Taking the easy way out…

With Passover and Easter upon us, I’m taking the opportunity to spend more time with family and friends this week, but I can’t help but steal away some reading and market gazing. Instead of my usual rant, I’ll provide some highlights instead:

• Treasuries are the hidden story of the time. They are slowly creeping down, with the 30 yr yield breaking above 4.6%, 10 yr yield holding and rising slightly, and jitters about Greece, Spain, and even the US finally making a dent. In the midst of it, David Rosenberg and Jim Grant and (respctfully) duking it out on whether Treasuries are a safe bet: http://www.ft.com/cms/s/0/05fc8bc6-3941-11df-8970-00144feabdc0.html
• Speaking of the US having less flexibility when dealing with the next crisis: http://www.theatlantic.com/business/archive/2010/03/much-ado-about-debt/38138/
• Then there’s the fact that day traders and prop desks are all trading between themselves. Like a sick game of musical chairs, when the music stops, the taxpayer will be the one that’s hurt. I continue to stay away from the banks, from leverage, and from believing this market. The money is made in the waiting, and this market is overvalued. It’s continued to go up DESPITE the valuations, not because of them, and that will change at some point (soon): http://www.zerohedge.com/article/are-pig-farmers-doing-all-trading-top-five-prop-desks-are-buying-and-selling-securities-leve?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+zerohedge%2Ffeed+%28zero+hedge+-+on+a+long+enough+timeline%2C+the+survival+rate+for+everyone+drops+to+zero%29&utm_content=Google+Reader

More on inverted swap spreads

The inversion of the 10 yr swap spread (10 year swap spread = 10 year LIBOR yield – 10 yr UST yield) might be the biggest under-reported story since…well, so many big stories out there…

ZeroHedge ran a summary of a report by Morgan Stanley and they did such a great job, that I won’t try to do better, but rather, encourage everyone to read this article.

One line from MS:

The issuance of UST debt is dwarfing Libor-related issuance. For example, we expect UST net issuance to be $1.7Tr and net issuance of MBS to be zero. Thus, the relative issuance of UST’s vs. Libor-based products mainly accounts for the inversion in swap spreads. This is a first sign of stress leading to higher UST yields and is not to be missed. (Their emphasis.)

Geopolitics – Are they priced in?

The stock market as a discounting mechanism has definitely been implying that things in the world are getting less risky. But are they? Earlier today, as ship off the coast of South Korea, in disputed waters sank. No one know for sure what’s happened yet, but it’s a good opportunity to posture some scenarios. If North Korea did fire on South Korea (http://www.cnn.com/2010/WORLD/asiapcf/03/26/south.korea.ship.sinking/index.html?hpt=T2) would the market go down? If tensions with Iran, or Israel, or Russia, or any of the “-stans” heat up, would the market feel comfortable that it had already anticipated these moves? There are so many cross currents at this juncture that it often feels difficult to keep track.

We tend to go back to valuations, so we already feel that the market is overvalued as we’ve outlined before. However, I’d like to posit that part of what makes the market overvalued is that it is specifically NOT assigning any uncertainty to the world stage, when in reality, it should. Aside from the protectionist talk all around (CNY reval for example, Russia/nat gas/Europe, Germany threatening Greece, etc.) there is additional risk from the political front that is more difficult to quantify and therefore to take into account, but it doesn’t make it any less real.

We’ll write more about it this weekend.

Social Security in deficit…this year!

Everyone knew it was going to happen someday soon, and estimates ranged from 2014-2030, but a new report released by the CBO shows that this year social security will pay out more than it takes in.

The problem, he said, is that payments have risen more than expected during the downturn, because jobs disappeared and people applied for benefits sooner than they had planned. At the same time, the program’s revenue has fallen sharply, because there are fewer paychecks to tax.

Analysts have long tried to predict the year when Social Security would pay out more than it took in because they view it as a tipping point — the first step of a long, slow march to insolvency, unless Congress strengthens the program’s finances.

…Although Social Security is often said to have a “trust fund,” the term really serves as an accounting device, to track the pay-as-you-go program’s revenue and outlays over time. Its so-called balance is, in fact, a history of its vast cash flows: the sum of all of its revenue in the past, minus all of its outlays. The balance is currently about $2.5 trillion because after the early 1980s the program had surplus revenue, year after year.Now that accumulated revenue will slowly start to shrink, as outlays start to exceed revenue. By law, Social Security cannot pay out more than its balance in any given year.

For accounting purposes, the system’s accumulated revenue is placed in Treasury securities.

In a year like this, the paper gains from the interest earned on the securities will more than cover the difference between what it takes in and pays out.

Mr. Goss, the actuary, emphasized that even the $29 billion shortfall projected for this year was small, relative to the roughly $700 billion that would flow in and out of the system. The system, he added, has a balance of about $2.5 trillion that will take decades to deplete. Mr. Goss said that large cushion could start to grow again if the economy recovers briskly.

Indeed, the Congressional Budget Office’s projection shows the ravages of the recession easing in the next few years, with small surpluses reappearing briefly in 2014 and 2015.

After that, demographic forces are expected to overtake the fund, as more and more baby boomers leave the work force, stop paying into the program and start collecting their benefits. At that point, outlays will exceed revenue every year, no matter how well the economy performs.

For the full article from The New York Times, click here.

First comes social security, then comes Medicare. The scary thing is that it will be slow at first, without much notice, but all the foundations will be there for everyone to see. Years from now, we’ll look back and think it was obvious.

Signs from the 7-yr auction

Not a good auction might be the understatement of the week. Bonds are telling us something, and it ain’t good. For starters, we’ve seen the benchmark 10-year yield rise to the highest it’s been in weeks, and it could easily approach 4% in the next few days at the rate it’s moving. We’ve been bearish on Treasuries for a while, but maybe the market is starting to agree. Watch the 10-yr for signs.

Throughout it all, the equity market seems to be completely oblivious to the implications of higher rates. Is the market piling into equities as a pressure release on expectations on inflation? I don’t know. The move higher in equities might just be month/quarter end buildup and nothing more.

Treasury Sees Tepid Demand for 7 Year Notes

By Deborah Levine

NEW YORK (MarketWatch) — The Treasury Department sold $32 billion in 7-year notes on Thursday at a yield of 3.374%, higher than traders anticipated. Bidders offered to buy $2.61 for every $1 of debt being sold, compared to an average of $2.83 at the last four sales, all for the same amount. Indirect bidders, a group that includes foreign central banks, bought 41.9%, versus an average of 49.7% of the last four. Direct bidders, a class that includes domestic money managers, purchased another 8.1%, compared to 11.3% on average. In the broader market, long-term bond yields, which move inversely to prices, turned higher before the auction results were released. Yields on 10-year notes rose 3 basis points to 3.89%, after jumping by the most since last summer on Wednesday.

Also, see this article from ZeroHedge yesterday about the move in 10-yr. I’m not a technician by trade, but for those out there who lean that way, this has some interesting insight. Click here for the article.

First on the daily triangle chart for the 10Y future, we show that we are potentially in a triangle formation and are approaching the support which I see at 115-24 here. The reason why the triangle formation is seductive because as highlighted for other markets, AUDCAD is in a massive triangle consolidation, and so is the Shanghai composite (more on this lower). Hence a similar configuration in rates does make some sense. Should we break below this level, the two key levels below are 114-30 and 114-13. As  can be seen on the daily chart, they correspond to the 2 necklines of 2 huge head and shoulders. These support levels are the key boundaries I indicated in my annual letter at the start of 2010. I personally do not think we will bypass them to the downside, but beare if we do, it would open the flood gates. Given how equities perform under higher yields and the pile of debt accumulated, I think yields rising in itself would bring back some risk aversion that would defeat the yields move up. Think of it as a dog biting its tail.The other consideration is that if we are indeed in a triangle formation, then the next leg is in theory up as this is a continuation pattern within the trend. Therefore I think shorts who have accumulated money on the downside should be careful as we move close to this cluster o supports, the next 20 bps will be hard to get through.

Japan’s big currency bet

I just couldn’t help bringing this up, especially since this morning’s Connect the Dots:

Because foreign currency reserves are viewed as a form of insurance, the risks of excess reserves are often overlooked. Japan holds reserves equal to 20% of GDP, more than it could possibly need for insurance purposes. These holdings make up a foreign asset portfolio that is subject to exchange rate risk. However, this risk is hidden because Japan’s reserves are primarily held in U.S. dollars and their value is reported in U.S. dollars. So as the local and global purchasing power of the dollar falls there is no change in the reported value of the reserves. As shown in the chart, Japan’s reserves increased by over $100 billion since June 2007, but fell by nearly ¥20 trillion when measured in local currency terms – over 4% of GDP. The risk of large losses in national wealth is even greater for China, whose reserves make up 50% of GDP. This risk will become apparent as and when China allows the renminbi to appreciate, in line with market pressures.

Source: http://blogs.cfr.org/geographics/2010/03/24/japan/

The question here is whether you want to invest alongside Japanese and Chinese government traders. I do not.

Valuation is important

I’ve often touted the decision-making process over end results as a way of evaluating positions and managers a priori. While I’ve tried and tested various factors, some have remained robust and predictive across markets, countries and asset classes. Guess what, they all revolve around value. Tweedy Browne tested some of these factors a while back and updated their research last year. I encourage everyone to read this, even if you don’t agree nor implement the factors (Tweedy apparently should have implemented their own research judging by their performance). For the full report, titled “What Has Worked In Investing” click here.

What Has Worked in Investing is an attempt to share with you our knowledge of
historically successful investment characteristics and approaches. Included in this booklet
are descriptions of over 50 studies, approximately half of which relate to non-U.S. stocks.
Our choice of studies has not been selective; we merely included most of the major studies
we have seen through the years. Interestingly, geography had no influence on the basic
conclusion that stocks possessing the characteristics described in this booklet provided the
best returns over long periods of time. While this conclusion comes as no surprise to us, it
does provide empirical evidence that Benjamin Graham’s principles of investing, first
described in 1934 in his book, Security Analysis, continue to serve investors well. A
knowledge of the recurring and often interrelated patterns of investment success over long
periods has not only enhanced our investment process, but has also provided long-term
perspective and, occasionally, patience and perseverance. We hope this knowledge will also
serve you well.

WHAT HAS WORKED IN INVESTING
1. Low Price in Relation to Asset Value Stocks
2. Low Price in Relation to Earnings Stocks
3. A Significant Pattern of Purchases by One or More Insiders
4. A Significant Decline in a Stock’s Price
5. Small Market Capitalization

…
Dr. Josef Lakonishok (University of Illinois), Dr. Robert W. Vishny (University of Chicago)
and Dr. Andrei Shleifer (Harvard University) presented a paper funded by the National
Bureau of Economic Research entitled, “Contrarian Investment, Extrapolation and Risk,”
May 1993, which examined investment returns from all companies listed on the New York
Stock Exchange (NYSE) and American Stock Exchange (AMEX) in relation to ratios of
price-to-book value, price-to-earnings and price-to-cash flow between 1968 and 1990. In
their abstract, the authors state, “This paper provides evidence that value strategies yield
higher returns because these strategies exploit the mistakes of the typical investor and not
because these strategies are fundamentally riskier.”

A subsequent paper, interestingly co-authored by Burton G. Malkiel, the Princeton
Professor and author of A Random Walk Down Wall Street, which argues against the
efficacy of actively managed investment strategies in favor of index funds, investigated
whether the predictable return advantages associated with contrarian strategies set forth in
previous empirical studies was persistent and exploitable by investment managers. In this
study published in The Journal of Economics and Statistics (May 1997) entitled, “The
Predictability of Stock Returns: A Cross-Sectional Simulation,” Zsuzsanna Fluck (New York
University), Burton G. Malkiel (Princeton) and Richard E. Quandt (Princeton) examined
the performance of 1,000 large-company stocks ranked by price/earnings ratios and priceto-
book value ratios from 1979 through 1995, and confirmed the findings of the previous
Lakonishok, Shleifer and Vishny study, “Contrarian Investment, Extrapolation and Risk,”
finding that,

The papers by Fluck, Malkiel and Quandt, and by Lakonishok, Shliefer and Vishny, together with similar studies described in the “Assets Bought Cheap” and “Earnings Bought Cheap” sections of What Has Worked In Investing demonstrate that, at the extreme, investors overvalue and undervalue individual stocks, and that the best returns come from buying stocks at the extreme end of the value spectrum.

Connecting the dots

There are so many things happening in the past few days, that it’s been hard to make sense of how they’re all related – but they are, and the signals are not good. In the end, we have to go back to valuations and relationships.

Equity markets are overvalued. No matter what valuation methodology I look to, the market looks overvalued by 30-50%. CAPE, Q-ratio, dividend yields, whatever. They all point to the same thing. I could be early. P/E ratios could expand from their current low 20′s. In 2000 they expanded to the 40′s. But the end result will be the same. Then there is the top-down approach. Stocks preform well coming from price instability toward price stability. Price instability can be either inflation OR deflation. Both are unstable. In the early 1980′s with rampant inflation (instability) we moved towards stability and stocks were able to perform well. We have now built a base of stability, which unfortunately means we will move towards instability. The longer we stay in this stable environment (ironically), the greater the danger that the developing fingers of instability will crack. P/E expansion cannot happen in this environment, so it won’t.

Treasury yields are heading higher. It doesn’t matter whether we move towards deflation or inflation. The worlds central banks are on a path of competitive devaluation and long-dated Treasury yields will have to rise (homegrown inflation and foreign countries no longer willing/able to finance our debts). Even in a deflationary environment, we will face higher rates. Economic books will have to be re-written, just as they were after the stagflation of the 1970′s. Bill Gross’s current piece is a must read, but I just want to highlight 2 paragraphs:

…In the U.S. in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don’t matter. Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.

The trend promises to get worse, not better. The imminent passage of health care reform represents a continuing litany of entitlement legislation that will add, not subtract, to future deficits and unfunded liabilities. No investment vigilante worth their salt or outrageous annual bonus would dare argue that current legislation is a deficit reducer as asserted by Democrats and in fact the Congressional Budget Office. Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money and that it is being “paid for” in the current bill with standard smoke, and all too familiar mirrors that have characterized such entitlement legislation for decades. An article by an ex-CBO director in The New York Times this past Sunday affirms these suspicions. “Fantasy in, fantasy out,” writes Douglas Holtz-Eakin who held the CBO Chair from 2003–2005. Front-end loaded revenues and back-end loaded expenses promote the fiction that a program that will cost $950 billion over the next 10 years actually reduces the deficit by $138 billion. After all the details are analyzed, Mr. Holtz-Eakin’s numbers affirm a vigilante’s suspicion – it will add $562 billion to the deficit over the next decade. Long-term bondholders beware.

Click here to access the full article.

Then we get to currencies. Competitive devaluations, entitlement programs, protectionism, tariffs, quantitative easing, and the rest of the games central banks and governments play are long-term inflationary on a global scale. However, on a relative basis, which the currency markets are, funny things are happening. The euro is getting hit from all sides, so the eurozone countries have to talk about its stability, even though they are probably secretly happy that the currency is depreciating. Good effect, bad reason. That puts pressure on the US, since a strengthening dollar is deflationary. Meanwhile, the Chinese are holding the yuan steady, but are getting pressure to revalue it upwards. The US is hoping that by getting the Chinese to revalue the yuan (and thereby devalue the dollar) they’ll get a bit of inflation pressure and maybe some uptick in exports. Slim chance. If anything, the Chinese recognize the US position and might devalue the yuan in a bold economic strategy to bolster their own position on the world economic stage. So the dollar is strengthening, even as no one really wants to hold longer term Treasuries. So where do you park billions of dollars when you don’t want to go out on the curve? The shorter the better, which leads us to one of the steepest yield curves in history, with funny inversions happening on the short end as money moves around and attempts to hedge other short end positions.

I can’t just leave the euro there. I continue to think it’s completely flawed. Worries over Greece have (finally) started to materialize. The initial pressure on the euro abated for a while, which I just couldn’t understand, since the problems were never about Greece (a small Euro member), but about Greece’s larger brethren. So now Portugal is in the crosshairs. (Read about the Fitch downgrade here.) We shorted the Euro and Yen in mid-November of 2009 (bought EUO and YCS – admittedly not the best implementation vehicles), but we were early.

That leads us to the yen. I must admit, I don’t get it. I’m short the yen, but I’ve been wrong for the past few months. It’s continued strength seems counter-intuitive (at best). The only explanation I have is that there is still some domestic support (which will end as the aging population uses it’s savings) and support from China and Europe who are uncomfortable with their own currencies. Otherwise, the Japanese might just be manipulating all the numbers. Either way, it’s will all end poorly for the yen, and I don’t think it will be long.

We haven’t even begun talking about commodities (bullish on some, negative on others), real estate (negative across the board; even more negative on Chinese real estate), and US Banks (still negative; think CRE).

Repo rates, 10 yr swap spreads, and valuations – not good

Earlier this morning, we highlighted that liquidity seemed to be pressured – at least marginally so, with increased LIBOR rates. On the flip side, we see increased risk taking as “The 10-year U.S. swap spread turned negative for the first time on record amid rising demand for higher-yielding assets such as corporate and emerging market securities.”

A negative swap spread means the Treasury yield is higher than the swap rate, which typically is greater given the floating payments are based on interest rates that contain credit risk, such as the London interbank offered rate, or Libor. The 30-year swap spread turned negative for the first time in August 2008, after the collapse of Lehman Brothers Holdings Inc. triggered a surge of hedging in swaps. The difference narrowed to negative 20.5 basis points today.

For the full article from Bloomberg, click here.

Risk taking is definitely in vogue, the hunt for yield continues, and everyone seems to be happier. Except me.

Valuations are mean reverting, and they are stretched. A lot of institutional investors will be forced to put money to work as we near month end. Who wants to show their investors that they didn’t participate in this rally. This is not just month end, but quarter end, so the pressure will be particularly strong to get rid of cash and deep value positions.

Barry Ritholz posted this graph earlier today and it was telling:

(Source: The Big Picture)

One thing left out was that the “average calculated takes into account the extreme overvaluation of the past bubble. In other words, the series will probably not just mean-revert to the current average, but rather to a normalized average. This implies a 40% overvaluation (on the low end). Now, maybe it’s off, but every factor we look at keeps bringing us back to the same point: the market is overvalued, and while it may continue to rise, it will do so in spite of valuation, not because of it, and it will eventually mean revert. At that point, investors who were not disciplined will be faced with permanent loss of capital. Pension plans and retirees are the ones most at risk in my mind. Pension plans, because they will not have cashflows to put more funding in and outflows will be growing every year. Retirees, because they have no choice but to start living on their savings and investments.

The fingers of instability that we’ve discussed in the past are growing.

BarChart.com Cheat Sheet

This is purely passing along something that might be of interest to some of our readers. It’s wholly unsolicited, I don’t know anything about nor anyone from barchart.com, and I’m not a technical trader, so I have no personal stake in this whatsoever.

That said, it looks like BarChart.com provides a cheat sheet on technical levels so that you have a sense of knowing where to put stop losses, etc. before going into a trade. Might be worth checking out. Here’s where I read about it: http://traderfeed.blogspot.com/2010/03/useful-cheat-sheet-from-barchartcom.html

Repo rates on the rise

March and April may end up being pivotal months for our rate discussions. On the one hand, we have MBS purchases slated to be finished by the end of March. On the other you have the implementations of the Supplementary Financing Program.

Check out the LIBOR 3 Month chart:

(Source: StockCharts.com)

It will be interested to see if this continues, stabilizes here, etc. and how it flows through to the rest of the curve and pricing structure.

For a quick summary of the situation, click here.

Q-Ratio and CAPE

We’ve been discussing the overvaluation of the markets for months. Now, with liquidity rolling over, will these valuations come into line or will the market continue higher?

At least judging by this posting on ZeroHedge, people are starting to notice.

To read the full article, click here.

Fractional reserve and Bernanke

Has anyone been able to confirm this or find out more information? This might be a huge piece of news for banks, USD, etc.

That simply does not make any sense. But it is right there in black and white on the Federal Reserve’s own website….

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

If there were no minimum reserve requirements, what kind of chaos would that lead to in our financial system?  Not that we are operating with sound money now, but is the solution to have no restrictions at all?  Of course not.

For the full article, click here.

I don’t believe it will happen, but it’s a scary proposition.

Healthcare

On Sunday, the House passed a bill to overhaul the US healthcare system. It will go through some modifications in the Senate and Obama will sign it into law. Then, the devil really will be in the details, and while no one is  quite sure what the ultimate impact will be, there are a few big picture items that have been mentioned.

For starters, the bill aims to increase coverage for roughly 30-35 million Americans, still shy of universal coverage, but it certainly sounds like its a move towards it. The people who are currently not insured, but can afford it, will be forced to buy insurance (good for insurance companies?) or be penalized (taxed). All the parties seem happy:

• The Democrats can say they passed a watershed healthcare bill, as promised.
• The drug companies will have that many more people buying drugs.
• The unions were able to obtain an exemption for being taxed on their Cadillac plans.
• Medicare costs are supposedly going to be cut.
• More people will be covered, many of them young and healthy, making the insured pool larger and healthier.

So who loses?

• Doctors will see payments cut, discussions now are around the 20% marker. The thinking was that cut reimbursements by 20% and doctors will just have to deal with 20% less. However, anyone who has actually run any PNL statement or business knows that this is not how things work. By cutting reimbursement rates for offices by 20%, the bill will kill any profit margin the offices had. (This is obvious since leases won’t go down 20%, staff won’t take a 20% pay cut [think nurses, billers, etc.], etc.) I have already spoken to a number of doctors/practice owners and if this reduction does indeed go into effect, they will be forced to shut down their offices. Clearly, it is a pro large institution move. Hospitals and large doctor practices will be net beneficiaries, but the vast majority of doctors will lose. Not really sure what will happen to them.
• Taxpayers will have to bail out the system because politicians do not know how to budget. Medicare was never supposed to be the largest government expenditure. Social Security was never supposed to go bankrupt. All government estimates – I would venture, in the history of mankind – are wrong. So why do people believe these?
• Insurance companies will ultimately be hurt. This bill moves the US one [huge] step closer to a single payer system – and that single payer isn’t a for-profit insurance company. Government options will be more attractive to employers (less liability) and young families (will end up being cheaper).

Let’s stop there for now. For a full description of the bill, click here. Another step in the absolutely wrong direction.

Why I bought PALM…(not a recommendation)

I usually write about the macro sphere, but I’ll venture out to share some thoughts on an individual position – not because I think you should purchase it, but just to share about my process. This is in no way a recommendation to buy or sell PALM since I do not know your individual situation! Additionally, this is for opportunistic portfolios, and not in our core value oriented strategies.

For starters, PALM is in an incredibly competitive, low margin business, with huge players (think NOK, RIMM, AAPL, GOOG, and more). While it was a pioneer in the touch screen space, it is no longer a leader. It came out earlier today with lower revenues than were expected. Worse, of the almost 1 million handsets that were shipped, only about 400K were actually sold. The story is not looking good so far.

It’s down almost 27% today. More bad news, some might say. It might go down further, but here are some thoughts on the other side.

PALM has a strong brand, strong technology, and strong licensing revenue. Further, it’s got some cash to help it along for a little while as it finds a suitor (which it will need because of its burn rate). Doing straight valuation on it is difficult because all the ratios are negative (negative earnings growth, negative P/B, etc.), but we went through it, and believe there is value in the company. Lastly, the stock has a 75% short ratio, which will need to get covered one way or another, and no one will want to step in front of a buyout, so it will happen soon, providing a necessary floor and a supply of willing buyers.

So I bought a small position at $4.14. It will probably go down further (it has while I was writing this post). But we bought a small position, and we’re un-levered, so we can hold on to it as the valuation gets sorted out.