Margin Debt: Will it revert or continue to rise?

Written August 9th, 2013

Zerohedge.com had a very interesting article earlier today summarizing a new research piece by Deutsche Bank about the current level of margin debt and the stories on said margin debt. In particular, the report looks at articles in 1999 and 2007 for correlation with today’s headlines.

As DB says, “we prepared a collection of press articles which were published around the key events during the past financial crises. Our key finding is straight forward. Irrespective of the publishing date, the articles read alike throughout the two major crisis periods, i.e. the “new technologies market equity bubble” (1999-00) and the “Great/Global Financial Crisis” (2007-08). Most interestingly, literally the same content can be found in todays’ press. Universal phrases include:

  • “A rising stock market encouraged more investors to go into debt to buy stocks, sending margin debt levels past their all-time high”.
  • “The National Association of Securities Dealers (NASD) has asked members to review their lending requirements in a sign of increasing concern that rising levels of margin debt could exacerbate a stock market plunch.”
  • “The Fed is concerned about a sharp rise in margin debt but has been unwilling to attack stock market speculation as high levels of leverage do not necessarily translate into high risk. The last time the Fed adjusted the margin rules was in 1974, when when it reduced the down payment required for stocks to 50 percent of the purchase price, from 65 percent.” […] “The Fed should return to its pre- 1974 policy of actively changing margin requirements in response to stock market speculation”.
  • “High margin debts show the effect of over-leveraging and mispricing of risk”.
  • “The movements in stocks cause brokerages to stop allowing customers to buy some of the volatile stocks on margin or require clients to put up more cash.”
  • “Either the market rises dramatically to make those loans good or in any down move there is tremendous selling pressure”.
  • “Until recently, most investors ignored red flags raised by regulators”.

I’m presenting this without further comment for the time being.

Relevant ETFs: SPY, SH, IWM, RWM

Flippin’ Treasuries

Written August 6th, 2013

Short note on slowest day of the year…

Back in 2007, flipping houses was all the rage. The idea was to buy a house, or better yet a preconstuction property, and “flip” it for a quick capital gain, with maximum leverage. Simple.

Well, who’s buying treasuries now? Flippers. Why do I call them flippers? With 10 year rates under 3%, on the margin, people buying treasuries at this point aren’t buying them for the 3% income, which means they’re expecting rates to go lower and thereby reap some capital gains on the trade. Flippers.

Nothing wrong with a trade and nothing wrong with capital gains. When Jeff Gundlach talks about rates going lower, he’s talking about making a trade. When a retiree’s financial advisor buys her a 60% allocation to fixed income, that financial advisor thinks he’s making an asset allocation “investment,” but in reality, he’s just taking a speculative position that no investor would like to hold on to for the next ten years.

So for those allocating to treasuries, just recognize that you’re in it for capital gains and not income. Remember that some people made a lot of money flipping houses, but someone got left holding the hot potato circa-2008. Make sure it’s not you.

Relevant ETFs: TBT, TLT

 

Story of the Week: Margin Compression

Written July 30th, 2013

Everywhere I turn, it’s Case-Shiller Housing prices increased here, increased there, what will higher mortgage rates mean for the next data point, etc. The Case-Shiller index is good for a long term series, but the data being released is for months ago. Today’s most important story has nothing to do with housing and everything to do with the coming valuation disconnect, namely, however expensive the P/E looks now, it will look even more expensive if prices continue to go up as profit margins come down.

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Housing and Finance

Written July 26th, 2013

I will admit that I have never run a bank, although I’ve loaned out money to family and friends to varying degrees of repayment success. It’s thus from an armchair perspective that I’ll boil down the banking business into a simple model: borrow short and lend long. Borrowing short comes from deposits, and lending long comes from mortgages. We can then add one more layer of complexity.

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To Taper or Not to Taper, That is the Question

Written July 24th, 2013

Everyone is talking about The Taper! Have you heard? Good news might mean that the Fed will taper. Should we then hope for bad news so the taper won’t happen? Is the Fed (and Obama & Co.), then, in a position to root for higher unemployment so their hand isn’t forced yet?

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A growing divergence between oil and stocks

Written July 2nd, 2013

The summer doldrums are here, regardless of last week’s volatility. For starters, no one wants to look at the markets when everyone else is out barbecuing. More importantly, there are so many diverging signals that no one wants to take large positions (e.g. do you go long Apple here or not? Will the Fed step up QE or not? Was that ISM figure positive or not?). Similarly, bonds seem to have found a bit of stability and are looking for direction. And yet, the secret is in the divergences we are starting to see.Last week, we discussed the divergence starting between gold and gold miners. Another one that’s showing up on our radar is the divergence between the stock market and oil.

Have you noticed that WTI is approaching $100 again?

wti

 

Could it be that oil is about to have a strong run, at least on a relative basis?

wtispx

 

What I do know is that the rise in oil will eventually be felt by consumers, although the impact might be slighter than in previous years, as natural gas is still under $4 (although significantly off its $2 low from 2012). Maybe inflationary, although I don’t think so on a headline scale. Maybe a picture of growth, although again, I don’t think so on a global scale.

So what’s driving oil up? Will oil come down as the USD strengthens? Why are the emerging markets continuing to crash, even ones that are oil rich? Do we start talking about inflation in needs/deflation in wants again? Is it purely an issue of the US markets being overvalued?

I’m not sure where the divergence stems from, but it’s there for the time being, and it’s worth noting. It could be anticipating increased unrest in the Middle East, inflationary pressures, or new global growth. It could be a hundred other things that in hindsight will look simple to spot or predict. For me, I’m maintaining my overweight to commodities, liking the recent bounce in our larger GDX/GDXJ position, and anticipating increased volatility in global equities.

Relevant ETFs: GDX, GDXJ, UUP, XLE, OIL, USO, GLD, DBC, SPY

 

Gold miners – Catching a falling knife or getting in before the turn?

Written June 26th, 2013

The markets are up. The markets are down. In the space of a few weeks, we’ve seen giants fall (is it true that Bridgewater is down 8% for the month? or, if Apple and gold are down, is Einhorn getting a margin call?). Even bond guru Jeff Gundlach is being forced to host special, off-schedule conference calls after announcing he’s buying treasuries into the weakness. They’re not wrong – they just didn’t read Stanley Druckenmiller’s brilliant summary of the current situation.

Part of my advantage, is that my strength is economic forecasting, but that only works in free markets, when markets are smarter than people. That’s how I started. I watched the stock market, how equities reacted to change in levels of economic activity and I could understand how price signals worked and how to forecast them. Today, all these price signals are compromised and I’m seriously questioning whether I have any competitive advantage left. Ten years ago, if the stock market had done what it has just done now, I could practically guarantee you that growth was going to accelerate. Now, it’s a possibility, but I would rather say that the market is rigged and people are chasing these assets, without growth necessarily backing confidence. It’s not predicting anything the way it used to and that really makes me reconsider my ability to generate superior returns. If the most important price in the most important economy in the world is being rigged, and everything else is priced off it, what am I supposed to read into other price movements?

- Stanley Druckenmiller

And there you have it folks. The speculators won. Investors lost. If you aren’t in US stocks this year, you’re down, with every major market in negative territory, with every bond class showing weakness, etc. etc. etc.

Now that we got that out of the way, let’s talk about picking up the pieces. If markets got crushed, and if markets are acting illogically, it must mean there are opportunities for us value players, and indeed, I think there are.

Gold is now sitting on a strong support. Not technical support. Fundamental support. Why is it fundamental support? Because it has been estimated that the true all-in cost of gold production is $1,150-$1,205. Gold is sitting slightly above that, but any break below will mean that global gold miners will be forced to shut down production, thereby limiting supply, and giving us that support. This, of course, assumes that supply and demand economics still have some logic, which is a big assumption, but one I’m willing to continue holding.

So gold is supported to some extent and I’d feel comfortable taking a small position here, waiting, the building around it.

What about the miners? They have been decimated. Unlike gold, which will find some support in the worst of times, the miners are now 50-80% off their 2011 highs.

gdx

 

GDX has underperformed the S&P by so much that it is now sitting on a 7 year relative low:

gdxspx

 

The problem, of course, is whether buying here is trying to catch a falling knife, or getting in at attractive levels. If gold breaks through the $1,200 mark, miners can easily go lower. Similarly, just due to market conditions, if equity markets sell-off, gold miners can come down just due to beta exposure.

On the other hand, GDX has a P/E under 11 and P/B just over 1. Starting to look pretty nice by my contrarian standards. A sector that is hated, lots of headline risk, and increasingly attractive fundamentals?

If GDX is attractive, GDXJ is even more so! The miners are trading at a P/E under 9, a P/B under 1, and a yield of 4.5%. It’s underperformed GDX by close to 40% since 2011, and is down almost 80% from it’s highs.

gdxj

 

Mind you, the juniors are significantly more volatile than both the market in general and their senior cousins. I anticipate that there will soon be news of management changes, funding issues, etc. but those are just the types of headlines I would expect near a bottom. We’re probably early; especially if gold continues its downward trajectory. However, on a relative basis, I’m comfortable stepping in. How much longer will it underperform stocks? I don’t think we’ll have to wait too long to find out the answer.

Relevant ETFs: GLD, GDX, GDXJ, UUP, SPY

Perspective on a painful day

Written June 20th, 2013

The S&P was off 41 points today and closed below the psychologically important 1,600. It was a painful day, with no place to hide. Stocks were down, but so were bonds, commodities, international markets, gold, etc. Not much green to be found. On the flip side, let’s keep some perspective. Here’s a chart of today’s move.

This is the 6 month charts:

spy6mos

 

Pretty dramatic. Until you go out a little. Here’s the daily chart for 5 years.

spy5yrs

 

Kind of hard to spot today.

Here’s GLD for the past 6 months:

gld6mos

 

Today was a brutal day – a gap down with no relief. I should know since I own a big position in gold.

Looking over 5 years, though…

gld5yrs

 

Still not pretty, but you come to realize that it’s been a difficult year, not just day.

All of that is to say that your time frame matters. If you are a short term or position trader, days like today can make or break your year. You need to look out for them both as risks, but also as huge opportunities. On the other hand, if you are like me and sit on positions for years, look for long-term themes, reallocate to losing positions when the theme continues, etc. then days like today are difficult, but not unexpected. Days like today are about managing client expectations, but they are not reasons to panic.

I anticipate that today’s broad sell-off  will scare many traders and investors into keeping larger cash balances for a while, but that rates will continue to be too low for anyone to sit on cash too too long. The money from these sell-offs will need to go back somewhere, and I think it will find it’s way to my value stocks and to physical commodities. It hasn’t flowed to those sectors the past year, but eventually, fundamentals will reign supreme.

Relevant ETFs: SPY, IWM, SH, RWM, GLD, GDX

On China

Written June 20th, 2013

I have been a China bear for longer than an ETF existed to play the Chinese rise. Visions of Russian propaganda farms kept creeping in to my interpretation of Chinese growth figures. When news of ghost towns first emerged, my response was a simple, knowing shrug. But now that the market is off about 25% for the year, news of a credit freeze is trickling out, and luxury makers are lowering growth forecasts, I can’t help but look to the Chinese markets for some value.Just to be clear, I’m not jumping in yet. FXI has a long way to go down before it hits bottom, I still don’t love the idea of investing in a totalitarian regime facing soon-to-be increasing social unrest, etc. But…

fxi

But earlier today, ZeroHedge reported that China’s overnight repo rate climbed to 25%, meaning that banks aren’t lending to each other. Since China’s financial system isn’t a free market, no interbank lending must come from high up. In turn, this leads me to believe that China is coordinating a credit crunch. Could the government be taking the opposite view of the developed world and be trying to bring asset prices, specifically real estate prices, down? Whatever it is, collapses like these usually open up huge opportunities to step in and provide liquidity, cash, investments, etc. The obvious comparison is to the US markets post Lehman. In hindsight, who doesn’t want to have stepped in to the markets in late 2008/early 2009? So China isn’t there yet, but I can envision the moment when even I am compelled to step into China’s markets.

Relevant ETFs: FXI, GXC

So do you want rates to rise or don’t you?

Written June 4th, 2013

I’m confused. If zero rates are so bad, why will it be bad if rates rise? Asked another way: If you paint yourself into a corner, how do you get out without stepping on the floor? Answer: Simple – you don’t. Zero rate ARE bad and it WILL hurt when they rise, but it doesn’t mean they shouldn’t.

Bill Gross came out with a piece today, and summarized the current conundrum thus:

In the process of reaching and stooping, prices on financial assets have soared and central banks have temporarily averted a debt deflation reminiscent of the Great Depression. Their near-zero-based interest rates and QEs that have lowered carry and risk premiums have stabilized real economies, but not returned them to old normal growth rates. History will likely record that these policies were necessary oxygen generators. But the misunderstood after effects of this chemotherapy may also one day find their way into economic annals or even accepted economic theory. Central banks – including today’s superquant, Kuroda, leading the Bank of Japan – seem to believe that higher and higher asset prices produced necessarily by more and more QE check writing will inevitably stimulate real economic growth via the spillover wealth effect into consumption and real investment. That theory requires challenge if only because it doesn’t seem to be working very well.

He goes on to succinctly summarize the implication:

Why it might not be working is fairly clear at least to your author. Once yields, risk spreads, volatility or liquidity premiums get so low, there is less and less incentive to take risk.

Sure, investors might switch from one overpriced asset to another, but zero bound rates mean companies are hesitant to invest in R&D, savers are hesitant to redeploy now, and entrepreneurs are hesitant to take additional risk on by hiring with lines of credit. I see risk-off everywhere – the business owner not wanting to rent a bigger space to the banker pulling in lines of credit. It’s even bigger than Bill Gross mentions, partly because companies don’t have any control of pricing, consumers aren’t seeing income growth, and on and on and on.

In that light, if the Fed leaves rates low, risk will continue to be mispriced, employment will continue to stagnate, and eventually margin compression will occur and equities will go down. On the other hand, if the Fed increases rates, any financial asset prices dependent on leverage will be forced to come down. So the Fed is in a bind. It can’t leave rates here, because it’s not stimulative, but it can’t raise rates either. It can try to lower them ala Japan, but that didn’t prove to work either. So, it’s just a matter of determining what is the path of least pain. I don’t think anyone has the answer to that one, although many think they know.

Relevant ETFs: TBT, TLT, UUP, GLD

Why not short treasuries?

Written June 3rd, 2013

I know you’re tempted to short treasuries. From 1.70 to 2.17 on the 10-year in no time at all. Who knows how much further it can go. Maybe we’ll even see 4% rates in our lifetime again. But don’t, and here’s why.

It seems so reasonable that rates would finally rise. Even the Fed is talking about tapering their purchases.

10yr

 

And yes, rates have gone up significantly on a percentage basis (although, they are back to where they were in early 2012), so who’s to say they won’t continue rising now…

I don’t buy it. Rates aren’t going up anytime soon, and here are just a few reasons why:

  • The Fed isn’t tapering, it’s just testing the waters. The answer it got was the one it expected: don’t stop. The back up in rates has given the Fed more room to start anew and more political pressure to keep going. After all, what president or senator wants to tell his/her constituents that their mortgage rates are going to go up and house price gains will stagnate.
  • Money has only begun to flow into the dollar. And once in the dollar, it’s gotta go somewhere.

usd

  • On a relative basis, where will money prefer to be? What pension fund is going to increase its allocation to European debt or Japanese debt? Even Japan’s own pension system is trying to dump JGBs and go into equities. 
  • Retirees still prefer 2% yield and no vol to 3-4% dividends with lots of vol. And even those 3-4% yields aren’t looking that great these days as the days of “fat” dividends seem long gone.
  • The bond bull isn’t going to end when people sell positions slowly in reaction to some “tapering” comments. The bond bull will end AFTER everyone buys into the theory that government debt issuance isn’t a problem.

We are close to the end. But I don’t think we’re there yet, and treasury shorts might be able to play some short term moves, but overall, they’ll get squeezed, and shorting treasuries will become the new widow-maker trade.

Relevant ETFs: TLT, TBT, UUP

 

 

Gold performance during times of deflation

Written May 16th, 2013

Everyone is absolutely certain they know what gold will do in times of inflation – obviously we’ll have a repeat of the 1970′s when gold gained in relative value terms, kept its purchasing power, and provided a hedge against inflation. With this backdrop, it is not surprising that the recent talk of deflation has hurt the yellow metal’s price. But is that warranted? 

Periods of inflation are easy to come by, and especially easy to find when looking globally. (One of the advantages of gold is that you can look at in in any currency denomination.) There has been a lot of academic work on the history of gold, and its performance during different time periods, and each one always comes out with a caveat that during such and such period, the price was fixed, or during that and that period this factor makes the data unusable. In the end, all of the data I’ve seen points to a similar conclusion: gold is a hedge against price instability – in either direction!

Price instability can stem from any number of factors, some monetary, others geopolitical or social. When I say price instability, I mean prices of good are difficult to predict, making it difficult for businesses to operate, plan, and invest, and for governments to face growing social unrest. These periods obviously include highly inflationary environments. What may surprise many investors, is that periods of deflation also qualify as periods of price instability, and while gold (or different proxies that aren’t fixed, such as silver) may go down, they often represent an opportunity for relative wealth protection, especially when compared to equity.

I recently reread an old article I had flagged from last year:

Although it may seem counter-intuitive, gold can be as effective a hedge against deflation as against inflation; in fact gold’s purchasing power is more likely to increase in deflationary periods than during inflationary eras.

Historical precedents suggest that gold’s worth is powerful during deflationary periods.

The article goes on to note that:

“The Golden Constant”, written by Roy Jastram over 30 years ago and recently re-released including fresh material by economist Jill Leyland, studies gold over a series of inflationary and deflationary periods, going as far back to the 17th century in England and the 19th century in America.

In England, over the past four centuries, gold lost its purchasing power in every period of inflation; by anything from 21 percent (in both 1675-1695 and 1752-1776) to 67 percent (1897-1920).

The story is similar for four periods out of five in the U.S., from 6 percent (1861-1864) to 70 percent (1897-1920).

The outlier here is the period of 1951-1976 when gold’s purchasing power did increase in the U.S., by 80 percent as the price corrected after its sustained period pegged to $35/ounce.

BUT GAINS VALUE DURING DEFLATION

In each of the four deflationary periods since the 17th century in England, gold has increased its purchasing power, by between 42 percent (1658-1669) and 251 percent (1920-1933).

In the U.S. there have been three recorded deflationary periods – and gold increased its purchasing power in each of them – by between 44 percent (1929-1933) and 100 percent (1814-1830).

The basic idea is that gold is a hedge against instability, and if that is the case, which I believe it is, gold’s role in a portfolio during our present environment should not be underestimated.

gld

 

Relevant ETFs: GLD SLV, GDX, GDXJ, UUP

If leverage is free, is every price reasonable for real estate?

Written May 7th, 2013

Here’s the dilemma – you see a house selling for a certain amount and realize that it doesn’t cost you much to finance it, because your carrying costs are low. Does that mean that you should buy it even if the price is absurdly high? More and more advisors, articles, and pundits are suggesting that you should, and I just can’t jump on that wagon. Here are just a few of the arguments I’m hearing:

  • Mortgage rates are at historic lows, so you definitely want to lock them in now.
  • Carrying costs are so low, you’ll always be able to rent the property out and cover your costs.
  • You  should buy as big as you can with as little money down because financing is virtually free.
  • Take out a big mortgage to take advantage of the tax deductions, depreciation, or other non-cash return.
  • International buyers will continue to pump up hot markets as they flee their currency-war-torn countries and seek safety in US properties.
  • Even Blackstone recognizes the potential in rental properties, so you should buy some also.

And that’s without accounting for the arguments and ads I’m hearing for flipping!

Are we living in 2006 in Florida? Can real estate prices never decline? Can people never need liquidity? Can South American countries never impose capital controls that will limit the flow of funds to US properties? Are 4% cap rates really so attractive that buyers need to bid the properties up and require only 3%? Can we not envision any situation where inflation is rampant, but real estate prices collapse (perhaps due to lack of financing ala Greece)?

The answers to all of these questions is caveat emptor. I like real estate in general, but am liking it less than I did a year ago. I like income properties, but I don’t like 3 caps. I think that investors don’t appreciate the risk of debt deflation – any property that is being purchased at too high a price and depends on financing for capital appreciation to juice returns is ALSO dependent on future buyers having access to similarly priced and available financing, which I find hard to envision. If Greece is to serve as any example, it should prove to us that a country can have wild inflation and deflation simultaneously. Namely, the currency can become worthless, and yet financing can evaporate overnight making any financially-dependent pricing collapse. In case you thought it couldn’t happen here, IT DID. When Lehman collapsed and liquidity dried up, financing costs went down but no one could access it, nor would anyone extend it (except the government and even then it wouldn’t extend it to you or me).

Last point for the time being – if prices are rising everywhere, but unequally, should I buy in the place that has been the hottest (e.g. NYC) and is expensive (relative to rents) or not? It all depends on your strategy. If you’re a value investor like me, the answer is a resounding NO, while momentum players will jump on the NYC wagon. The momo guys have been right so far and I can’t say I’m unhappy that I own my apartment, but my value hairs are on edge and I don’t know that I can hold on to this trade for much longer. After all, if I like to buy when everyone is selling, I also have to sell when everyone is buying.

Relevant ETFs: GLD, UUP, UUD

 

Gold, repo rates, and backwardation

From the FT.com:

The conspiracy channels continue to make a big deal about the backwardation of gold — which is a situation in which gold prices for today are higher than for tomorrow. The thinking is that this must indicate rampant demand for physical gold.

The Financial Times delves into why gold, as a financial instrument, is subject to backwardation. Contrary to conspiracy theories, it notes, backwardation is to be expected when lenders and borrowers in the repo markets have multiple competing rates and suggests that gold’s backwardation is due to negative real interest rates.

That’s not to say that the signal is uninteresting. It is interesting — but it’s interesting because it suggests gold collateral markets are telling us that real-world rates (as opposed to those publicised by the Fed) are more negative than we think they are.

The Fed (and other major central banks), in other words, is fighting an increasingly difficult battle to prop up short-term rates.

It’s a point often missed that in the repo world, the Fed’s SOMA account has been competing more aggressively with the US repo dealer market. Repo rates that would otherwise be negative have as a consequence been propped up by the increasingly competitive operations of the New York Fed repo desk in the market.

The article goes on to note that:

For as long as gold remains in collateral mode, however, it’s likely the backwardation will only intensify (we’ll have more on that in a follow-up post). At this stage it’s fair to state that the curve backwardates because the gold repo rate has to compete with the paper money rate to some degree, which is becoming more negative. It also encourages curve trades which position themselves to take advantage of further backwardation as well — and exacerbate the phenomenon.

Here’s my simple conclusion – despite increased volatility, as long as rates remain manipulated and fiat currencies are printed with abandon, investors should hold on to gold positions, with the understanding that volatility in gold will increase as institutional money buys and liquidates gold, just as it does other collateral positions.

Simple; just not easy.

Relevant ETFs: GLD, SLV, UUP, AGG, TBT, TLT

Value indicators are hard to time, but shouldn’t be ignored

Written April 30th, 2013

I often write about market valuation metrics, from CAPE to Q, and the conclusion is always the same: they’re all really bad to use as timing factors. On the other hand, for us long-term investors, these factors shouldn’t be ignored and can give us insight into a general bias, or at least give us insight into the risks we might choose to take.

One indicator that is often mentioned as a favorite of Warren Buffet’s is the market cap to GDP:

buffett

So it’s overvalued. Not anything we didn’t know already by looking at some of my favoriet valuation metrics:

valuation-indicators-geometric

 

So we know the equity markets are overvalued by anywhere from 40-60% depending on the day and measuring stick.

But here’s one that I haven’t looked at in a while – margin debt:

CK-130430-Fig-1

 

I knew it was high. I knew it was a drag in the past, but I just didn’t remember to look, so I was glad to see this chart on dshort.com. Conclusion?

No new conclusion to draw from this in particular; just another data point. A few interesting points to note: when margin is high, any margin call might impact the best performing assets as margin calls are met with winners, not losers. Any tick up in margin costs could quickly impact equities. Net worth can still go down before any correction. We are all macro traders at turning points!

Relevant ETFs: SPY, GLD, UUP, AGG, IWM, SH