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Wednesday, 15 September 2010

For Bad News Bulls, Adversity Is Opportunity

LONDON — For the better part of a year, a small band of investors and economists has been arguing that the torrent of grim news on jobs and the stagnating United States economy is shrouding an immutable fact: the recovery is at hand — you just can’t see it yet.

At a time when fear-stricken hedge funds are stocking up on gold, retail investors are fleeing the stock market and gloom-peddling economists like Nouriel Roubini are commanding the airwaves, making a bullish case for stocks can be lonely, dispiriting work.

But therein lies the opportunity for investors like John A. Paulson, the hedge fund executive who made billions by betting on a housing crash, and Bill Miller, the mutual fund manager at Legg Mason Capital Management best known for his 15-year streak of beating the Standard & Poor’s 500-stock index.

Mr. Paulson has big stakes in companies like Bank of America and JPMorgan Chase as well as the French automaker Renault. Mr. Miller is betting on I.B.M. and Citigroup, and says that large capitalization American stocks have not been this cheap compared with bonds since 1951.

“The corporate earnings of both European exporters and U.S. companies have exceeded analyst estimates,” Mr. Paulson wrote in a letter to investors this summer. “The S.& P. 500 now trades at only 13.8 times 2010 estimates, well below the 30-year average of 19.5.”

So far, the returns have been hard in coming.

Mr. Paulson’s Recovery fund was down 9 percent in August, and over the last three years Mr. Miller’s main fund is down 16.5 percent, compared with a 10 percent decline in the S.& P. 500.

For many analysts, the idea that one should ignore the chief economic indicators is absurd — especially when they suggest that the world’s largest economy is heading into a deep slump.

“To steal a march on the market, one should follow the leading indicators closely,” Albert Edwards, a well-known bearish strategist at Société Générale, wrote in a note last week. He is forecasting a 50 percent retreat for the S.& P. 500. “These are variously pointing either to a hard landing or, at best, a decisive slowdown.”

The bad news bulls do not dispute that the relentless beat of lost jobs and sagging house sales represents a serious economic threat.

But they argue that in many respects this avalanche of bad news has little bearing for a growing number of corporations that are making money by relying more on technology, borrowing at rock-bottom rates and increasing sales to galloping overseas markets in China, Brazil and India.

“Yes, the job numbers are frightening,” said Michael Hintze, the founder of CQS Management, a fixed-income hedge fund based in London. “But that does not affect a company like Glaxo, which sells a value-added product into markets like China, the U.K. and Indonesia.”

No doubt, the indicators of fear remain powerful.

They include the persistence of net short positions on the broad indexes; the still relatively high financing costs for banks, despite low interest rates, which curtail lending; a rising number of large Wall Street banks that are forecasting an increased likelihood of a second recession; and most significant, the widely held notion that house prices in the United States will not soon recover.

Mr. Hintze, who manages about $6.8 billion, refers to what is commonly known in financial circles as an “upcrash,” in which a market consumed with negativity finally realizes that things are not so bad and begins to climb the wall of fear and produces a sharp, and in some cases, long-lasting rally.

What Mr. Hintze and other like-minded investors are betting on is that in spite of the combination of high sovereign debt and unemployment figures, global companies with worldwide brands and limited leverage are in a position to drive a longer, more sustained stock market boom.

But for that to happen, they say, investors must break free of a tendency to either stay on the sidelines or continue selling whenever there is a bad report on jobs or housing.

“Apple does not depend on U.S. housing starts, nor does BMW,” said David F. Marvin, chairman of Marvin & Palmer Associates, an institutional global equity fund based in Wilmington, Del.

Since 2007, Mr. Marvin’s assets under management have shrunk to $4.6 billion from $12 billion, and he concedes that it has been hard to persuade clients to take risks, given what has happened since 2008.

“When you are burned that badly you get cautious,” he continued. “But there is a real boom going on now in emerging markets from China to Korea and India, where incomes are rising and there is demand for the upscale products that LVMH and Mercedes produce.”

In a report on the United States economy published in July, the director of economic research for the Milken Institute, Ross C. DeVol, pointed out that in the second quarter corporate investment in equipment and software increased at an annualized — and unprecedented — rate of 24.9 percent as companies made use of available cash and easy borrowing terms to become less reliant on human workers.

“It’s a bit of a disconnect because this will retard job growth,” Mr. DeVol said, “but companies are becoming more efficient.”

Mr. DeVol is forecasting United States unemployment of about 7.7 percent at the end of 2012, a high figure for the country but one that he argues reflects the fact that many people who have lost their jobs as a result of the recession will not be qualified to re-enter the work force.

And therein lies the rub. Is the rise of a global corporate elite, increasingly dependent on markets like China, India, Turkey and Brazil, enough to generate a broad-based stock market recovery even as house prices sink and good jobs remain increasingly difficult to find in the United States and Europe?

A large number of hedge funds, generally seen to be the most courageous of investors, remain for the most part on the sidelines. Hurt by poor performance this year, prime brokers say many of the big funds are largely unwilling to take on significant leverage and make a bet on stocks.

All of which leaves the bad news bulls in a distinct minority, rarely seen and not often heard — for now at least.

“The prevailing view is definitely negative,” said Byron R. Wien, global strategist for the Blackstone Group, adding that he had begun to observe a tendency for investors to take on more risk. “But that provides an opportunity for optimists.”

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