Some thoughts for a long weekend

Norman Fosback has a market timing system developed in the 1970′s, which was simple: invest before long weekends and holidays and sell afterwards; the rest of the time, sit in cash. Mark Hulbert reviewed the system multiple time (check it out here) and it’s been one of his top performers over the years. In the bear markets, it’s particularly strong, mostly because it sits in cash for roughly 70% of the time.

So it got me thinking about going into this weekend. We had a very strong day yesterday, and as I write this, we’re not giving too much of it back. I do ask myself, however, what issues might pop up this particular Memorial Day weekend.

South and North Korea are getting frisky. Spain just got downgraded by Fitch. The Fed came out with short term deposit auction – supposedly to decrease money supply? Surprising on multiple levels (it’s been stabilizing, economic activity doesn’t seem to justify tightening, just re-iterated to the Europeans structure of currency swaps, etc.)

At the same time, financial reform bills are moving through Congress, the administration is dealing with offshore drilling, and China is issuing statements that it will hold on to eurozone bonds (which obviously means it wants to get rid of them).

Just a lot of noise out there. I anticipate volatility to remain high, but valuations will be a magnet for asset prices to come down, just like they are for real estate after a brief bounce.

Continuing fodder for questioning China

In a clear case of confirmatory bias, I keep highlighting data points to make readers skeptical of China. Here’s another one:

Mexico’s exports to the U.S. are taking market share from China as demand rises for Mexican-made refrigerators from Whirlpool Corp. and Dodge Ram pickups from Chrysler Group LLC.Mexico’s share of the $427.7 billion in goods and services the U.S. imported in the first three months of the year rose to a record 12.3 percent from 11 percent a year ago, helped by a weaker peso and U.S. companies moving manufacturing south of the border. China’s share fell to 17 percent from 18.4 percent.

To combat China’s low-cost manufacturing industry, Mexican factories have shifted to goods that are expensive to ship overseas and those that require more complex manufacturing, such as automobiles and appliances, said Luis de la Calle, a former Mexican negotiator for the North American Free Trade Agreement. Mexico adopted the strategy after China’s entry into the World Trade Organization in 2001 caused the closure of hundreds of textile, toy and electronics plants.

Of course manufacturing will move to Mexico. Cheap labor, lower transport costs, no military or economic threat, lower tariff fears, and IT’S NOT COMMUNIST. For the full article, click here.

Fingerprints? Feels like I’ve played this game….

I noticed something familiar in the markets action the last few sessions but I just couldn’t put my finger on it until today. I had seen this before. Or at least I had seen this market action played out before. A dozen times even, but I never thought I would see in the indexes. This is exactly the action I saw repeatedly play out in small commodity markets that were notoriously controlled by a few strong traders with a limited form of market power. I am not a conspiracy theorist. I am not claiming these markets are being “manipulated”, only that the action shows the mark of a strong bear intelligently squeezing out other shorts, churning profits on the way down, and limiting up moves through heavy market making practices.

Lets say you have a solid bear position on, but you don’t have the patience to just sit back and wait for the market to unfold. What can you do? A lot actually, especially in a market with a number of weak (or weakened) players. First, assume a fairly large short position. This would have to be a significant size for the market, but not maxed out, as you would need room to add to it,  so lets say, 50% of max size.  From there, when the time is right and the downtrend gets momentum, add a new position in slightly out of the money puts. Now the game is on. Start with the after hours market. Sell quickly, especially in the later hours when volume is very light. Press on through the morning, especially from 5-630am so people wake up with a sense that things are weak. From there the ball gets rolling – delta hedgers start hedging, people start jumping on board. Especially people with momentum following systems. And I get the feeling these guys make up a big part of the market today.

Market opens down big; you push a little, getting a bit extended on your short, but that’s ok.  After a solid move, you start slowly covering. No jumping, no gapping, no out of control runs, just a solid two way keeping the market in check.  A short covering where you cover your overnight shorts, extract value from trading around your options, and end the day with the same base short position, only this time with a little more money in your pocket and hopefully a few other shorts who’ve been ridding your coat tails shaken out.

It’s really not as hard as it sounds. It doesn’t work in a very liquid or deep market, but I don’t think we have that anymore. I am not sure what made me put everything together, and I really have to wonder if someone could actually do this in the major  markets, but I see fingerprints of a strong trader moving the market lower, while squeezing profits out.

10 year treasuries – the time has come

I shorted 10 year treasuries today, as mentioned in an earlier post; and there’s a good chance that I’m early, also discussed. I decided to share some of the thought process, if not all the financial assumptions, because I received a lot of questions on the post.

Since some of the comments had similar themes, I’ll combine and paraphrase:

Is shorting treasuries an inflationary position?

The answer is a definite maybe. Historically, the thinking has been as inflation goes up, interest rates will rise and treasury prices will fall. Makes sense. The real issue is one of causality. It’s true that inflation might cause rates to rise, but so could other things (for example, China not showing up for an auction).

Is shorting treasuries a risk trade?

This series of questions revolved around the belief that the run-up in treasuries was a manifestation of risk being taken off the table. Agreed. But at some point, being long treasuries becomes its own manifestation of the risk trade. Locking in 3.2% (or less) for 10 years seems pretty risky to me in an environment of increased quantitative easing, increased taxes, slower growth, etc. Some of the comments suggested that instead of shorting treasuries, I should go long equities as a better expression of the risk trade. If that was the trade, I’d agree, but I believe there is a strong chance that we can have slower growth AND higher long term rates.

What are possible scenarios where we could see treasuries fall AND equities head lower?

Stocks and bonds might have low correlation on a short term basis, but on a longer term basis, equities had their biggest bull market run from the early 1980′s through 1999/2000 – a twenty year bull market. Simultaneously (correlation or causation?), interest rates went from 17+% down to 3+% in the greatest bond bull market in history. Looking forward, why wouldn’t we expect their bear markets to coincide as well? Asset allocation works well as long as assets aren’t correlated, yet throughout the investing public’s experience, all asset classes that they invested in (stocks, bonds, real estate being the major ones) went up. So one scenario is just a simple correlation without trying to explain the cause, but we can do better.

Digging deeper, let’s examine the famous deflationary argument (to which I happen to ascribe). Deflation is the ultimate fear trade. Investors get scared of holding long term investments and begin hoarding shorter term investments, ultimately preferring cash to pretty much everything else. There are a few commodities that end up being safe havens in deflationary environments (gold, perishable foodstuffs, etc.), but financial assets as a whole are not them. On a valuation perspective, if companies lose pricing power, margins erode, people spend less, and people have less money that they are willing to invest/lend believing that by waiting things might go on sale. So stocks go down. At the same time, governments are forced to pump ever increasing amounts of stimulus and spend increasing amounts on social services. How? Well, they print more and they borrow more, thereby increasing the supply of treasuries available. You get the picture.

But let’s assume you don’t believe we’re going that route. Here’s what really took me over the edge as I started looking at the different scenarios: China, Japan, and the Middle East. My argument is that being long treasuries is being long China, Japan, and the Middle East – none of which I want to be long. Let’s take China as the poster child. Equities are in a bear market. Social unrest is always a risk. Rural/urban disparity continues to worry those in power and the overcapacity built over the past 10 years is unprofitable. At the same time, their biggest trading partner, Europe, is facing its own problems and slower growth, rendering its investments in infrastructure, capacity, and stashes of commodities foolish (at best). And oh yeah, their surplus is concentrated in US treasuries, with the risk that Bernanke & Co. will inflate their deficits away. What’s a bureaucrat to do? One day (I believe soon), there will be a failed auction. By failed I don’t mean that the Chinese (or Japanese or Middle East block) won’t show up at all, just that they won’t bid aggressively, they won’t take down as much, or they won’t take down the long end. Guess what, they need to spend that money domestically, not lend it to the US so that we can lend it to Greece. No inflationary pressures, just fewer bids. A scary proposition and a huge game theory nightmare since all the other players will have to scramble to front run each other. FUBAR.

I’m probably early in my assessment, and treasuries might still be the safe haven trade tomorrow, and later in the week, as we get more auctions, everyone will show up as usual. However, the scenarios are real, and if nothing else, pose a serious risk to those who chose to use longer term treasuries to lock in 3+% for the next 10 years.

For reference and for those who like charts:

OIS, Fed swaps, and Europe

Why would the Fed loan money to Europe when Europe doesn’t want to lend money to Europe?

The Federal Reserve has a lever it can pull to help European officials combat a worsening financial crisis: Reducing the interest rate it charges on U.S. dollar loans it makes through the European Central Bank to dollar-starved commercial banks in Europe. The move, though not a cure-all, could relieve some of the strains in European money markets.

The loans currently are priced one percentage point above a market rate called Overnight Indexed Swaps (OIS), which tracks the expected path of the Fed’s benchmark federal funds rate. The loans are set above OIS to discourage foreign banks from using the government program too aggressively. But the Fed could reduce that penalty to encourage more borrowing and ease some of the financial strain on foreign banks in need of dollars.

For the full article, click here.

So the euro sucks, European banks don’t trust each other and LIBOR is rising (although still incredibly low by historical standards), and the Eurozone countries can’t get it together to figure out a way to provide liquidity to each other. Should the Fed help? Definitely. Sometimes politics and stability are more important than economics. So the Fed set up swap lines priced off OIS. Again, contrary to the article above, the interest charged is pretty low given the fact that each European country should have a negative FICO score. Now, the markets are discussing ways for the Fed to renegotiate for a lower rate! Incredible and highly dangerous. The thinking is that by lending to other central banks, the US is limiting its own exposure (the euro can always be printed). It begs the question – the US taxpayer is footing the bill, so are we getting a good deal? I don’t think so. Even at 1% over OIS I think it’s a bad deal, but at least it’s something that would make the Eurozone countries a little hesitant to borrow too much. Do we really want to encourage European countries to borrow from us, then pay us back in valueless euros? What’s the benefit and cost? Some at the Fed would argue that the instability caused by not reducing the rates would be too costly. I would argue that like all inflation it is a stealth tax being imposed on America and the taxpayers will bear the ultimate cost, probably by owning devalued euros and obligations denominated in them.

Probably premature…

I’ve often gone into positions prematurely, but without being overlevered, and my long term horizon, I’m comfortable with positions moving in either direction as long as the valuations support them. So I went short treasuries today. Yup, they’ve been moving up and yup, I believe the risk trade still needs to continue unwinding, and yup, I’m probably premature. However, one day soon, we will have a failed auction or at least one that is very undersubscribed. The Chinese and Japanese and Middle East nations won’t show up to receive 3.1% for 10 years. The risk trade will need to be unwound – the biggest risk trade in the history of the world: long US Treasuries. And when that happens, I won’t have the opportunity to position myself and my clients. When that happens, it will be too late to put on new positions. So I’m going in early. This is not in any way a recommendation for you to do the same, as I have no idea what your individual portfolios invest in, look like, etc. nor do I know your risk profiles.

At 3.1%, assuming inflation is 0%, your real return is 3.1%. Obviously, if deflation takes hold (a strong possibility and one that I believe is the most likely scenario short to medium term) that real return starts looking higher. However, I believe we are going into a period where both will coexist – higher lending rates AND deflation. We are already seeing it with interbank lending rates (LIBOR) going up despite extremely accomodative monetary policy. The same will be true on the UST side.

Positioning and waiting

This is the opportunity to wait, and watch, and prepare.

For those with a military background, while navigating or flying, one always needs to be planning ahead. Especially with ships that take time to respond, or planes where the next step comes up faster than a blink, planning ahead is key. We planned ahead for this period months ago, by increasing cash holdings, buying VXX, shorting the euro, etc. Some of our plans didn’t work out (short yen and short treasuries, specifically).

So how are we preparing for the next steps? I still believe that the short yen and short treasuries positions are the right places to be. Once the carry trade unwind ends, the yen will be the most vulnerable currency in the world. I’m also looking for opportunities to buy things cheaply – but I’m not in any rush. Our investment style doesn’t depend on any second-by-second move, since we hold positions for relatively long periods of time. To that end, I’m looking at opportunities in Europe, Southeast Asia (e.g. Thailand, Indonesia, Vietnam, not China), and the US. We’re not at extreme undervaluations at this point, but I’ll be prepared when the opportunities come.

LIBOR has a long way to go

I’ve been reading reports on LIBOR, the interbank lending rate and a measure of the willingness of banks to do business with each other. It’s just over 0.51% (3- month), which is higher than where it was a couple of days and weeks ago. But it’s got a long way to go to reach 2008/2009 levels, so don’t be lulled into a sense of a top in the LIBOR:

Dow futures down 148

As I write this, Dow futures are down 148. Euro under 1.23. Hong Kong, Nikkei, and the rest of Asia down sharply. Is it time to buy the dip? Nope – it continues to be about the waiting.

And that is why we aren’t buying the dips

In a market that has no “real”, long term buyers, buying the dips is a trading strategy, not an investment strategy. The fundamentals do not scream “buy” and therefore the direction is to the downside, with no protection – meaning, the bids can just disappear (literally). So we continue to be cautious and wary and suspicious of any rally.

And oh, by the way, Spain’s banks suck. North/South Korea is a real hot potato. Oil covering the gulf? Ewwww.

Hugh Hendry’s Eclectica Fund Letter

This is a must read for investors. Hugh Hendry is one of a handful of fund managers that I believe actually get it: it’s not about style or asset class, it’s about finding undervalued opportunities around the globe.

His letter details why he’s pessimistic on Japan, and is therefore NOT shorting the yen. Pessimistic on China because THEY ARE COMMUNISTS (my emphasis) and you cannot trust a totalitarian regime – a point I’ve often made on these pages. He sees (hyper)inflation coming, but first deflation – I tend to agree. And, oh yeah, he’s buying corn – we’ve discussed ag here recently (although I believe that exposure through financial instruments might be tested in the near future as liquidation of ALL financial assets takes hold).

For the full letter, click here.

The equity markets were down today…

…is one of the bigger understatements I heard in the news. Not only did the DOW drop 376 point, the S&P fall through key technical levels, and the Nasdaq fall off a small cliff, everything else was down too – except the euro and the yen? What is going on here?

It will take years for the current cover-ups to be revealed, and I am not much of a conspiracy theorist, but the move by the Swiss yesterday and today was out in the open, while the moves by some unknown buyer (rumor has it that it might be Uncle Sam) was top-secret. Well, as governments start to believe that they can control currency levels, rates, money flows, etc. inefficiencies will only increase. Check out this article about China’s recent resource hoarding.

The international trading system is about to encounter an entirely new challenge. The global hunger for natural resources is inspiring a surge in restrictions on exports of crucial raw materials. As with so much else in trade nowadays, the focus of this emerging conflict is on China. The Chinese stand accused by some trading partners of hoarding rare elements and other raw materials that are essential to many globally traded products.

But China is hardly the only country considering export restrictions as the race for natural resources heats up in the wake of the recession. The sharp increase in restraints is happening world-wide, and raises fundamental questions about the rules and the resiliency of the World Trade Organization…

But you can’t fool all of the people all of the time. I am not a technician by nature, so I have to go back to valuations. I’ve said it before: equity markets continue to be 30% or more overvalued. Real estate across the board is overvalued. There were a round of recent speculators that were probably able to make some money, but commercial real estate is going to continue to be a drag on regional banks, and ripple through the economy.

What is surprising is the continued inhuman strength of the yen. I’ll be looking for opportunities to increase short exposure to it. While I expect yields on 10-year to be bid as a safe haven, they are in a precarious position and I don’t think they’ll go below the 2.5% range, so I’ll be looking to increase short exposure there as well. In the meantime, we wait. The opportunities to buy will be there in the future, but for now, capital preservation is the order of the day.

As a sidebet: how long before we hear about a large hedge fund liquidation?

Of carry trades and unwinds

As the euro vol spikes, not to mention every currency pair imaginable, we continue to look to the currency markets as THE story of the day. I’ve often discussed the carry trade, the systematic leverage, and the deflationary impact of the debt reduction. The next level of analysis is to try to measure the size of the carry trade globally. As funds reduce their risk positions, funding currencies become stronger (witness the yen) against the risk assets funded. But if we could measure the extent of the unwind, we’ll be able to know when the yen should stop appreciating, since no speculator would be purchasing the yen for yield (virtually 0%).

While there are numerous ideas we’ve explored, I would like to share 3 articles (one general, 2 academic) that might interest our readers:

1. Fears rise for dollar carry trade future, by Peter Garnham at FT.com

At the World Economic Forum in Davos last month, Zhu Min, deputy governor of the People’s Bank of China, spoke openly about his biggest fear for global financial markets in 2010.“To me, the big risk this year is the dollar carry trade,” he said “It is a massive issue. Estimates are that the dollar carry trade is $1,500bn – which is much bigger than Japan’s carry trade was.”

2. Risk and return in carry trade, by Imad A. Moosa:

By using six currency combinations involving two funding
currencies and three target currencies, analysis of historical
data from the recent past and Monte Carlo simulations show
that carry trade can be profitable if conducted over a long
period of time, but the risk involved can be high. The riskreturn
trade off does not exist in the rational sense (a high
interest differential is not necessarily associated with a high
volatility of interest rates, and vice versa), since there is no
clear-cut relationship between the interest rate differential
and the movement of exchange rate. With a positive interest
rate differential the exchange rate is as likely to rise as
to fall, thus a positive differential (no matter how big) is no
guarantee of positive return. A significant adverse movement
in the exchange rate could wipe out the carry trader
on a single occasion.

The results show that carry trade may or may not outperform
stock market investment, but on average the former
seems to fare better than the latter. However, there are
caveats that must be taken into account when one attempts
to reach a conclusion of this sort. …
Other caveats pertain to two points raised by Burnside et al.
(2006). The first point is that although the Sharpe ratios associated
with carry trade may look high, the amount of money
that can be made out of this operation is relatively small. On
the basis of their results, they find that to generate an average
annual pay off of one million pounds, the speculator must bet
28.6 million pounds every month. In general, very large sums
of money are needed to generate profit of reasonable magnitude,
which limits the usefulness of carry trade for individual
investors, who are typically unable to raise this kind of money.
In the aftermath of the subprime crisis, not even most institutional
investors can raise this kind of money. What makes
things even worse is that the bid-offer spreads are increasing
functions of order size, which means that the rate of return on
carry trade declines as the transaction size increases. A factor
with a similar effect is price pressure, which drives a wedge
between average and marginal Sharpe ratios. This means that
as the transaction size increases, the marginal Sharpe ratio
declines towards zero, although the average Sharpe ratio
remains positive. Big transactions are needed to earn more
money from carry trade, but the rate of return declines as the
transaction size increases because of the bid-offer spreads
and price pressure.

Another problem with carry trade is that, unlike stock market
investment, high Sharpe ratios do not necessarily represent
compensation for risk because the payoff is not associated
with standard risk factors. If we consider the interest rate
differential as the source of return and the volatility of the
exchange rate as the source of risk, then (as we have seen)
the risk-return trade off in a traditional sense disappears.
Finally, we must not forget that returns on stock market
investments do not only come from capital appreciation (rising
stock prices) but also from dividends, which are ignored
in this exercise.

Carry trade has become very popular because of the perceived
profitability of the operation. However, it seems that
carry traders have been oblivious to the risk inherent in
such an operation while concentrating on the interest rate
differential. Excessive enthusiasm about carry trade has
been a reflection of herd behavior, similar to what happens
in any market bubble (although carry trade is not necessarily
associated with a bubble). However, it seems that taste is
changing away from carry trade, as reports surface about
large-scale unwinding of carry trade positions by institutional
and individual investors. If Dennis (2007) is correct in saying
that “carry trade falls out of favour,” then it is likely that a
lot of people have realized, in hindsight, that carry trade is
not as lucrative as it once appeared to be.

3. Evidence of carry trade, by Gabriele Galati, Alexandra Heath, and Patrick McGuire at BIS

Interest rate differentials have been a driving force behind exchange rate movements in
recent years. This has focused market attention on the role of currency carry trade
positions, and on the possibility that a sudden unwinding might adversely affect
financial stability. However, carry trades are notoriously difficult to track in the available
data. This special feature first outlines the investor base and trading strategies used in
carry trades, and then explores various sources of data to gauge activity.

(This article points to some data sources at BIS for measuring size of carry trade activity.)

Worldwide currency intervention

The same governments that ran up debts, kept interest rates artificially low, subsidized bad mortgages, etc., etc., etc. believe that they can adequately control the currency markets – the biggest in the world. So…

The Swiss National Bank is intervening, click here and here.

The Fed’s swap lines are all in effect and we’ll be finding ways to subsidize the Europeans.

Greece is testing the waters of exiting the euro.

Germany is out of its mind and announced that it’s banning certain shorting activity (only adding to jitters that it has no clue what it’s doing).

And here in the US we have continued whiffs of deflation, when all the Fed wants is inflation.

Look for continued competitive devaluations, currency controls, and other shenanigans.

Around the markets in 6 charts or less

With so much noise and conflicting news, we’ll try to boil it down to some of the interesting areas (by no means an exhaustive review). While we’re not technically inclined, a picture is often worth a thousand words, so without further ado:

Chart 1 Gold:Euro

As troubles in the eurozone mount, markets are looking for outlets – heck, Europeans themselves are looking for outlets. We’ve mentioned the euro:yen pair and have maintained our usd:euro position, but gold in euro terms is hitting new all time highs and is acting as a real fear gauge for the European markets.

Chart 2 EEM

Speaking of fear gauges, the emerging markets were all the rage just a few short months ago, with strategists discussing divergence and internal growth metrics. Money poured into EEM as the USD was going down. Oh, how the world is changing. EEM now looks like it’s rolling over and while I am not posting it, Chinese equities, long the poster children of emerging growth, look poised to continue their downward spiral. Turns out valuations matter and government direction of the economy isn’t all that great.

Chart 3 IWM

I have to admit that IWM has been surprisingly strong and stable so far. I guess everything is up for interpretation: either you believe the markets are always right and the strength in light of bad news is a bullish signal, or you believe that markets are inefficient and haven’t yet priced in just how bad things are. Guess where I am…

Chart 4 10 year yield ($TNX)

I have a long term fear of the government inflating our way out of debt, but in the shorter run, treasuries are still offering a safe haven. I have a small exposure to short treasuries (through TBT), but it has moved against our portfolios; yet, I am not changing it. I believe longer term, treasuries are in a very dangerous position. While deflation might be in our future, I don’t think there is too much upside here. That said, I have been wrong so far. I’ll be looking to add to this position if levels go to the extreme levels of late 2009.

Chart 5 Oil

As we continue to think about the inflation/deflation debate, oil is a good place to start looking. At least at the moment, it doesn’t look like it’s pointing to rampant inflation. Might this be the final deflationary play? Maybe, but I’d at least point out that it can go a long way down and stay down for much longer than inflationary-minded investors would have you believe – peak or no peak.

Chart 6 Agriculture:REIT

And then, as if I wasn’t confusing you enough, I’ll refute my own deflationary assessment, and point out that agriculture has been lagging REITS. At first blush, this might suggest that agriculture is poised to rebound relative to the REITS sector, which sounds quasi inflationary. Au contraire… There is a big disconnect which we’ve pointed to before. In this new world order we can have deflation AND increasing yields. We can have inflationary pressure from ags AND deflationary pressure from real estate as credit gets unwound.

Lastly, I don’t have a chart for it, but I do want to highlight one other thing: geopolitics have been surprisingly calm in the news, pictures of civil unrest from Greece notwithstanding. But…Thailand is facing civil unrest, Israel and Iran are at a critical juncture, Russia is getting bolder, and today South Korea officially held North Korea responsible for the sinking of their boat a couple of months ago – just to name a few situations ready to provide fodder. Geopolitical risks remain and getting more contentious with the eurozone teetering, the US administration inwardly focused (misfocused?) and perennial troublemakers like Russia stepping it up.