The Random Walk

Financial market analysis

Edited by:
Miles Hamilton
Adrian Booth
 Random Walk commentary Adrian Booth
The phrase „trading range‟ is being used
more often than in 2009. In 2009 the
common phrase was „rally‟. Since October
of last year the FTSE 100 and the S&P 500
have remained unchanged and a sideways
pattern has formed as investors await
clarity on a number of issues. The first and
most prominent is the Greece debacle as
well as the „exit strategy‟ of central banks.
Politicians and mainstream economists
have been cheerleading this „recovery‟
now for over a year, yet he fact remains we
are stuck in a long painful deleveraging
process that will take years, not quarters.
During a period of deleveraging or „on and
off‟ recession, investors realise the true
value of assets such as stocks and real
estate. Now that equity prices have soared
majestically in the past year we believe
that a „crash warning‟ is in order. This
warning is just that; a warning. It‟s not a
forecast. A prediction. A calculation.
We still think it‟s wise to remain cautious
in the current environment as
policymakers continue to play with fire.
Equity prices could still rise. In fact the
best performing stock market of this last
decade was Zimbabwe, when measured in
worthless currency. Sure you would have
made a hefty profit in Zimbabwe dollars,
except your money could buy less. The
index jumped a few thousand percent. In
gold terms or measured in Euros the index
essentially crashed.
For all the stimulus measures the
government undertook, the economy is
still in the dumps. Real unemployment
reaching 17%, when counting those forced
to work part time or have given up
searching, and new home sales have failed
to recover. Bank lending continues to
decline and new business loans are scarce.
The FDIC‟s Quarterly Banking Profile
states that bank lending shrunk by 7.5% or
$587bn in the fourth quarter of 2009. It‟s
deposit insurance fund is now at a negative
$20.9bn. GDP should take a hit as a result
and the FDIC may need a bailout from the
US Treasury. Expect it to tap its line of
credit with the Treasury by years end. The
FDIC‟s recent numbers also show an
increase of 27% from the 3rd quarter of
troubled banks. This raises the total to 702
institutions. New home sales in the US
shrunk by 11.2% in January, or 309,000
units annualized. Freddie Mac is currently
bleeding money with a $7.8bn loss it made
in the 4th quarter. With trillions pumped
into the system, we clearly aren‟t getting
value for money. The economic picture
remains dire for the US and the rest of the
world. With only 5% of the world‟s
population, the US is borrowing 2/3 of the
worlds savings. In 2009, $5.3 trillion was
required to fund the World‟s economies.
Over $3 trillion was for the US alone. The
authorities can only paper over this mess
for so long before the tide goes out. It‟s as
Warren Buffet said: “It‟s only when the
tide goes out do you realise whose been
swimming naked”. In the case of the US
economy, the tide is starting to turn once
more. •
Editor’s comment: The masked problem.
My impression is that for the US, the main development
is that the Greek debt crisis has masked the incipient
backlog of foreclosures and mortgage losses. To me this
seems to reflect the fact that banks have delinquencies
and foreclosures that need to be worked through as they
still present a risk to their balance sheets. Ultimately, it
seems that banks have not fully realized the losses that
the collapsed housing market has created.
 The gold bug
George Soros said that Gold was in an ‘ultimate bubble’ and he has recently increased his stake in a Gold exchange
traded fund. While many believe this is contradictory, there is a strategy that I think Soros is pursuing. By Miles Hamilton

While the gold price is up 64% over the George Soros has recently doubled his
last three years, gold shares are up by only stake in the in exchange-traded fund
20% over the same period. If gold shares SPDR. I believe that this is because he has
make up some of the lost ground, investors predicted the possible correlation. From
could benefit. the beginning of 2009 to the present, Gold
and the SPDR ETF have gained nearly an
identical amount. On a return basis, they
have been moving in tandem earning 23%
in this time frame. The two securities have
developed a strong correlation since April
of last year and it seems that there will be
an inevitable dissipation. The only way
this will happen is if gold languishes or the
SPDR ETF sees returns greater than the
Gold price. •
The graph above reflects how there is a
disparity between the price of gold and the
price of gold shares. The graph shows the
Deal or no deal?
Bankers say that the biggest worry among potential
market index for gold stock in Canada
bidders at the moment is not how to finance a deal but
(white) and the price of Gold (orange).
how institutional investors will react to it given the
Thus, it is possible that there will be a
recent economic turmoil. By Folarin Araromi.
convergence in the two indexes with the
price of gold
decreasing and
stocks
increasing.
Therefore, an
investor could
short gold and
take a long
position on
gold stocks to
Given the scale and scope of the worst
profit from the convergence and
economic downturn in decades, it is of
correlation.
little surprise that the global mergers &
As the centre graph reflects, March has acquisitions (M&A) market suffered badly
been the worst month for the price of Gold in 2009. A total of 9,493 deals, worth
and Credit Suisse believes that on this US$1.76tn, came to market over the year,
a decline of more than 25% in terms of
basis we can expect Gold to drop in price.
both deal volume and value from 2008.
This is evidence to suggest that a
convergence is imminent.

Global deal value is correlated to the
volatility of the equity capital markets
(ECM), lagging on average by one quarter,
such that the value and number of deals
has tracked the equities markets since
1990. While growth in ECM encourages
M&A to grow at similar rate, a
consequence of falling confidence in the
ECM is that M&A activity dries up. This
was particularly evident in March 2009
when the FTSE 100 plummeted to 3512,
the lowest level since the eve of the Iraq
war in March 2003.
In 2009, a meager nine firms launched an
initial public offering (IPO) on the London
Stock Exchange, raising less than £1bn,
the lowest amount in more than 15 years,
according to Dealogic. The UK market for
IPOs, which before the crisis had seen
companies from home and abroad rush to
tap London's financial infrastructure, froze
over as traumatised investors cowered
from risk. Despite this, there are a number
of encouraging signs that M&A and ECM
are recovering as deal making conditions
and market confidence slowly improve.
This can be seen to good effect by looking
at the quarterly breakdown of 2009 deal
flow with announced activity increasing
each quarter, trending upwards from 2,093
transactions in Q1 to 2,686 deals in Q4.
Q4 2009 also accounted for 30% of the
year‟s transactions as the financing
environment, and the general economic
climate began to improve. The climate for
large-cap deal making undoubtedly
improved as the year progressed, borne out
by the fact that five of the top 10 deals of
the year were announced in November or
December. This trend has continued into
2010 with several significant deals being
announced in the first few weeks of the
year. David Brooks, head of M&A at
Grant Thornton, asserts “While 2009 was
about repairing balance sheets with a
strong focus on cash flow and profitability,
2010 will see an increase in acquisitive
listed firms taking advantage of relatively
low valuations”. Proof again that even in
difficult times firms with strong balance
sheets and well defined strategies are able
to do big deals.
Furthermore, global ECM issuance
doubled in January 2010 when compared
to the same period last year. US, Europe
and Asia Pacific ECM are all up too 77%,
443% and 132% respectively compared to
January 2009. Follow-On offerings were
the main driver of ECM activity making
up 68.8% of the total activity for January
2010.
Additionally, a further wave of companies
is expecting to float in the first half of this
year as corporate and investor confidence
 increases with market rallies. However,
"The UK IPO market has always been a
size and price sensitive arena, and it is
today. As ever, vendors will try to execute
on proposals which are unrealistic and
end up disappointed. I would expect to see
a high degree of price debate in UK IPOs
this year” says Rupert Hume-Kendall,
president of International ECM at Bank of
America Merrill Lynch. 2010 has certainly
got off to a good start, especially with
Kraft‟s £11.5bn takeover of Cadbury
punctuating the end of the recession in
Britain, but the question still lingers - will The graph above shows the spread
investors get indigestion, or will the bout between European corporate bond yields
of renewed confidence allows a broader and equity dividend yields has fallen to 78
range of companies to come to market basis points, the lowest level since 2005. A
further into the year? • narrow gap favours stocks. Historically,
when similar levels have been reached
Editor‟s comment: Oil and Gas M&A equities have outperformed bonds and so
the implication of this is that equities are
Mergers and acquisitions activity in the oil and gas
intrinsically cheap relative to credit. In
sector is at its highest level since records began with a
effect, there is a cross- asset mispricing
value of $38.8bn. Activity has been spurred by a
stabilisation in the price of crude oil and that has opportunity as bonds do not offer that
reduced one of the traditional impediments to M&A- much extra yield. •
a gulf between buyer and seller valuation. Currently,

Commodities,
Goldman Sachs is ranked first in global oil M&A with
two deals worth a combined $13.5bn.

Deflation and Interest

Canelo stock valuation
rates. By Adrian Booth
According to a valuation method developed by Peter
Canelo from Morgan Stanley, stocks are undervalued
The talk of imminent interest rate rises has
if bond and dividend yields are similar. In this short
sparked concern that, as money looses its
article we apply this concept to the current financial
cheap status, commodities will suffer.
markets. By Miles Hamilton

According various strategists at Morgan

Stanley, European stocks are set to
outperform debt as the difference between
the yields on companies‟ stocks and bonds
is the narrowest in at least five years.
The chart above shows the 3-Month note
yield as well as the prices of industrial
metals and futures contracts linked to
commodities. We can see that in times of
sharply rising interest rates, commodities
perform exceptionally well. Yu Yingxi, a
Barclays analyst, mentioned in a report
that this shouldn‟t be counter-intuitive
seeing as rising interest rates are either
linked to rising inflation or growing
confidence in the economy. The future rise
in interest rates could therefore be a
profitable trade on commodities and
precious metals in particular in the next
few years.
However, it‟s obvious from the chart
above that the long term trend for
commodities is downward. The chart
below shows the inflation adjusted price
for a commodity index going back to
1934. The trend line remains down,
making it hard to make money in
commodities in the long run. That does not
mean to say an investor can play the one to
two decade long secular bull markets that
occur every so often. We care currently in
one that started in 1999 and that could last
to at least 2013-2015 where it may reach
its climax.
Deflation Plays:
The investment battlefield still dominated
between the forces of inflation and
deflation still rages on. The chart below
from David Rosenberg shows total loan
leases in bank credit from commercial
banks in the US. The unprecedented fall
continues and money supply, measured by
the broadest measure M2, also carry‟s on
declining.
This magazine believes the long term
outlook for the US and world economy is
inflation (hence the recommendation on
gold last week). This does not mean that
deflation risks cannot persist in the short
run. The best way to trade this short run
deflation play is through the Barclays
TIPS Bond Fund ETF. Many out there in
the investing world believe that TIPS
(Treasury Inflation Protected Securities)
come with a floating interest rate that is
linked to the consumer price index. In fact
it is the principle that changes, not the
interest rate. This makes this trade a safer
bet then others. The principle on these
TIPS changes twice a year with inflation
and rise as inflation rises. The upside to
this trade is that the par value of the
security will not drop below par no matter
how severe the deflation.
 Say, for example, the bonds value is $100.
If inflation rises to 10% in a year the
principle will rise by $10 and the value
will rise to $110. If, however, deflation is
at 5% and the real value of the security
declines to $95 dollars, the value of the
investment will not drop below par value
of $100. This is essentially an option on
inflation that protects the investor‟s capital
during inflationary times while remaining
profitable the more severe deflation
becomes. •
Editor‟s comment: Why will TIPS be a good investment?
At the moment, the breakeven rate or the yield spread between
a nominal Treasury and a TIPS bond maturing in mid-2019 is
approximately 2.3%. This suggests that investors collectively
expect inflation to run around this level. On the basis that we
expect inflation to be higher than the level reflected by the
differential, a TIPS bond could be a good investment as an
investor will receive an inflation adjustment on their principal,
which will translate into a higher payment at maturity along
with higher real yields because of the coupons received during
the lifetime of the bond.
A catalyst for correction:
Sterling
With widening fiscal deficits and heightened political
uncertainty, the pound fell to a low of against the
dollar on the 1st of march, the weakest level since
May 2009. By Miles Hamilton
In 1992 Gordon Brown stated that „A weak
currency arises from a weak economy,
which in turn is the result of a weak
government‟; a theory that has certainly
come back to haunt him. Sterling recently
dropped to $1.4780 against the dollar
because of worsening perceptions about
the prospects for the UK economy and
lack in the credibility of UK economic
policy.
The chart above shows the pound dropping
as speculators increased bets on its decline.
Investors are close to the most bearish on
sterling since at least 1992, as the Treasury
last month said its budget is heading for a
deficit exceeding 170 billion pounds ($262
billion) this financial year. According to
Satoshi Okumoto from Fukoku Mutual
Life Insurance Co. investors are
speculating that there will be a decline in
the pound as the government may have to
gradually weaken the pound in order to
prevent a further widening of the budget
deficit. •
Risky Business
In the past month, the risk premium on Greek
government bonds have fallen and in this article
we dissect this risk premium and analyse its
various components. By Miles Hamilton
The latter part of this month has seen an
improvement in sentiment as equity
markets shrugged off a rather turbulent
few weeks with regards to Greece. In
essence this is because the ECB has shown
its capability of supporting and controlling
the Greece situation and this has subsided
fears of a Greek default.
The decrease in default probability has
manifested itself in Greece‟s credit spread
which has fallen considerably from a peak
of 430bps to about 350bps. What these
credit spreads suggest is that Greece last
month had a 30% chance of defaulting on
its 5 year bond and this has decreased to a
25% default probability.
markets have consequently frozen.
Subsequently, there is only demand for
Greek collateral repos priced with a 40-50
basis point liquidity premium above
benchmark.

The default risk has fallen because the

European Central Bank can provide funds
by purchasing existing Greek bonds from
banks and institutions. Effectively this
means that the ECB can monetize the debt
issuances of European governments.

Risk premium for government bonds is

made up of two main factors; default risk
premium and liquidity premium. The most
substantial and significant is default risk
and this has been the main factor that has
elevated risk premiums.
The rising risk premium is explained by
Greece‟s rising debt levels. As GaveKal
stated „the correlation between public debt
ratios and Eurozone bond yields has
systematically been above 70% over recent
months.‟ This is because the Euro is
constitutionally anchored on sound public
finances because of the Stability and
Growth Pact, something that Greece has
betrayed.
However, GaveKal made an interesting
comment that liquidity accounts for 15%
of the risk premium. Throughout the
development of the Greek crisis, the
concept of liquidity risk has been rather
overlooked. Thus, I believe that there is a
liquidity risk that has not been considered.
The Greek repo market epitomises this
illiquidity. As sovereign risk has spilled
over into the financial sector, investors
have lost confidence and the Greek repo
The graph above shows how turnover in
the Greek stock markets have declined
reflecting a fall in liquidity. According to
Dimitris Kontogiannis, it is not easy to
find buyers of Greek debt when foreign
players want to sell a good amount of
bonds, leading to the widening of the
sovereign spreads. Many investors have
pointed the finger at the local secondary
electronic bond trading platform, which is
not liquid in periods of market stress
because the majority of primary dealers of
Greek government debt are not active as
they should be.
Lena Komileva, head of G7 market
economics at Tullett, stated that „we've
seen some positive reaction (to talk of a
rescue) in ancillary markets that have
liquidity but the funding market is still
shunning the risk of volatility and credit
risk in very short maturities‟ she said.
The LIBOR / OIS spread is often
suggested as being a measure of illiquidity.
BNP Paribas analyst Alessandro Tentori
said that the spread of Libor rates over
overnight indexed swap rates (OIS) --
currently 21 basis points -- may widen if
the ECB reverts to variable rate tenders as
some banks will have to bid well above the
marginal rate to secure liquidity.

th
In the Financial Times on the 4 of March,
David Hale questioned why the Greek
crisis was a problem for the Euro when it
only comprises 2% of European GDP.
Well in response to this, it seems, as
GaveKal suggests, that Greek risk
premiums are not accounting for the
potential dislocation of the Euro, however,
what has arisen from the Greek crisis and
what is a serious problem is the re-
emergence of country risk. The new reality
is that Greece's funding costs will
increasingly be a manifestation of Greek
fundamentals rather than German
fundamentals.
A further problem for Greece could be the
decreasing activity in the high yield
markets. To me this is of most pertinence
for Greece and its ultimate recovery.
Traditionally, Europe‟s high yield market
has been dominated by loans from banks
rather than bonds. That meant that there
was far less need for companies to get high
ratings which is in direct contrast to the
US which has the biggest and most mature
capital market. However, the loan market
was one of the biggest casualties in the
crisis and firms have been forced to find
money elsewhere. The growth of the high
yield market was intended to fill the gap.
Subsequently, if the high yield market
stalls, companies are in danger of being
starved of funds at a time when they are
most needed.
Thus, the current relapse in the Greek high
yield market could be a sign of turbulence
to come. Todd Youngberg from Aviva said
that „Investors are getting selective and
lower quality deals with light covenants
and high leverage will see the effect.‟
Furthermore, Boris Okuliar from UBS
said that „ratings are generally a firm
requisite for coming to market‟ and this a
quality that the Greek market currently
lacks. •
The Guru Column
This is a new column devoted to what the market
wizards are investing their money in. Our focus
this month is George Soros By Adrian Booth
George Soros‟ latest portfolio holdings
include a large purchase (94 million
shares) of Citigroup stock. We also know
Soros is betting heavily on Gold with a 6
million purchase of the „Spider Gold‟ ETF,
despite calling a bubble early last month.
Its clear from observing the sector
weightings of his portfolio that Soros
favours the Oil and Gas sector. 29.9% of
his portfolio is weighted in this sector
alone, with consumer services coming in at
second with 14.9%. His biggest oil holding
is Sandridge Energy Inc (SD), a company
with a principal focus on exploration and
production. Soros has a holding of 1.25
million shares with a value of $11m. Soros
isn‟t the only one. Legendary oil baron T.
Boone Pickens also has a substantial
holding in the company. Judging by Soros‟
investing habits, we know he is betting
heavily on oil and commodities. This
reflects our view that commodities will be
the best play for the next decade as
emerging markets continue to grow and
currencies continue to be debased. Add
low inventories of many commodities to
the picture and the stage is set for the bull
market to continue. •
 5 most financially-
damaging in peacetime
history by William Whyte
Chernobyl – the largest socio-economic
disaster in peacetime history: over 200,000
people had to be relocated at great cost to
the country‟s finances, and the total cost
(including investigation, resettlement, and
compensation to victims) has been
estimated to be $200 Billion. The cost of a
new steel shelter for the remains of the
Chernobyl nuclear plant cost $2 billion
alone. Even until 1998, the Ukrainian
Government took obligatory payments by
employers (from their workers‟ salaries) of
5% to go to a special government fund
dealing with the consequences of the 1986
disaster.
Space Shuttle Columbia- a disaster for
NASA and state funding in the US. After
crashing during re-entry over Texas in
February 2003, just under $500 million
was spent on the investigation, making it
the costliest aerospace accident
investigation in history. The original cost
of the shuttle was $2 Billion in 1978,
coming to $6.3 Billion taking into account
inflation for today. The search and
recovery of debris cost $300 million alone,
bringing the overall total to $13 Billion.
Prestige Oil – In November 2002, the
Prestige oil tanker was carrying 77,000
tons of heavy fuel oil when one of its
twelve tanks burst during a storm off
Galicia , Spain. According to a report by
the Pontevedra Economist Board, the total
cleanup cost $12 billion, not to mention
the 20 million gallons of oil lost at sea.
Piper Alpha Oil - At its peak, this rig
produced 31,000 barrels of oil a day, one
of the largest amounts for any single oil
producer globally. July 6 1988, the 300
foot rig platform was engulfed in flames. It
eventually collapsed, killing 167 workers
and resulting in $3.4 Billion in damages.
Exxon Valdez- Although not one the
largest spills, the sheer remoteness of the
ship when it lost its 10.8 million gallons of
oil in 1989 rendered a huge cost to
Exxon‟s clean-up receipt: approximately
$2.5 billon, including a victim
compensation of $500 million (as decided
by the US Supreme Court). •
Editors Word
We would like to express our appreciation to
all the contributions from those who helped
out. Thank you to Folarin for the excellent
article on M&A activity this year and William
who provided a great article on economic
catastrophes. We would now like to pitch for
contributions to financial research and writing
by any of those interested. This is a great
opportunity to get involved and help develop
your knowledge of the on goings in today‟s
financial markets. If you have any enquiries or
want to work with us don‟t hesitate to contact
us.
Miles Hamilton:
Number: 07841 014 338
Email: Mileshamilton@hotmail.co.uk
Adrian Booth
Number: 078 50122 007
Email: Adrian.booth17@gmail.com
This article features views and ideas that intend to give a
subject account of market events. Thus, they are purely an
expression of opinion. The article is intended for the
exclusive use of students and teachers of Cass Business
School. Unauthorized reproduction or distribution of this
material in whole or in part is strictly prohibited. Please
consult Miles Hamilton for further information.