Chinese labor shortages?

Yesterday’s article in the FT highlight an interesting point: what happens when Chinese labor is no longer cheap? The article highlighted that with a new manufacturing cycle starting, many firms are having difficulty finding the workers necessary to fill large orders. Is this where we’ll start seeing wage inflation? Will China, long an exporter of deflationary forces, start exporting inflation? I don’t know, but the inflation/deflation debate continues and we’re trying to sort through it. For the full article, click here.

Connecting the dots 2-25-2010

Or at least trying to keep track of everything…

I want to first give you an insight into what I’ve been reading this morning, then we’ll see where it leads us.

As many of you know, I’m a believer that excess profits flow through to the real estate sector and have referred to Fred Harrison’s book on the subject often (http://www.amazon.com/Boom-Bust-Prices-Banking-Depression/dp/0856832545/ref=sr_1_1?ie=UTF8&s=books&qid=1267115867&sr=8-1 – it’s a must read). The essence of the logic is that a profits increase, real estate owners will charge higher rents, thus limiting growth in profits. This increased rent leads to higher real estate valuations. On the downside, the same is true. Combined with 4 to 1 or more leverage, the moves have large implications for the economy, investments, etc. Thus, I was encouraged to read one of my favorites (Calculated Risk) write about exactly this topic: Housing: The Best Leading Indicator for the Economy. I wasn’t surprised that the conclusion was that our best case scenario is that “these leading indicators suggest any growth will be sluggish and choppy.” I will actually take it further to note that these figures don’t even account for the shadow inventory of homes (foreclosures at different stages, and people who have held off selling due to climate) and they do not account for the coming pressure on margins at each level of the chain. So I am even more concerned.The above post refers to an academic article, which you can download here. From that paper we can see the importance of being proactive when trying to contain a real estate bubble and the danger of powering it with easier and easier monetary policies.

Then, in the same breath, I read that mortgage rates are going over 5%. Read the full article here. They are still insanely cheap, but from a psychological perspective, or from a rate of change perspective, this doesn’t bode well, especially considering that the governments MBS buying program is supposed to end soon.

Gold is a favorite topic for readers, and I think discussions of gold end up leading to some interesting additional investment implications (we own gold in client accounts, along with other metals and mining shares). Well, I’m a bit confused. On the one hand, ft.com reported on Feb 18th that:

“For China, directly buying IMF gold has become far too sensitive an issue because it would send such a strong negative signal about the dollar and that would be extremely dangerous for their own holdings of US Treasuries,” says one senior dealer. “The publicity generated by India’s decision to buy gold from the IMF last year could have scared off other central banks.”

Read full article here.

Then, this morning, I read the following headline: Confirmation Of Chinese IMF Gold Purchasing Intentions? on zerohedge.com. And at the same time, Treasuries are rallying. So either the Chinese are not purchasing the gold or they are. If they are, it is not (not yet?) sending any negative message to the market about Treasuries. Should it? I thought so.

In the meantime, California canceled it’s $2 billion GO bond offering. Obviously. The state is on the verge of bankruptcy, so who wants to bid?

Separately, some of you may be following the double-standards and moral questions being faced by Apple over it’s wishy-washy policies over sexually explicit content on its apps. The main hypocrisy is that large firms, like Playboy and SportIllustrated’s swimsuit pictures and apps are OK, while smaller developers are getting censored, even when they’re not promoting sex. As a further insult, any user can go to safari and surf for porn directly, so it’s the app programmers getting squeezed. Anyway, I don’t really want to discuss the hypocrisy of our society’s view of porn, but something did catch my eye today: Wal-Mart bought Vudu, and online purveyor of movies. Now, Wal-Mart never pretends to be open minded like Apple, so it was without much fanfare that they decided to shut down Vudu’s adult section (Hot And Bothered: Walmart Shutting Down Vudu’s Adult Section). What is interesting here for me is whether Vudu will be as profitable for WMT without that section. I know nothing about Vudu’s financials, but I just have to assume not.

In the meantime, we have the healthcare summit, struggling markets, and weaker euro. We’ll have more on these later.

SEC limits short sales

Under-reported and under-reacted-to (is that even a term?), the SEC in a split vote decided to put limits on shorting.

SEC commissioners voted 3-to-2 to curb short sales of a stock after it falls 10% in one day, with the rule requiring short sellers to exceed the highest bid for the remainder of that trading day and the following in short sales of that security.

For the full article, click here.

For those interested in efficient markets, price discovery, market mechanisms, etc. this is another blow. How is it that the futures markets and bond markets can run at least as efficiently as the equity markets without these ridiculous sort of market manipulating tactics by the regulators? Shorting is NOT un-American. It’s a huge risk, where the statistics work against the trader, so if someone decides to short, there is often a good reason behind it. If they’re wrong, let the price discovery process work so that other investors and traders can pick up a good bargain.

So let’s get this straight: Volcker’s plan to limit prop trading by banks is out the window, shorting limits are in vogue? Hmmm.

Municipal pressure…continued

Rockefeller Institute report on state tax revenues:

State tax revenues declined by 4.1 percent nationwide during the final quarter of calendar 2009, the fifth consecutive quarter of reduced collections, according to a report issued today by the Rockefeller Institute of Government.

The five straight quarters of year-over-year decline in overall tax collections represent a record length of such decreases, the Institute said. Collections from each of the two major revenue sources, income and sales taxes, also fell for a fifth straight quarter. The decline, however, was not as sharp as those in the three preceding quarters of 2009.

“States will likely face further revenue weakness in the first quarter of 2010,” said Lucy Dadayan, senior policy analyst at the Rockefeller Institute and author of the report.

The report is now available on the Institute’s Web site.

Troubled banks stand at 700+

The FDIC came out today with a report highlighting the dangers still present from commercial real estate, and in the process increased the number of distressed banks to 702. In an interview on Bloomberg, Bair tried to put it in perspective by pointing out that there are roughly 8,000 banks in the US. While true, that would mean that almost 10% of the banks are distressed. Simultaneously, the FDIC fund fell to $20.9 billion at the end of 2009 (down by $12.6 billion in the final 3 months of the year).

Read both:

• CBS Marketwatch: FDIC: Number of troubled banks rises to 702
• Zerohedge: FDIC Hits Record “Default” Level As Deposit Insurance Fund Plunges By $12.7 Billion To NEGATIVE 20.9 Billion

The implications for me are that banks are not ready to lead us much higher. Additionally, with roughly 30-40% of earnings on the S&P driven by the financial sector, which in turn is being driven by the steep yield curve, the S&P will face major resistance as margins and revenue face pressure.

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Obama keeps going on healthcare

The broad strokes are in, but I will withhold judgment until it’s all in. For now, here’s a brief summary:

• Expands coverage to 31 million Americans
• Increases tax credits to buy insurance
• Sets up entity that could block big rate increases
• Imposes 2.9% Medicare tax on unearned income
• Cuts the deficit by $100 billion over 10 years

For the full summary click here.

I just read Ezekiel J. Emanuel‘s book Healthcare Guaranteed. The author is Rahm’s brother, so it might be worth listening since he might have some influence on the debate. Emanuel (the doctor) goes through and criticizes the piecemeal attempt to fix healthcare. For starters, he is against an employer based plan. He goes on to show how having a “means-test” is expensive to implement. He shows how medical insurance premiums and fear of lawsuits plague the system. He highlights the incentives to cheat the system. And on and on and on. His solution – a voucher system for a minimum plan, that is equivalent to what Congress receives, with the ability to purchase additional insurance on top of it. To pay for it, he proposes a VAT of roughly 10%.

Admirable. I agree with his assessment of the problems, and I agree that the employer-based system is unfair and expensive to administer, especially for smaller firms. Now, I’m not sure I agree with the voucher system, not am I sure about the regressive VAT tax (yes, VAT sounds good, but it hits lower and middle income families harder than higher earners). But at least it sounds like he’s on the right track. I can’t help but not see any of his analysis in the current administration’s plan.

Emanuel has 7 goals of for healthcare reform:

1. Guaranteed coverage…FOR ALL: the current proposals fail on this front, since roughly 15 million people will still not be covered.
2. Effective cost controls: Emanuel doesn’t give a good solution for this, but it’s a good goal nonetheless. On this front, it looks like the administration is proposing price controls. For those who remember the price controls of the 1970′s on fuel, pork, and wood, you’ll also note that there was big money to be made in the futures markets. If this plan goes through, look for futures markets around healthcare to develop where producers will be able to arbitrage the cash/futures markets.
3. High-Quality, Coordinated Care: Emanuel criticizes the fragmented, fee-for service arrangement and seems to imply that large institutions will be better equipped to deliver coordinated healthcare. Maybe, maybe not. It will be interesting to see how the administration deals with this.
4. Choice: Again, let’s wait for the details.
5. Fair funding: I’m not optimistic, but I’ll give the plan the benefit of the doubt for now, until we find out more about where the funding will come from.
6. Reasonable dispute resolution: Have not heard anyone mention capping malpractice, or dealing with this issue. I have a personal solution: Patients who sue and win can receive some capped amount, with the rest going to the hospital or to research centers to better whatever caused the mistake. Patients will no longer be able to get rich of doctors’ mistakes, and lawyers fees will be capped at fair market value of hours works. Or something along those lines. But no-one asked me.
7. Economic revitalization: Emanuel rightly points out that healthcare benefits put a strain on employer-employee relations, and create friction in moving jobs, starting businesses, hiring, etc. I do not see how the current plans alleviates that, since it maintains the employer based system. Again, that should be the starting point of reform.

Emanuel and I might disagree on the details of delivery, human nature in decision-making, economics, etc. but his fundamental principle that the system needs to be overhauled and that patches will only delay the inevitable collapse are spot on. Obama should read his book before Thursday.

Major elements of Obama’s health-care proposal
Expands coverage to 31 million Americans Increases tax credits to buy insurance Sets up entity that could block big rate increases Imposes 2.9% Medicare tax on unearned income Cuts the deficit by $100 billion over 10 years

The language of trading

Trading is often described in “war” language: “I got killed”, “I beat the market maker”, win/lose, and I’m sure our readers can think of more colorful examples. In his book Trading to Win, Ari Kiev wrote about some interesting correlations were some of the more successful traders used surfing and fishing language to describe their experience with the markets: “I was able to ride the wave”, the market as a sea, etc.

In last months letter, Colony Capital’s Tom Barrack, Jr. highlights the same themes again…

Don’t Stress the Distress
Jan 17, 2010
Both distressed investors and investors in distress are anxious and discontent because they are languishing in the doldrums of “status quo.” The unanticipated tranquility of zero interest rates and the new mantra of “pretend and extend” by holders of debt instruments have sent both groups into a holding pattern that has become a bit surprising.

The meltdown in the global financial system brought out the big guns. They possessed historical skill and incomparable talent as they harvested new funding. They were convinced that the opportunistic wave of the day would be distress. There are dozens of distress strategies and theories and most of them have not yet resulted in meaningful amounts of attractively deployed capital. Likewise, borrowers who themselves are in distress as a result of high debt loads and underperforming businesses and properties are finding that banks are not interested in lending money. Amazingly, banks also are not in a hurry to perfect their security or foreclose on businesses or properties. We are all stuck in the middle of a flat sea with no waves and no wind.

I was reading one of my son’s school admission applications the other night. It was an essay question asking him to discuss what mistakes had he made and what he had learned. He chose a surfing incident in which he was a bit arrogant and he had turned his back on Mother Nature. It reminded me of some great investor guidelines. I have always felt that surfing is a great metaphor for investing. Below are a few credos that characterize both a big wave surfer and a successful investor:

• Know exactly how to exit before you enter.
• Being in the right spot is more important than the size of the wave.
• The waves you let go are more important than the wave you catch.
• If you miss a wave be sure that another will come behind it.
• Stay out of the water when wild amateurs are present.
• Avoid crowded take offs.
• Don’t panic in a wipeout and don’t fight the current.
• Success is achieved by taking risk, not avoiding risk.
• Push too hard and you get hurt – don’t push hard enough and you can get hurt even worse.
• Get in the water yourself to evaluate the current by instinct – the height and direction of the swell, the wind, the tide, the temperature, the coral reef bottoms, the peak, the trough, the time between sets and the position – data without experience will deaden your senses.
• Know where the “impact zone” is and how to stay out of it.
• Humility trumps arrogance.
• You need to be in condition for the worst circumstance in the worst situation not the best circumstance of the best situation.
• A successful outing is being able to surf another day.

For the source, click here.

The New Rules of War

Writing in this issues Foreign Policy magazine, John Arquilla analyzes what he sees as the future of warfare, and potential pitfalls and opportunities for the US military. Arquilla argues that wars of the future will be based on small, mobile, swarms that cannot be fought by the traditional mass army, which is based on large, cumbersome units and machinery. Actually, it reminds me of an age-old line of thought in military circles – two quick examples: the crusaders were powerful knights, used to fighting in the mild European hills. They wore incredibly heavy metal armor and fought with long spears and heavy swords. When they came to the Middle East, they used the same techniques they had from Europe. Hmmm. Heavy metal armor in the desert? Long spears against smaller, faster horses? A recipe for disaster. If that sounds familiar, the Russians in Afghanistan faced the same issues, using large metal tanks with many moving parts in the desert. Didn’t turn out well for them either.

Arquilla gives a good overview of the changes he believes are needed. Interesting read, and scary that the decision-makers aren’t giving it more credence.

The New Rules of War

Soros in the FT, Munger in Slate

When some of the biggest investors in the world go so mainstream, you might want to at least listen. Below is the article by George Soros discussing the continuing problems for the euro. After, read Charlie Mungers parable about a country that came to financial ruin. Implications – well, read on…

• George Soros: The euro will face bigger tests than Greece
• Charlie Munger: Basically, It’s Over

Conversations have gotten a lot harder

It might be me, but lately it seems that every conversation veers towards healthcare policy, financial bailouts, Bernanke, debt, and stochastic modeling – well, the last part is probably just me. I’ve been struggling to define, for myself and others, what are the main issues around each topic. Certainly, little ditties about Keynes vs. Hayek are cute:

\”Fear the Boom and Bust\” a Hayek vs. Keynes Rap Anthem

But I’m not sure they inform the debate. On the other side, you have James Galbraith posting in The Guardian about the need for more deficit spending in the US and Europe: http://www.guardian.co.uk/commentisfree/2010/feb/19/keynes-current-crisis.

The articles on both side are endless, and I’ve come to a simpler definition of the two sides. Each side operates under a fundamentally different framework, and it doesn’t matter whether the issue is healthcare or the economy. One framework believes that bureaucracies can generate efficiencies, and that government, can fulfill it’s intentions, which are inherently better than for-profit players, and which are more representative of what the population wants. The other side doesn’t trust bureaucracies, and believes that decisions made by institutions are inherently inefficient, with power plays, political maneuvering, and fiefdoms working against the benefit of the individual. Both sides have their extremists, who do not represent the reality and nuance of the arguments. On one extreme, you have advocates for government spending who do not understand any economics, while on the other side you have advocates for no government intervention and are detached from the realities and complexities of running any organization and thus the benefits of processes.

This administration obviously leans towards a pro-government view of the world. No voter should be surprised. The administration was very honest in its plans from the beginning. They believe that the way to fix healthcare was by consolidating the decision making of health administration in a governmental body. The entire jobs effort is an attempt to have government “create” jobs that weren’t there. It is a continuation of a process that has been happening for decades; it is not Democrat or Repulican, it’s not Bush or Obama. The modern day federal government can trace its roots to the New Deal, social security, medicare, and the cold war.

The conversation about bailouts and handouts needs to shift, and now is as good a time as any. The conversation needs to shift towards our basic conception of government’s role. Do we, as a society, have faith in our government to give it more decision-making powers over our day to day lives or not? Do we trust our politicians or not? If the answers are “YES”, then solutions seem easy, because they revolve around giving government more control and power. If the answers are “NO”, then the solutions are quite difficult, since we still want some certain basis problems fixed, but we have no guiding authority to make them. Our readers will know where we would err, and it is NOT with giving government more powers. Which means things get messy. It means giving government power to bailout in an emergency, but also putting in place the mechanisms to pull out ASAP. It means feeling a lot of pain as our real estate goes down because government isn’t providing cheap funding to people who shouldn’t get it. It means paying more to borrow. It mean sacrificing a debt-dependent life-style. It means working for your money, and working hard (like on the weekend).

The stuff you read about Keynes and Hayek is only the surface, the manifestation of a much deeper struggle we are experiencing as a society. It will not end quickly and it will probably not end decisively. Yet, at least we should recognize what the debate is about.

Geopolitics…

Does anyone remember Iran? The oil markets do. They’re back pushing $80. At some point, sounds like it might be in the near future, the geopolitics in the area will once again come to the front burner. I guess once Tiger is off the air.

http://www.latimes.com/news/nation-and-world/la-fg-iran-nukes19-2010feb19,0,4731330.story

Fed raises discount rate

Yesterday, after the close, the Fed raised the discount rate from 50 to 75 basis points. http://www.bloomberg.com/apps/news?pid=20601087&sid=akOfpZxuLUc4

I don’t envy Bernanke. Poor guy has no good options. If he raises rates and the markets go down, he gets blamed, and the Robert Reich’s of the world scream. If he doesn’t raise rates, markets start to fear inflation, and every Hayekian (economist, that is) starts talking about the end of the world. In the end, it doesn’t matter. The Fed doesn’t control long term rates, which are a more realistic barometer, and those rates have been rising. The 2-10 spread is at historic highs, and the Fed was forced to raise short term rates (a bit), just to pretend to stop the free ride that banks are getting.

In the meantime, we posted yesterday, that while banks show a slight delevering, the rest of the economy is still levered and not going down yet. We anticipate that this will start changing in the next few months and quarters. In the meantime, inflationary pressures are muted, mostly because the 30% of the CPI composed of owners-equivalent rent continues to go down – and should maintain it’s trend for a while. It would seem that all is well on that front.

So what else am I thinking about? Well, WMT and DELL both show signs of margin compression, which we have been anticipating. Gold is holding up well, and is at all time highs when priced in euros. 10-yr yields are up. And all that said, the market is holding up better than we anticipated. Maybe that’s a sign it will continue rising for a while. Our timing is never that great, since our calls tend to be a bit early. So we continue to look to valuations, and hold defensive positions, including cash.

What we’re watching unfold…

Warning: This post has nothing new for readers of our newsletter. It’s just that things are unfolding almost according to plan, so we thought we’d put some of today’s headlines and moves in front of you, all in one place…

In no particular order:

• Italian derivatives draw scrutiny as Greece tensions heighten: Yes, Italy used currency swaps. It will turn out that others did as well. Are you surprised? 6 months ago, before anyone had coined the term PIIGS, we were discussing the crowded short USD trade, and the feeling that the markets were overconfident in Europe, even though it faced structural issues. The euro continues to face headwinds. Greece was the canary, but the real issue is Italy and Spain. We continue to be short the euro vs. USD.
• Coming Soon: Chapter 9 Municipal Bankruptcies: This was an interesting post about a little know quirk in bankruptcy law regarding municipalities. In essence, Chapter 9 gives municipalities protection from creditors as they work out payment plans. Guess who holds muni’s…yup, individual, taxable investors.
• PEW Study Shows Trillion Dollar State Pension Gap; Can Anything Be Done?: As if muni problems weren’t enough with tax revenues falling faster than expenses, Mike Shedlock highlights the looming pension shortfalls. If governments accounted for their liabilities like any corporation (other than Enron), they’d already be insolvent. We continue to hold no direct exposure to muni’s. When the stampeded out the door starts, every mutual fund and laddered portfolio will take a massive hit (and will form the basis of a once in a lifetime opportunity).
• Gold: I don’t want to write to much about this, but suffice it to say that Soros came out saying gold was in a major bubble (obviously hoping to talk the price down) as he accumulated one of the largest positions in the world. Read the full article on Soros here. Simultaneously, the IMF is selling some more gold (I won’t even link to it since it’s all over and is old news) and the market is waiting to see if India buys more (and front runs China again?). We’re maintaining our position in GLD, GDX, SLV, PALL, PPLT.
• Meanwhile, 10-yr yield is over 3.8%. We continue to have exposure to short Treasuries. Fun little graphic from Mike Shedlock here.

None of these are specific recommendations, since we do not know your particular situation. These are our thoughts and positions ONLY.

Watch the 10-Year

Everyone is talking about Plosser discussing selling off the Fed’s MBS hoard. It’s obviously necessary, but completely unfeasible given a still shaky housing market and no lending. Additionally, it would fly in the face of the Fed’s QE campaign. Lastly, who’s going to buy the securities?

http://www.marketwatch.com/story/fed-should-sell-mortgage-backed-bonds-plosser-2010-02-17

So the Fed is left holding the bag for now. You’d think that at least they should start tightening requirements and lending a bit less, instead of trying to dump their holdings. But alas, no.

Instead, the government is taking over private debt on a monumental scale. For an excellent analysis of where do we see deleveraging (and NOT), check this out: http://www.ritholtz.com/blog/2010/02/is-the-second-leg-of-the-credit-crisis-starting/. The conclusion from this article is:

The “Great Recession” has essentially only resulted in deleveraging of the financial sector. The overall levels of debt are still rising, thanks to a very modest deleveraging of the non-financial sector and a big releveraging of the government sector.

Was the only problem that the financial sector was too leveraged?  If so, the Great Recession returned the markets to sane debt levels.  If not, then the government releveraging has prevented the correction and deleveraging needed to put the credit crisis firmly behind us.  We fear the latter may be closer to the truth and the credit crisis is only partially complete.  The next major deleveraging will occur in the government sector.

Is this what widening sovereign CDS rates are telling us?

My answer: Yes!!