History of Debt

I came across this article earlier this week, and only now got to fully reading it – which is unfortunate. Something interesting happened while reading it, namely, there is a big disconnect between the initial blurb and the conclusion.

Here’s the initial blurb:

Throughout its 5000 year history, debt has always involved institutions – whether Mesopotamian sacred kingship, Mosaic jubilees, Sharia or Canon Law – that place controls on debt’s potentially catastrophic social consequences. It is only in the current era, writes anthropologist David Graeber, that we have begun to see the creation of the first effective planetary administrative system largely in order to protect the interests of creditors. (Emphasis mine.)

Yet, after reading this very provocative interpretation, I was struck by the conclusion:

Historically, as we have seen, ages of virtual, credit money have also involved creating some sort of overarching institutions – Mesopotamian sacred kingship, Mosaic jubilees, Sharia or Canon Law – that place some sort of controls on the potentially catastrophic social consequences of debt. Almost invariably, they involve institutions (usually not strictly coincident to the state, usually larger) to protect debtors. So far the movement this time has been the other way around: starting with the ’80s we have begun to see the creation of the first effective planetary administrative system, operating through the IMF, World Bank, corporations and other financial institutions, largely in order to protect the interests of creditors. However, this apparatus was very quickly thrown into crisis, first by the very rapid development of global social movements (the alter-globalisation movement), which effectively destroyed the moral authority of institutions like the IMF and left many of them very close to bankrupt, and now by the current banking crisis and global economic collapse.

. . . Finally, thinking about debt outside the twin intellectual straitjackets of state and market opens up exciting possibilities. For instance, we can ask: in a society in which that foundation of violence had finally been yanked away, what exactly would free men and women owe each other? What sort of promises and commitments should they make to each other?

(Emphasis mine.)

To read the full article, click here.

What struck me was stating on that we have created effective organizations, then showing how ineffective they have been. Similarly, the author discusses the role of violence (or the threat of violence) in creating democracy, yet seems optimistic that large institutions can decrease freedom but increase democracy simultaneously. So some things don’t quite make sense to me in his analysis. That being said, if you like Niall Ferguson, or economic history in general, you will probably like this piece.

Quoteable

Small debt produces a debtor; a large one, an enemy.
Publilius Syrus

Spanish Q1 2010 Unemployment Number Accidentally Leaked, Surpasses 20% For First Time Since 1997

The above headline was just released and may be an important market mover tomorrow. We continue to focus on valuations and market sentiment, but many of our readers might find this interesting nonetheless.

For the full story, click here.

Yaron Sadan now a weekly columnist on Minyanville

We are very pleased to announce that Minyanville, a leading financial website, has selected Yaron as one of its “Professors” or regular contributors, and will feature pertinent articles from The Hard Trade on a weekly basis. Articles posted on Minyanville will be publicly available on The Hard Trade website.

The Hard Trade or Greece Redux

In November 2009, amid fears that the dollar would crumble and with calls from central banks around the world to diversify assets, I discussed “the hard trade” of buying the US dollar against both the euro and yen – now, I stand by that investment. Since then, the currency markets continue to be a main focus for signals of stabilization, relative returns, etc. Greece and Portugal were just canaries in our global coalmine, and I have often written about them (pessimistically).

I continue to view Greece as a canary for the euro and the structure of the European union, but today I want to explore a new direction. The question I find myself asking is: when will Greece become a value play, if at all? 2-year Greek bonds are yielding roughly 13%. Is that enough to compensate for the risk of default? When everything looks so obvious, I often have to stop myself from buying into the mania – and that is where I am with Greece. Yes, the situation continues to worsen. Yes, the rioting in the streets looks bad on TV. I anticipate continued capital flight from the country. And yet…shouldn’t all this information already be priced in to the markets? Mind you, I’m not calling a bottom, or trying to catch a falling knife; rather, I’m exploring whether and when there will be potential in the space.

(Source: StockCharts.com)

Maybe the fall is not completely done…

Maybe I’m a bit early…

Maybe there’s no easy way to play it…

Or maybe…

There isn’t a Greece ETF trading in the US (although they appear so quickly, who knows if there will be one by the time I finish writing?). However, there are a few ADRs that look interesting, such as National Bank of Greece (NBG) and Hellenic Telecommunications Organization SA (OTE). Both stocks have recently been shunned by investors and reporting requirements are limited, but let’s at least recognize that there is some contrarian potential here:

(Source: StockCharts.com)

(Source: StockCharts.com)

With recent significant spikes in volume, it’s difficult to imagine that there are sellers left, or people who haven’t heard the news and already taken their stand. Going long anything Greek certainly seems difficult these days, but the hard trade is often the best.

(Disclosure: I have no position in neither NBG nor OTE, but I have exposure to short euro and yen positions. This is in no way a recommendation to buy or sell any security! These positions are subject to change at any time.)

While everyone watches equities

You should be looking elsewhere. Amazon, MSFT, EBay, and Baxter are getting some attention (in both directions), and IWM is bonkers, but the real story is the reversal in yen and DXY going up. Dollar strength here, with increasing yield. Hmmmm. Dollar strength is deflationary – so why the higher yield? This is the real story of the market, and as it unravels, the mysteries we discuss daily will be revealed. Equities are a distraction from the main show these days.

High Risk = Low Return

When I go shopping, I like a good deal. Who doesn’t?

Yet when shoppers enter the big mall of stock investing, they switch gears, often shunning good deals for the marked up items instead. Why? So many reasons we won’t even go there. Academia has proposed some theories about buyers only taking on risk if they are compensated for it, and measuring risk against a basket or market or securities. In fact, the data leads to a different conclusion altogether.

A recent paper by Baker, Bradley, and Wurgler continues brings further evidence to support our contention that risk doesn’t pay off:

Abstract
Over the past 41 years, high volatility and high beta stocks have substantially underperformed low volatility and low beta stocks in U.S. markets. We propose an explanation that combines the average investor’s preference for risk and the typical institutional investor’s mandate to maximize the ratio of excess returns and tracking error relative to a fixed benchmark (the information ratio) without resorting to leverage. Models of delegated asset management show that such mandates discourage arbitrage activity in both high alpha, low beta stocks and low alpha, high beta stocks. This explanation is consistent with several aspects of the low volatility anomaly including why it has strengthened in recent years even as institutional investors have become more dominant.

For the full article, click here.

And for those who haven’t read it yet, please read Josef Lakonishok’s work on how behavioral biases lead to value opportunities. This is an oldie but a goodie from Lakonishok, Vishny, and Shleifer. Here’s the abstract:

For many years, stock market analysts have argued that value strategies outperform the market. These value strategies call for buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value. While there is some agreement that value strategies produce higher returns, the interpretation of why they do so is more controversial. 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.

For the full article, click here.

ZIRP revisited

We wrote about the quirks of the Fed zero interest rate policy a while ago, and the limits of monetary policy at these levels. A few readers wrote me to ask about specific implications for trades and investable ideas, but at the time, most of the information was academic. Now, as the Fed programs trail off (although I have a feeling some will continue for a while longer) some traders are pointing to very real and scary implication. Institutional Risk Analytics has a fantastic piece by Alan Boyce, in which he shows how the Fed has managed to maintain the facade, discusses the coming increase in interest rate volatility, and the implications for the Fed and traders. There’s also a great summary on ZeroHedge, which I encourage you to read. For those trading or hedging in any credit market, this is an important development to watch, and more and more traders will come to grips with the implications in the coming years.

If you’re just tuning in…

If you’re just tuning in, the Greek bailout is on the rocks, Portugal spreads over Bunds is at the highest ever, and Germany’s long bond auction wasn’t great – yup, the euro is still in trouble.

Here in the US news that the government came out with its case against GS on the same day that a report criticizing the SEC handling of Stanton (ponzi schemer) makes the case look even more politically driven. Separately, some smart people are pointing to a modified P/E for the market suggesting a 35% overvaluation (specifically, Jeremy Grantham and David Rosenberg), which is in line with what we’ve been saying for a while. I’ll take that a step further and mention that when markets go to one extreme, they usually tend to revert to another extreme, which means that once the markets correct, they’ll probably correct by more than 35%.

In Asia, Jim Chanos and Marc Faber are ganging up on China, pointing to a massively levered economy and an unsustainable real estate bubble. Not really sure how to play it from this side of the ocean. Faber in the meantime, continued building on his gold theme and warned of holding any paper currencies.

Just to catch you up.

Pimco Warns of Deflation Risk as Central Banks to Cool Stimulus

April 13 (Bloomberg) — Developed economies face the risk of deflation as central banks end programs to revive their financial systems, according to Pacific Investment Management Co., the biggest holder of inflation-linked Treasuries.

A slowdown in economic growth is adding to deflation pressures, said Mihir Worah, who oversees the $18 billion Pimco Real Return Fund. Pimco, which runs the world’s biggest bond fund, is “underweight” inflation-linked bonds in portfolios that focus on the debt, he wrote in a report.

“There is a near-term risk of flipping to deflation given our view that developed economies have not fully healed and consumers are not yet ready to stand on their own two feet,” Worah wrote on the Newport Beach, California-based company’s Web site.

http://www.businessweek.com/news/2010-04-13/pimco-warns-of-deflation-risk-as-central-banks-to-cool-stimulus.html

While you were talking about GS, Portugal happened

First, read this article from the NY Times.

LONDON — Next target: Portugal.

Speculators have begun to zero in on another small member of Europe’s troubled monetary zone, highlighting the same economic flaw that brought Greece to the verge of insolvency: a chronically low savings rate that forces a reliance on the now-diminishing appetite of foreign investors to finance persistent deficits.

Guess what – when governments told you that Greece was contained, they were wrong.

Guess what else – the stability of the euro is temporary.

Guess what else – the Greek bailout won’t help the euro long term.

Guess one last time what else – even after we all pass the Greek and Portuguese mishmash, Spain is coming up with the same issues.

This is not the time to buy dips, but rather, it’s the time to wait for serious undervaluation in any position. The real money and returns are made in the waiting.

For some further readings, click here for an article from BusinessWeek.

Goldman’s plight might be the spark, but it ain’t all that

If you live in a cave and haven’t heard, the SEC came out in the middle of the day on Friday to charge Goldman with fraud over a securitization deal it helped underwrite for Paulson. Lots of nuance and many details to follow, but the gist seems to be that Paulson materially influenced the collateralized assets that he was trying to short and GS may have mislead ACA, the outside management firm hired to lend the deal some credibility. Now, the SEC isn’t charging Paulson (yet?) nor ACA (yet?), but rather is focusing on a single deal and a single senior VP at GS. In the worst case scenario for GS (best case for the SEC), GS misled and committed the fraud and will pay a fine. In the best case scenario for GS (worst case for the SEC), GS was marginally ignorant, and the SEC will once again look like it doesn’t understand the firms and securities it’s supposed to oversee.

Did the SEC really need to come out with this news in the middle of the day? By focusing on one transaction and not a pattern, will financial reform ever be effective? Is this politically driven by higher-ups?

Goldman will end up figuring this all out (and probably finding a way to profit from it), but this story shouldn’t be the focus going forward. The real focus is GLD and Paulson’s positions. Gold lost 2% on Friday. Why? Some are speculating that Paulson will need to raise cash in anticipation of redemptions, or other reasons. If that is the case, the market might be front-running Paulson by selling off any positions in which he is a large investors, GLD being one of them. Check out this news story. If that is indeed the case, then the following weeks could see a lot of volatility in Paulson’s names:

Top 10 Holdings as of 12/31/09

SPDR Gold Trust

GLD

NYSE

31,500,000

$3,380,265,000

17.08%

FINANCIAL

Bank of America Corporation

BAC

NYSE

151,034,229

$2,274,575,000

11.49%

FINANCIAL

AngloGold Ashanti Limited

AU

NYSE

42,849,864

$1,721,708,000

8.7%

BASIC MATERIALS

Citigroup Inc.

C

NYSE

506,700,000

$1,677,177,000

8.47%

FINANCIAL

Boston Scientific Corporation

BSX

NYSE

99,135,000

$892,215,000

4.51%

HEALTHCARE

Comcast Corporation

CMCSA

NASDAQGS

44,000,000

$741,840,000

3.75%

SERVICES

Sun Microsystems, Inc.

JAVA

NASDAQGS

74,000,000

$693,380,000

3.5%

TECHNOLOGY

Capital One Financial Corporation

COF

NYSE

17,000,000

$652,800,000

3.3%

FINANCIAL

Suntrust Banks Inc.

STI

NYSE

30,380,700

$616,424,000

3.11%

FINANCIAL

Kinross Gold Corporation

KGC

NYSE

31,500,000

$583,322,000

2.95%

BASIC MATERIALS

Source: DaveManuel.com

Lots of gold exposure and lots of financial exposure. One thing that’s particularly telling was how quickly and how far GS fell on the news, while the market stayed relatively firm. Both sides are telling, depending on whether you’re a bull or bear. The bears will point out that a minor piece of news sent GS down 13%, meaning there are no buyers out there. The bulls will point out that the market was relatively stable and held up well, showing resilience in the face of bad news. I’m biased in that the valuations of the market lead me to look for weaknesses. GS is just one example yesterday and it overshadowed GOOG, which was down 7.5% despite positive earnings.

It will take time to understand the full ramifications of the case, but at first go, it looks like the SEC might be focusing on the trees over the forest (disclosure issues are minor compared to the prop trading conflicts of interest – which this case doesn’t have!!). That being said, eventually the market will continue to use the news as an excuse to realign valuations, so it’s only a matter of time.

Conflicting data and the hard trade

The past couple of days, we here at The Hard Trade have been trying to figure out what is actually the HARD TRADE, namely, which trade looks painful from a psychological perspective but may yet reveal itself as the most rewarding?

We’ll get to get to that in a moment, but first, here are just some of the cross currents we have read in the past 2 days (in no particular order):

• Insider’s kicked up their selling. Read the article here. You can get the details in the article, but the gist is that the ratio of sellers to buyers is relatively high. Not a great sign.
• While The World Was Focused On The Yuan, Everyone Missed The Real Tectonic Landmark. Read the full article here. Competitive devaluations? Nope. Singapore might be leading the Asian currencies up in a bid to buy up resources around the world. Should the US worry? Yup. Let’s see: higher Asian currencies means less money flowing into Treasuries as their trade surpluses drop and strategically dangerous as US loses access to raw materials globally.
• In the meantime, foreclosures jump 7% (click here for the article) but we also read that strategic defaults increase consumer spending (click here for the article). Much like the theory that broken windows and natural disasters increase GDP (Broken Window Fallacy), this doesn’t seem like a sustainable trend that can be relied on.
• In the meantime, weekly initial unemployment claims rise to 484,000. For a good summary and chart, click here.
• I follow the technicals a little less than valuation and fundamental data, but seeing the extremes on the put/call ratio certainly doesn’t add to my comfort level. Read it here. On top of that, shorts have been squeezed out already, so the support they provide is gone. Read the numbers here.
• Not that I trust these types of headlines, but heck, I was already wondering: George Soros Warns Of Biggest Market Crash To Come, As “We Are Facing A Yet Larger Bubble” Than During Credit Crisis (Click here for story.)
• Earnings wise, Bloomberg ran a story (click here) that showed how bank earnings (you’d have to be dumb to be a bank and not make money in this environment with the yield curve as it is) are driving the earnings recovery of the market. Check out this chart:

• We’ve got Albert Edwards warning of deflation (click here) and Morgan Stanley exploring the breakup of the euro (click here), while Richard Koo from Nomura compares the US real estate to Japan’s in the 1990′s and it ain’t pretty (click here).

All against a backdrop of a market that is grinding higher and grinding up shorts every day, making hedging or negative directional bets incredibly costly and painful.

The hard trade: is it harder to stay long given all the negative news out there or to go short as the market continually moves against you?

If you trade commodities, ETF’s, futures, or anything: Read This!

This might be the most important article on the structure of trading in physical, options, futures markets that I’ve ever read. For those involved in these markets, it’s a must read. I can’t excerpt it – because IT IS ALL IMPORTANT! It is pretty technical, but it highlights the pitfalls of trading, issues with financial vs. physical exposure, etc.

To go to the article, click here.

And for those who say real estate is stable…

Morgan Stanley has told investors in its $8.8 billion real-estate fund that it may lose nearly two-thirds of its money from bum property investments, according to fund documents reviewed by The Wall Street Journal. That would likely make it the biggest dollar loss—$5.4 billion—in the history of private-equity real-estate investing.

Not much more to say, but there was an additional nugget in the article:

When times were good, the fund generated fat fees for various segments of the bank. In 2007 alone, Morgan Stanley earned $104 million in acquisition fees, $22 million in fund-management fees, $13 million in financing fees, $36 million in real-estate-management fees, and $21 million in financial-advisory fees, according to fund documents reviewed by the Journal.

To read the full article, click here.

Not much more too say (now for real). Illiquid, no transparency, too much risk, conflicts of interest, etc. The story is old.