Markets

Bull markets are born out of pessimism, grow on scepticism, mature on optimism and die on euphoria" John Templeton

the painful lessons of the past:

F

Equity markets follow credit markets

Equity markets crack on average six months after credit markets do.

Credit spreads widened ahead of of the crashes in 87 and 2000.

However equity and credit markets are more conected today.


Why
One of the biggest arbitrage trades in financial markets history is the massive use of cheap debt to buy cheaper equity.

The arbitrage gap still exists so the bull market is still intact.

At the last peak the bond yield was nearly 9% and the earnings yield was just 3%.

St present the earnings yield for both has converged to about 6% on both.

BBB bonds yields might have to rise 2% points

At the earnings yield of 4 that would involve the PE rising from 17 to 25 which is a very bullish sceneraio

However liquidity is another factor

The growth of nations

South Korea 1970, already enjoyed a decade of growth at close to 10%. It continued to grow close to that rate for a another quarter.

India was almost sealed from the world economy. Indias annual growth in income per head has fallen.

The priority in development is strong growth, which industrialisation can deliver.

Industry is the sector in which rapid and sustained rises in productivity are feasible.

IAS 36 Goodwill amortisation

Writing off goodwikll has the limited virtue of limiting the acquisition price, becuase the amortisation required reduces net profits.
Under IAS an acquiring company no longer has to amortise the goodwill of the business it acquires.

Bank manager mode

The equity market has been in classic bank manager mode: pressing money on those who don't need it, and turning away those who do

mark-to-market

mark to market CDOs

FInancials 2 (US)

Consider that the Q2 median earnings growth for financials so far, based on companies that have reported, is 17%, according to Zacks. That's much slower than 2006's hefty gain, but 17% puts financials second in 2007's Q2 horse race, so far

Financials

In an age of globalized finance, the business of money has been spectacularly attractive, and the assumption will continue to prevail until it won't.

Numico

Danone expects only to beat its weighted cost of capital six or seven years after the deal.

Oil an equities

Oil up 43%
Long term futures interest at all time high
Last Years crude price pike helped to depress glovbal stocks.
Good for oril stocks but bad for equities

Growth versus value bias

For years desperately low real yields have pushed pension funds and life companies into risky assets, as a means to fulfill promises to pensioneers and policyholders.

If corporate spending pushed up real yields, promises can met with lower risk.

For pension funds higher real yields mean lower liabilities through a higher discount rate.

Institutions would no longer have ths same appetite for CLOs.

Utilities today command a higher multiple than ths market (17 times versus 13 times), due to the institutional hunger for - inflation proofed- yield, private equity and infrastructure funds.

Higher investment should result in higer earnings. In normal times growth commands a higher premium than value.

In the end we might see and end to the huge bias towards value rather than growth stocks which characterised the market since 2000.

Chips

Chip production relative to chip inventories, the "SPI" index, is set to rise steadily until April of '08, and the Philadelphia Semiconductor Index may follow upward.

Shimada says in the last decade, the SOX and other chip indexes have followed the rise and fall of the SPI pretty closely.

Spiralling affluency in emerging markets

Richemond article

Food prices will rise between 20-30%

over the next decade supported by the growth in bio fuels and increased food demand from emerging markets.

The US economy isd bouncing along ...

at a a steady underlying growth path.

Teh US might stioll be thrown either by continued bad news from housing or an overly sharp tightening of credit markets.

However, coprporate spending and the labour market at the moment seem to be very robust.

US quarterly outlook

S&P consensus earningsgrowth expectations are calling for only 4.4%, given that GDP is expected to grow 3.7%, compared with 7.8% in the first quarter on the back of a 0.7% growth of the economy.

Given overseas economic strngth, a weaker dollar and a share buybacks we are likely to see positive surprises.

2008
political uncertainties
growing economic nationalism
protectionist attituted in the US and Europe
Unfavourable change of taxes

Stocks and wages

The ability of American companies to produce powerful earnings growth thas come from the interrelated effects of
- globalisation
- technology/productivity/outsourcing/off-shoring and
- the decline of union power.

Since labouyr costs comprise roughly 70% of US corporate costs, there is a very tight inverse relationship between profits and labour costs.

Anything that mighht disrupt the labour/earnings equation ends up being crucial to the stock market outlook.

NAV reits

In the Us reits are trading 8% below net asset value.

Land Securities and Britosh Land are traing below NAV by as much as 20%.

This means is that sharehodlers suspect that NAVs could be heading downwards.

This is a particularly bearish sentiment given that the best propoerty companies tend to create value through

- development
- refurbishment and
- land deals,

even when times are hard.

Interest rate swap

insurance against rising interest rates in combination with mortgages

Capital ideas evolving

The ideas that currently govern the way money is invested

1. The concept of balancing risk and return through tracking the mean and variance of market of market prices


2. The Capital asset pricing model that divides the return of a securityt into "beta" of sensitivity to the market and "alpha" an uncorrelated return

3. The efficient market that holds that the market always attempts to incorporate all available information

4. Black Scholes: which makes it possible to piut a notional value on options

Behavioural Finance suibstuitue insights from experimental psychology for the assumption of traditional economists athat people always act rationally.

CFO 2

Today, CFOs must actively contribute to their company’s development.

It is no longer enough to be a wizard with the numbers.

As an independent business partner, the CFO must help the company and its businesses
to develop their strategy by making the financial implications of the strategy transparent.

In regular review meetings, he or she is pointing out whether the business is headed in the right direction, where changes are needed, and where risks or new opportunities are emerging.

Thus, the CFO drives the design of structures, systems, and processes.

From my personal perspective as the CFO of SAP, this means that I have to proactively support our transformation from a pure software-solution vendor to a provider of both business application software and a business process platform that is increasingly focused on volume business.

To proactively support the lines of business during this transformation, we need time to concentrate on strategic topics.

One way we are making that space is by migrating transactional and standardizable finance processes to shared service centers. Service level
agreements ensure that these processes, which form the backbone of any finance organization, reflect best
practices. This allows us to move from processing transactions to supporting decision-making and performance
management.

At the same time, however, there is inherent tension in the role of the CFO as he or she is not only a business partner. The other role is that of a steward who is responsible for safeguarding the interests of stakeholders.

There can be no compromise on compliance. The quality of corporate governance will be a source of differentiation in its own right.

What does this dual role imply from an HR perspective? Finance people must not limit themselves to the back room; they must be happy working in a customer-facing environment, but still in a compliant and disciplined way.

Therefore, the CFO must look for people who enjoy communicating and working in teams. If working in finance ever was purely administrative and repetitive, it certainly is no longer that today.

Stakeholders not only expect excellent corporate governance; they also want an objective, transparent picture of the company, its prospects, and its risks. To meet all these expectations, the CFO and the finance staff need a profound understanding of their company, what the drivers of its market value are, and which risks and opportunities it is faced with.

CFO

The CFO is pivotal to restoring public trust and that he or she has to serve as an important bridge between the CEO and the board on governing matters.

In addition the CFO must expand the role of economic corporate steward, daring to dissent when necessary, and must serve, in his or her strategist role, the CEO with effective insights on the affairs of the company and its businesses.

In a survey of CFO Europe, 71% of the CEOs reported, that their CFO is their closest business confident.

But the new CFO-mission is not an easy one. CFOs have to fulfil various, partly contradicting tasks in parallel. They have to

Re-establish corporate trust and business integrit

Protect the company’s bottom line

Enable for profitable growth and shareholder value creation

Do more with less (increase the efficiency and quality of financial operations)

1. Restoring corporate trust and business integrity through a world-class corporate financial infrastructure

After a series of corporate scandals (Enron, WorldCom etc.) trust of investors in corporations has sharply declined – a fact that is threatening a company’s capability to finance its activities and ultimately, its “license to operate”. The Chief Financial Officer (CFO) and the finance function is playing a leading role in restoring corporate trust and business integrity.

2. Protecting the bottom line through extended transparency and dynamic performance management

After the economic boom of the 1990s, when most companies focused on top line growth at nearly any cost, many corporate executives are facing today, in the actual global economic contraction, a major challenge: declining sales figures force them to reduce costs in order to protect their bottom line.

This is putting the CFO and his finance team into center stage.

But today’s highly competitive and dynamic markets require companies to do intelligent cost reduction - cost reduction that is not hurting their existing growth potential, intangible assets such as human capital, intellectual capital or customer and business partner relations, and that is not putting their future at risk.

For this, corporate executives, business managers and controllers require extended information about current performance and about future risks and new business opportunities – beyond the transparency the traditional P&L and Balance Sheet delivers.

CFOs must react by providing new analytic tools that deliver not only accurate and timely information on current financial performance, but also on its drivers across the entire business.

One of the main objectives is to enable for more accurate forecasts, not just of financial performance but also of the underlying business drivers. Rolling financial and business forecasts are forming the foundation for dynamic performance management that help managers and executive to achieve their company’s performance targets in a dynamic business environment.

3. Enabling for profitable growth and shareholder value creation in a challenging business environment

Today, value creation strategies based on M&A activities, as applied widely in the 1990s, have come to a limit: when assets exchange at full market price no value added is created.

Still in some cases M&A and financial dealings can create value, but only if combined with accuracy and discipline in the evaluation and integration phase.

For most companies however, shareholder value today comes from internally generated growth and/or resource, cost and capital efficiencies.

But efforts in both areas work out only, if applied continuously - quick wins are exceptions. This also requires accuracy and discipline – unique characteristics the CFO brings to the table in the corporate management team.

So it is no wonder, that CFOs are involved more than ever in (the more seldom) M&A activities, are playing a leading role in strategy planning and execution, and in long term efficiency and productivity management.

A best practice in strategy management and corporate performance management is a portfolio management approach that takes into account the entire bandwidths of risk/return and all operational value drivers on the business unit level below.

This requires much more transparency for corporate management of the business units risk/return prospects and their value drivers than the traditional budgeting and financial reporting approach. The CFO is called to establish this transparency and to implement the tools and procedures to enable top management to make better trade-off decisions and to make the link between corporate and business units more productive.

Also the ability to manage for internal growth requires a deeper cut into the business: CFOs have to help business mangers to understand the economics of their businesses in order to create profits and value. For instance, they have to help them to understand customer requirements from an economic perspective and to select the appropriate service levels and products accordingly (as a result, customers requiring low service might be guided to buy commodity products only online).

Resource and cost efficiency is usually the result of continuous optimization work rather than of a one off event. CFOs have to establish and implement the procedures and systems to make that happen – for instance through continuous benchmarking as part of the performance management process.

And finally CFOs have to make sure, that created value is properly communicated to the financial community so that it can be recognized by outsiders and is reflected in the company’s share price.

CFOs under pressure

As a result, the CFO, usually the senior corporate executives with the heaviest workload already, finds his agenda even more extended and the pressure is increasing.

But in order to be able to fulfil their new tasks, implement the required financial control, assure current and future financial performance, and reduce cost of finance and increase at the same time the productivity of finance, CFOs have to depart from how they ran their finance operation in the past. In addition, many companies have weaknesses in their existing finance operations.

Many companies have significant weaknesses in their financial operations

Many companies have focused their investments for business process and systems improvements/innovation in recent years on business operations (CRM, SRM, SCM). As a result, most companies have significant weaknesses in their financial operations and most CFOs are concerned to catch up:

They have little confidence in their ability to predict future financials performance and liquidity

They are using outdated, inefficient and not integrated budgeting tools

They have extended closing period

They have high levels of financial working capital bound in accounts receivables and bank accounts

They have high processing and service costs

According to a recent benchmark study of The Hackett Group, cost of world-class finance organizations is 2.4 times lower than at average firms (0.43 vs. 1.05 percent of revenue). This is creating a tough benchmark for many CFOs.

How to make it happen?

How can CFO’s achieve significant cost savings and provide high quality financial services at the same time?

Everything starts with better concepts. CFOs first have to come up with more intelligent process and organizational concepts for finance and then they have to find ways how to depart from where they are today in order to realize quick cost savings that free up resources needed for the next step.

Best in class companies do not spend more on technology than average companies to achieve cost efficiency and high quality financial services. In fact they spend even a little bit less (see figure 2).

The key to this is:

- more intelligent business,

- finance and IT concepts whereas business/finance concepts have to be the starting point – not technology.

Or, as Peter Drucker phrased it:

“A new information revolution I under way. […]. It is not a revolution in technology, machinery, techniques, software or speed. It is a revolution in CONCEPTS.

So far, for fifty years, Information Technology has centered on DATA – their collection, storage, transmission, presentation. It has focused on the “T” in “IT”. The new information revolutions focus on the “I”. They ask “What is the MEANING of information and its PURPOSE?”

Fixing the IT landscape problem in order to create the foundation of the new financial infrastructure

Already, most finance functions have made a significant shift – driven by investment in information systems and shared service centers – toward being less resource intensive, more efficient teams, particularly in the area of transaction processing, allowing increased emphasis on decision support. In the future, finance will be even leaner.

With many tasks delegated to business managers or handled by shared service centers or external outsourcers, the finance staff will act as coordinators and offer higher value, adding more strategic services.

Standardized, integrated processes and systems will be embedded within the business, and they will be available globally to users who can operate them without needing to be aware of where they are located and maintained.

The critical role of decision support may be fulfilled primarily by managers outside finance. Finance professionals will adopt a new training and coaching role to transfer appropriate skills and techniques. The result: finance will become more virtual (see figure 3).

When CFOs and their finance staff have outlined that vision and defined the appropriate programs they are often confronted with a critical problem: the existing IT landscape does not keep pace with this vision.

It even does not allow to move forward and to do the first step, because the grown IT landscape with too many different systems and a very heterogeneous portfolio of incompatible applications, data structures, interfaces etc. is binding to much IT resources.

As a result, IT is not able to support the new finance initiative in a satisfying way.

So many CFOs have agreed with their CIOs to fix the IT system landscape first.

The objective is clear: to consolidate ERP (Enterprises Resource Planning) other critical systems in the company in order to safe maintenance costs (reduce TCO – Total Cost of Ownership) and to leverage this process to consolidate also the finance organization, finance processes and reduce the number of different processes, data structures and interfaces.

The benefit can be significant. According to AMR Research, ERP consolidation can lead to an overall decrease in IT maintenance costs of 25%. Other sources report costs savings of even 30-50%.

Figure 3: Moving to a new financial infrastructure require companies to fix their existing IT landscape first

Figure 4: A finance transformation projects is first and foremost not an IT project – it starts and ends with business, finance and organizational concepts

Options insider trading

Well-timed bets on call options, the investment of choice for traders tipped off to deals before they're announced.

Market makers are getting hurt because they're obliged, in return for reduced fees from exchanges, to create liquidity by quoting prices at which they'll buy and sell securities.

The firms rely on statistical odds to make a small profit on the difference between the purchase and sale prices.

When a trader buys an options contract knowing that the price of the underlying stock will rise, the market maker can't win.

SEC Lawsuits

While the U.S. Securities and Exchange Commission has filed at least 22 insider-trading lawsuits this year, including a case involving TXU options, market makers say the agency is just scratching the surface.

Market makers account for 44 percent of the options contracts traded in the U.S., according to Chicago- based Options Clearing Corp., which guarantees all trades.

In addition to Greenwich, Connecticut-based Interactive Brokers, the biggest market makers include Goldman, based in New York; Chicago's Citadel and PEAK6; and Susquehanna International Group LLP in the Philadelphia suburb of Bala Cynwyd, Pennsylvania. Spokesmen for Goldman, Citadel and Susquehanna declined to comment.

``There isn't a long list of market makers in options,'' said Andy Nybo, a senior analyst at Tabb Group, the Westborough, Massachusetts-based consultant. If some of the largest firms are sustaining losses, ``I would expect other market makers to see the same kind of activity.''

London Account

The TXU case reveals how sophisticated an options-trading scheme can be.

According to the SEC's lawsuit, Hafiz Naseem, an investment banker in New York at Credit Suisse Group, tipped off Pakistani financier Ajaz Rahim about the leveraged buyout of TXU in the weeks before the $32 billion deal was announced Feb. 26.

The agency alleges that Rahim, who was based in Karachi, made about $5 million by buying call options in advance through a London account with Switzerland's UBS AG.

Regulators claim Naseem leaked word of eight other transactions. Naseem has denied the charges. Rahim's lawyer has said he plans to contest the case against him.

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Blink of an Eye

The 22 insider-trading cases that the SEC has initiated this year is more than the total filed during the 1990s and harkens back two decades to the days of Ivan Boesky, Martin Siegel and Dennis Levine.

The NYSE last year referred 111 incidents of suspected insider trading to the SEC for further scrutiny, exceeding the 98 it sent to the agency in 2000, at the height of the bull market. Through June 22, the exchange had referred 57 such cases to the SEC, including the one involving TXU.

Getting a complete picture of insider trading in options is impossible because the Options Regulatory Surveillance Authority, formed last year by the six U.S. options exchanges to police the market, won't provide data on its referrals.

A decade ago, brokers working on the floors of exchanges who received a suspicious order were able to warn market makers to hedge their positions against losses, said Peter Bottini, a former trader at the Chicago Board Options Exchange who's now an executive vice president at online brokerage OptionsXpress Holdings Inc.

Now, with the advent of electronic trading, thousands of contracts can change hands across the country in the blink of an eye.

Dow Jones Takeover

``Between the anonymity of electronic trading and the fact that there's such large liquidity, it's very easy to trade relatively significant quantities of options,'' said Steve Sosnick, a risk manager at Interactive's market-making unit, Timber Hill.

Hulsizer says PEAK6, which makes markets for options in more than 2,000 companies, was stuck with ``several millions of dollars'' in losses after selling calls on shares of Dow Jones & Co. before News Corp.'s $60-a-share offer for the newspaper publisher was disclosed on May 1.

Those contracts obliged PEAK6 to sell shares in Dow Jones at below-market value after the stock surged 55 percent.

The day before the bid from Rupert Murdoch's News Corp. became public, it cost 35 cents to buy calls with the right to purchase Dow Jones shares for $45 through September. That contract's price shot up 3,330 percent to $12 after the news broke.

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