Connecting the dots 2-25-2010

Fed raises discount rate

What we’re watching unfold…

Bank of England Halts Bond Purchases, Obama Supports Free Trade, where we went wrong, and more

The carnage from yesterday masked a lot of interesting news bits, some good, some bad, some just plain confusing:

• For starters, CBS Marketwatch ran a story about Bank of England Halts Bond Purchases. As central banks around the world face up to the reality that even they are not bigger than the markets, quantitative easing programs are likely to be pulled back. We’re seeing it in England, but as the PIIGS come under continued fire, they’ll also be mandated to cut back fiscal spending. Unlike the US, the PIIGS are closer to states in that they have limited leeway on deficits and printing. It might actually end up being their saving grace if they can get their PR story straight.

• On our side of the pond, President Obama made a step in the right direction by going against his party, and coming out in support of free trade. The NY Times ran the following story: White House Unveils Plan to Double U.S. Exports. While encouraging, the language did not contain the commitment that we’d prefer to see, and I’m afraid that this is all just talk.

But in announcing the new strategy, the commerce secretary, Gary Locke, did not say when the administration might send Congress three completed free-trade accords — with Colombia, Panama and South Korea. Many trade specialists say that is essential to prod other countries to negotiate with the United States. But the move is likely to cause a rift with Mr. Obama’s liberal supporters in the Democratic Party, as well as free-trade opponents in the Republican Party.

So we’re left holding our breath. I don’t think the Obama administration will have the political will or power to go against their base of unions and left and right wing protectionists. In fact, I wouldn’t be surprised to see protectionist measures implemented over the course of the year.

• Obviously, Australia left it’s interest rates unchanged. Screwed the carry trade for a lot of people yesterday, but was not that surprising to us. Remember, we’re long USD vs. JPY and vs. EUO. We just believe that USD will still be the beneficiary of the unwinding of risk as must happen. We should have been like Wells Fargo, who shorting the carry trade on the yield curve, and taken more aggressive positions in long USD.

• Where we went wrong: We’ve allocated a small portion of our portfolio to a metals portfolio. We built a position in gold and maintained it. We increased our exposure by building positions in SLV, PALL, and PPLT. We got in too late and should have diversified some of our gold holdings earlier. We are down between 8-18% on the positions. While it’s painful, we continue to hold these positions. First, the individual positions are small. Second, the entire position in metals is relatively small. Third, we maintain that the reasoning behind owning exposure to physical metals continues and we’re happy about the diversification into metals other than gold. We’re not in copper at all. Additionally, today we added a small exposure to GDX as the spread between GDX and GLD seems to imply that there is more potential for outperformance in the miners than in the physical. Here’s the chart from StockCharts.com:

This is the ratio of GLD:GDX. It’s not at the hyperextended levels of Oct. 2008, when the ratio was over 4, but it still looks like the valuation of the miners is low relative to the price of gold.

• Lastly, I want to discuss Treasuries. In 1992, as Soros was breaking the Bank of England, the trade was a simple understanding that no entity nor government is stronger than the market on a long term basis. We have been getting comments and notes about how we can see a continued debt deflationary environment, with a stronger dollar, and lower Treasuries. In the 1970’s, the thinking was that inflation and growth went hand in hand. Stimulate inflation and you’ll get to full employment (sound familiar?). Instead, we had a previously unimaginable situation where we had inflation and no growth, and with it a new term: stagflation. In my mind, we can enter a period where people will want to hoard dollars and not lend it out to the government. It’s the worst possible world for the Fed, whereby they will face higher borrowing costs without stimulating any inflation since the velocity of money will go down. If fiscal policy doesn’t cut government spending, we will be in a very weak position with very few places to hide. Once spending does start, we will face the specter of inflation that will continue to put downward pressures on Treasuries, this time on the short end. We are stuck and the losers will be the holders of long-dated Treasuries. For the Treasury market to rally from here, an investor would have to believe that the Fed, Treasuries, and government can orchestrate a “soft-landing” where domestic savings rates inch up, foreigners continue to want to finance our deficits, trade balances magically and incrementally improve, etc. I’m not a big believer.

Is deflation winning out?

In the ongoing debate between inflation and deflation, we’ve heard both sides, tried to look to the historical record for guidance, sought comfort from statistics and experts, yet in the end have come up with strong arguments on all sides. We’re not even sure all the information is conflicting anymore, but in the end, we have to define and quantify a bias, a world view, a story that binds the different pieces together. We find ourselves continually biased towards deflation. It’s colored our decisions, and impacted our investments, and still we find ourselves now with seemingly conflicting investing ideas: short bonds and long metals sounds like it might be inflationary trades, underweight equity and long cash sound like they are deflationary trades. Underweight real estate, overweight India and zero weight to China – how do those all fit in? Are they hedges against each other? Compounding each other?

Let’s start with some basics. Deflation happens when an organization loses pricing power. It happens when organizations need to find lower market clearing prices. It can happen in positive ways (for example, by paying $500 for a laptop with the computing power that cost $5,000 a few short years ago) or negative ways (for example, when you’re house sells for 15% less than it did 3 years ago). It is initially painful to the seller, and especially painful to the levered seller. For the buyer, it feels great – initially. Until it doesn’t. At some point, the buyer decides that it’s worthwhile to wait longer for an even better deal. At some point after that, the buyer realizes that whatever product of service he/she is selling will probably also need to be discounted in order to clear, at which point a bit of fear sets in. And there’s the danger. On a more macro level – organizations that lose pricing power face a squeeze on margins. Those that are levered then face a squeeze on financing. On a more macro level – trade goes down, protectionism looks like a good idea, and then it’s over. At some point market clearing prices are reached, companies that survive with strong balance sheets regain pricing power, etc.

Why go through this exercise? Let’s think through the organizations we have to analyze: people, households, companies, governments. As we go through each organization, we find deflationary forces:

1. People – labor is not in control these days. Wages are stagnant, at best. Unemployment is at 10% and if you’re using good statistics, closer to 18%. If anything, wages will be put under pressure in the near future.
2. Households – continue to be indebted, even though many are trying to lower it. Residential real estate has been nationalized, with 95% of new mortgage originations occurring through GSE’s. Real estate has not stabilized, and commercial real estate is about to roll over.
3. Companies – retails has actually held up better than expected, but credit card defaults are rising and the consumer will require more and more sales (deflation) to purchase. Internal demand from Asia hasn’t materialize (yet). Most importantly, margins have risen to such high levels off the back of squeezing costs. Margins going forward will be tough without an increase in revenues, which hasn’t come.
4. Governments – governments can lose pricing power as well. Japan has been a startling anomaly, but I wouldn’t depend on it continuing or working for others. With debt to GDP starting to hit important levels, government bonds will lose their appeal, and with it, their pricing power. So, prices will have to go on sale. We’re seeing it already in the municipal bond market. We’re seeing it with sovereigns like Greece. We’ll see it with Treasuries as well. If the US government loses pricing power, won’t the dollar fall as well? Actually, it might not. The dollar will still be needed for trade, for a safe haven, and as a relative trade against the worse government situations in Japan and Europe, so we can have a situation where the dollar is up and the Treasuries are down.

All of these organizations seem to me to point to a contraction of margins on all fronts, loss of pricing power, consolidation, retrenchment, and balance sheet rewinds to the pre-”stock option/insanely low interest rate/agency-moral hazard games of manager vs. owner/etc.” times.

We continue to mistrust rallies at these valuations, and are wary of people screaming to buy the dips.

Crude Oil

If crude hasn’t gone down by now, do you think it will? Unless demand crumbles, what will push it down from here? Oil is now in limbo and I believe geopolitical tensions will provide a support.

Here are a couple of scenarios:

We’ve seen inflation remain tame. If jobs do not pick up, inflation may remain tame (Phillips curve), at which point oil should stay stable, as it has. If jobs do pick up, then inflationary pressures may ensue, at which point you probably want to be long oil. So let’s assume that oil goes down to 30% from here to the $55 range, which isn’t unlikely if there’s major deflation or continued global economic slowdown. If there’s inflationary pressures and even some geopolitical plays, then oil could easily surpass any previous high. Then you have to put weights to get an expected return. It appears to me that at this stage, the risk/reward for oil might be attractive. I do not have any direct exposure at the time of this writing, but this is one of the areas we’re exploring now.

For those interested in Phillips Curve stuff, click here for the latest research from the San Fran Fed.

Rare earth metals

I’m on the fence about rare earth metals – is this really just a global economy trade? I don’t think so. I think if you take some of the reports we’ve been discussing about lack of infrastructure, and limited build out of different commodity operations, there might be some underlying support regardless of immediate economic performance. As a disclaimer, I purchased PALL and PPLT, two newly formed ETF’s for palladium and platinum a couple of days ago. I do not recommend them, since I do not know your individual situation!

So it was interesting to read the following article (click here) about molybdenum prices. Here’s a quote:

Prices for molybdenum, a base metal used to make stainless steel, will likely rise 55% in the next two years, JP Morgan analysts said Thursday.

The question is why will these move? Will it be a currency play? Inflationary pressure? Economic growth? Better yet, what will make the prices come down? Is it speculative positions that drove prices up and they will soon go back to previous levels? I’m not sure, but for now I like the fundamentals on the ETF’s I mentioned. They will probably be volatile, but it’s part of the metals allocation, so there’s not a lot of exposure from a portfolio standpoint. Just something to consider.

New year, same themes

Not to take away from people’s obsession with year-end figures, but from an investing perspective it is an arbitrary date. So not much has changed, other than performance clocks are reset and new risk can be taken with more months to make up any shortfalls.

Enough of that. Getting back to talking gold. Interesting article on gold’s performance in different currencies. Read the article here. The most interesting tidbit for me actually came towards the end:

Given that that it presently takes 65 ounces of silver to purchase one ounce of gold, and that their historical ratio is about 16-to-1, a weighting of 67% gold and 33% silver for your bullion holdings continues to make sense. If the ratio falls to 20-to-1, for example, those percentage weightings will almost reverse solely because of silver’s outperformance compared to gold.

China: Never liked it, now like it even less

Long time readers know that I do not like the idea of investing in command and control markets, with little or no transparency, pegged currencies, and imminent social unrest; I dislike investing in these markets even more after they go up, even as their biggest consumer market is struggling.

So it is with that in mind that I encourage you to read the following:

1. Chanos is shorting China: http://www.thedailycrux.com/content/3656/Jim_Chanos
2. Mike Shedlock has a piece on the Chinese bubble: http://globaleconomicanalysis.blogspot.com/2009/12/china-faces-crash-scenario.html

And we’ll continue to present more. The only question is “so what”? I looked for ways for individual investors to play this idea, but the options are slim. For starters, there is FXP, but…be careful. This is not necessarily getting you the short exposure you need. For starters, it’s a levered ETF, which we have an inherent fear of. Then, it only shorts 25 stocks. Then it turns out it only shorts the Hong Kong listed shares, not the mainland shares (which can’t be shorted). For more details, click here.

A better way to play it, but less directly, is to short the things that went up because of (supposed or anticipated) Chinese demand. Yup, commodities are up there, such as copper, aluminum, etc.

I personally haven’t found a great way to play this theme, but I’m working on it and am happy to hear thoughts and suggestions.

Placing speculative limits is BAD – now if only the Fed will heed it’s own research

In a recent paper published by the New York Fed, Erkko Etula shows that speculators help stabilize commodity markets. To quote:

Taken together, my results highlight the importance of speculative capital for the stability of commodity markets. In this way, the paper not only contributes to the broader literature on limits of arbitrage pioneered by Shleifer and Vishny (1997), but also shows that recent arguments in favor of speculative
trading restrictions have been starkly misguided.

Another interesting outgrowth of this research is that Etula is able to model some of the volatility of commodities based on the flow of funds report. For those trading in the options arena, especially those using quant based approaches, this might point to an interesting factor to test further. For the full report click here.

Gold Buying by Central Banks Signals Sell as Past Haunts Future

If the past is any guide, central banks buying gold is a strong contra-indicator. Just something to think about as you send me more emails about gold going up forever. http://www.bloomberg.com/apps/news?pid=20601087&sid=arhlK7_y34Mg&pos=4

Maybe I was wrong on inflation

In my last post, I wrote that I don’t see the increased PPI as necessarily pointing to inflation, yet, in the spirit of showing the other side, I must address the following announcement from Coke.

Coke banks on smaller packs to counter commodity price rise

Press Trust of India / New Delhi December 15, 2009, 17:17 IST

Pressed hard by rising input costs, especially that of sugar, global beverages major Coca- Cola is turning towards smaller packs for its products in order to push volumes and keep pressure on margins in check.

“The (rising) commodity prices are putting pressure on our margins…We have done cost rationalisations of our products. Besides, a lot of innovations in terms of new products and different packages have helped us,” Coca-Cola President and Chief Executive Officer Atul Singh told PTI.

Speaking on the sidelines of the Global Sports Summit held here, he said increasing commodity prices, especially that of sugar has “clearly impacted our cost structure”.

In order to reduce the pressure on margins, Coke has come out with smaller packs for its products, which are priced slightly lower than bigger packs. For instance, it has launched its fruit drink ‘Minute Maid Pulpy Orange’ in a tetrapack of 250 ml priced at Rs 15 compared with 500 ml PET bottles for Rs 25.

Earlier this year, the firm also introduced its popular carbonated drink ‘Sprite’ in a 350 ml bottle for Rs 15, which was available in a 500 ml bottle for Rs 22.

Singh said cost rationalisation and innovative packages have helped in maintaining volume growth that the company has witnessed in the last 13 quarters.

Coca-Cola has posted 37 per cent volume growth in India during the third quarter ended September, 2009.

For anyone who remembers what a real Hershey’s bar looks like, one of the ways inflation can creep in without notice is when prices remain the same, but packages gets smaller. So choose your positions carefully.

Coke banks on smaller packs to counter commodity price rise

Press Trust of India / New Delhi December 15, 2009, 17:17 IST

Pressed hard by rising input costs, especially that of sugar, global beverages major Coca- Cola is turning towards smaller packs for its products in order to push volumes and keep pressure on margins in check.

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“The (rising) commodity prices are putting pressure on our margins…We have done cost rationalisations of our products. Besides, a lot of innovations in terms of new products and different packages have helped us,” Coca-Cola President and Chief Executive Officer Atul Singh told PTI.

Speaking on the sidelines of the Global Sports Summit held here, he said increasing commodity prices, especially that of sugar has “clearly impacted our cost structure”.

In order to reduce the pressure on margins, Coke has come out with smaller packs for its products, which are priced slightly lower than bigger packs. For instance, it has launched its fruit drink ‘Minute Maid Pulpy Orange’ in a tetrapack of 250 ml priced at Rs 15 compared with 500 ml PET bottles for Rs 25.

Earlier this year, the firm also introduced its popular carbonated drink ‘Sprite’ in a 350 ml bottle for Rs 15, which was available in a 500 ml bottle for Rs 22.

Singh said cost rationalisation and innovative packages have helped in maintaining volume growth that the company has witnessed in the last 13 quarters.

Coca-Cola has posted 37 per cent volume growth in India during the third quarter ended September, 2009.

US PPI

Producer price index rose 1.8% in November, seasonally adjusted. Here’s the statement:

The Producer Price Index for Finished Goods rose 1.8 percent in November, seasonally adjusted.
This increase followed a 0.3-percent advance in October and a 0.6-percent decrease in September. The index for finished goods less foods and energy rose 0.5 percent in November.

So what does it mean? No one knows . . . yet. One month in the busy holiday season does not a trend make. But it might be pointing to a pickup in inflation (if it flows through to the finished goods). That would be a positive and a negative. It would be a positive in that it would mean that companies have pricing power, can raise the prices of goods and thereby maintain margins. It would be a negative in that Treasuries would continue selling off and rates would rise. All in all, I don’t think companies will have the pricing power to match the increase in PPI. Best Buy came out today with great numbers, except for the fact that the things people are buying are the lower margin items. If PPI goes up but companies do not have the ability to raise prices, that means pressure on margins, which are already cyclically high. Net, this might signal lower bottom line earnings, so I don’t see this as a sign of inflationary pressure. Also, with real estate still not stabilizing, owners equivalent rent will continue to put downward pressure on the CPI, and coupled with 10+% unemployment, decreased new lending, and lots of spare capacity for utilization by factories, I don’t see this as immediately inflationary.

Notes from underground – Yra Harris

Notes from underground – Yra Harris