthened the process. And we are going down that Japanese road.
