Connecting the dots 2-25-2010

Or at least trying to keep track of everything... I want to first give you an insight into what I've been reading this morning, then we'll see where it leads us. As many of you know, I'm a believer that excess profits flow through to the real estate sector and have referred to Fred Harrison's book on the subject often (http://www.amazon.com/Boom-Bust-Prices-Banking-Depression/dp/0856832545/ref=sr_1_1?ie=UTF8&s=books&qid=1267115867&sr=8-1 - it's a must read).Viewing the remainder of this article requires a Subscription

What we’re watching unfold…

Warning: This post has nothing new for readers of our newsletter.Viewing the remainder of this article requires a Subscription

Anticipation and why we’re not writing about the Euro

I’m seeing stories left and right about Greece…and Portugal…and Spain…and the EURO. I’m not surprised, but I feel like this is by now an old story for our readers. Europe is facing an unsustainable situation and it was only a question of timing for when would the “Union” come under fire. So now, everyone is talking about the PIIGS, or Greek spreads (not taramosalata), etc. but I feel like they should have been discussing these issues months ago. Instead, just a few months back, everyone was talking about the death of the dollar and shifting to the Euro to diversify reserves. I just couldn’t believe that Russian central bankers would get that right. For investors (as opposed to traders), you had to be set up months ago, and had to wait a while. Traders can now try to jump on the bandwagon, but the investor who was looking at the valuations and positioning of the major player could sit back and look at it unfold. So for us, there’s nothing to write about the Euro here. It’s still in trouble. We’re maintaining our short position versus the dollar (not adding, not taking anything off), and we continue to wait.

So now the question is how do we position ourselves for the future. Looking forward, the bond market seems to be the area that needs the attention. Why? Because it is the most heavily manipulated market right now. Let’s try to describe the real estate market to an outsider (in it’s current form): well, homeowners can’t afford the houses on the market, so the government taxes them so that they can give them a credit, then it provides them with cheaper financing than they deserve, thereby taking on risk, which it (the government) doesn’t know how to value and keeps off its balance sheet. Does that sound like a market you’d want to invest in? Probably not. Taking that description to the Treasury market, the government provides 0% financing (look how well that worked out for GM) to banks so that they can in turn lend it out, which they do. They lend it out to the government by buying longer dated bonds, which in turn is given right back to the banks for more cheap financing. If this sounds like an Enron type scheme, where there’s no economic value to the transaction, only the middle man gets a cut, or a large Ponzi scheme that is bound to fail as soon as one party runs out of suckers, then you understand our contention that the Treasury market is unsustainable. We are probably off on the timing, but we usually are early as we try to build positions in anticipation.

The inflation/deflation debate will be meaningless for the bond market. We can have deflation and declining bonds (just like we can have inflation with no growth, which was assumed to never happen prior to the 1970’s). Rates have to go up to reflect how expensive it is to lock up money and provide financing in an uncertain environment. The government can manage short term rates, but it’s the long-term rates that will tell the story. Bonds might stage safe-haven rallies, but the support will ultimately fail, as investors shy away from providing the US government with cheap financing. How many times can the Senate increase the debt ceiling? See related story: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=as..HY4pCfZc.

If you haven’t seen it, please read Reinhart and Rogoff’s piece This Time Is Different piece, highlighting the tipping points for debt to GDP levels (happens to be 90%, the US is currently at 84% if you don’t use accrual methodology and don’t count Fannie and Freddie as government liabilities).

So now, we wait in anticipation. And once everyone realizes what’s happening, we’ll already have to start searching for the next place to wait. Investing is all about the waiting.

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.

Connect the dots: Dubai World, China, USD, Yen, Deflation, and Bernanke

So Dubai World, the government investment vehicle (is that sovereign wealth fund?) is unable to make payments on $59 billion of debt. Please tell me you are not surprised! Command economies run by bureaucrats are always doomed. Investment vehicles run by same governments are doomed. I have no problem taking the other side of a trade from any SWF. Why? Because they are usually wrong. Some in the media are calling this a black swan event. Having kamikaze planes hit buildings in New York and DC is a black swan event. Having a debt laden government default is not.

For the past few weeks, I have been pointing out to readers my logic behind buying dollars. I did not know when or what would happen that would cause a flight to the dollar, but when so many people agreed that the dollar was going down, and when so many governments were discussing selling their dollar holdings, and when the dollar was down against every currency imaginable, there just didn’t seem to be anyone left to buy it: so I had to take that trade. I really dislike being on the same side of the trade as everyone else.

So what now? Well, the deterioration of the Euro will continue and GBP will be right alongside, maybe even beating it on the way down. China: I never liked China, and I still don’t like China (http://dyn.politico.com/printstory.cfm?uuid=DAB3DF2E-18FE-70B2-A8C736A21C10553A). If you want to play the space, go with Korea or Taiwan instead. I continue to favor India and Brazil (as long as they don’t get too involved in currency controls) long, long term over most other emerging countries. Japanese Yen: this is a tough one. Money will be flowing in as risk trades are unwound, but the government doesn’t want a rising currency, so they’ll have to step in. Overall, I believe they’ll be able to sell it faster than the US government can devalue the dollar, so that’s where I stand. What about the Fed and Treasury? They are in panic mode. All their efforts at quantitative easing have been for naught. People don’t want to spend. Banks can’t lend. The dollar will go up (at least for now) and that means deflationary forces with no tools left to pump money into the system. Krugman was wrong and I now wish we had the money we spent so hastily to support non-sensical businesses, like GM and AIG. Housing, contrary to popular opinion, is not going up. This is the time where the people who have cash will want to keep it for the really good deals that will be coming, but they’re not here yet.

In May, I wrote about what will be the signs that the worse is over (http://thehardtrade.com/archives/3150): employment, real estate, tough words and actions on the foreign policy side, and addressing transfer payments. With this as our rubric, employment not stabilizing yet, real estate not stabilizing yet, no tough words or actions to stand up to Europe or China (can Obama please say something tough to Hu just once??), and transfer payments are not only NOT being addressed, they are being exacerbated with misguided bills on healthcare. So we wait.

Connecting the dots

We haven’t had one of these in a while, so I thought it might be time to connect some of the dots.

For starters, NYU published a paper that outlines why timing is better than buy and hold. The good news and bad news is that these types of research articles criticizing buy and hold tend to come at market turns. Its both good and bad because it either signals we are going higher or going lower. If you need to guess my opinion, let me make it easy…it’s probably bad news. It’s not to say that buy and hold is the right strategy, mind you; I happen that there are periods that are more attractive than others to invest, it’s just that these articles are a good contra indicator.

Then, we have Marc Faber mentioning somewhere (I don’t recall where I read it) that gold won’t ever (yes, it will never) fall below $1,000. Now, never is a long time, and that is quite a bold statement. I don’t know if Faber remembers that in the mid 70’s people also believed that gold would never fall. Anyway, not sure what to make of that yet, but it implies a currency armageddon with far ranging implications that not even Faber can predict.

Then, you have the most widely talked about carry trade in history: short dollar. Everyone knows it’s stretched, yet everyone is shorting the dollar. When I say everyone, I really mean a lot of investors and professional money managers. I read a recent article that outlined why short dollar was actually not such a big deal because most people are long the dollar in other ways (job, house, etc.). That is a fallacy. When thinking about investing and trading, the decision makers are the marginal players, and they are shorting the dollar and buying risky assets. It’s worked for the past few months and might continue to work for the next little while, but in my mind, we might have a situation where the dollar goes up, and not in an orderly fashion like it did on the way down. I am positioning portfolios for it already by shorting the Euro and Yen. I’m also looking to short the Pound soon. I might be the only one, but those are the best trades.

The equity market – if it wasn’t crazy until now, it got there recently. How else do you explain 10+% unemployment (headline), 17+% more realistically, and the reaction of the market? Consumer confidence might be up, but that is misleading, and temporary in my opinion. With no margin expansion left and no top line growth, companies are sporting exhorbitant, unrealistic P/E’s that must be compressed. Since the “E’s” aren’t rising, sooner or later the “P’s” will fall. It will seem obvious in hindsight.

Fixed income – I just read that you can buy a Blackberry Storm on Amazon for a penny. Talk about deflation!! So maybe there’s some support for bond prices, but again, it’s all a sham. We are not Japan. The US has too little savings, we are not creditors to the world like Japan was, and we have runaway government spending, so for rates to go to zero, as they did in Japan seems highlight unlikely. The flip side is that spreads with other sovereigns are totally out of whack. Emerging market debt is ridiculously expensive and I don’t care what people say, Brazil’s debt is still more risky than the US’s.

As we’ve been outlining the past few weeks, there are huge disconnects and conflicting signals in the various markets. In the end, valuations and fundamentals will have to be priced into all the various asset classes, but I think people are going to be surprised when new correlations develop. For example, if gold and the dollar go up together, or US debt and Brazil debt go down together. The safe haven might end up surprising even the gold bugs.

Connect the dots 6-10-09: Part I

We’re going to start the weekend with our weekly market monitors.

 

What do we have here? This year is full of stress, but looking at the broad averages, the S&P is down slightly. What a ride!? So what do we see when we look deeper?…

Commodities (ex natural gas), emerging markets, and tech certainly pop out. Interestingly, I’m not sure they are telling the same story. Tech tends to be low debt companies. Earlier today Goldman even upgraded Dell and hinted that investors should revisit tech. Companies would be pulling back on some tech investing in the current environment, except…Except for productivity enhancing tech or cost saving tech. Remember, a lot of companies still have cash on their balance sheet from a year of decreased transactions. Stock buy-backs and dividends aren’t where the companies want to spend their cash because re-issuing shares down the line seems questionable at this stage. Large acquisitions are out of the question. So, what’s left?

Commodity related industries tend to be capital intensive and they’re certainly levered to any growth. Yet, in an environment like this, growth assumptions are low or negative for most of the world, so I doubt that the argument holds. Instead, maybe the answer lies in the expectation that inventories need to be rebuilt. Over the past 18 months, despite the consumer slowdown, production levels decreased even faster and inventories have shrunk to the point where any pickup could send producers scrambling. Who’s facing the shortest inventory? Not surprisingly, our old auto industry is front and center. Once again, the US auto manufacturers are going to get caught flat-footed. They’ll finally face a little bit of demand, but not enough capacity will be on line and commodity prices will have gotten away from them.

Anyway, TBT continues to grind lower and any “investors” left in it, should see some of our previous postings on levered ETF’s. It will slowly grind away at your returns, even if the direction is correct. (I do not own TBT nor do I own it in client accounts.) I’ll speak more about the bonds complex next week, but I have to admit that everyone and their brother is telling me about bonds with equity like returns, but sitting at the top of the capital structure. I think the “easy money” of buying solid bonds at 60 to 70 cents on the dollar is gone. Now you’re in for a grind with the smartest guys in the room. Maybe that 8-9% yield on a BBB credit is OK given that Treasuries are paying 3%, but when Treasuries go to 6% (not a far stretch) these will go down much farther and much faster. Do you really think the yield will go down? So you’re clipping a nice coupon, which is well and good as long as they pay, but if California can default so can that from AA company. And if you think the economy will improve, better to get the leverage in the equity. It’s probably at decade lows (using a representative BBB company).

Barron’s has mentioned it. The Big Picture has mentioned it. So you should at least be aware of it. Last year, Rogoff and Reinhart wrote an analysis of financial crises and the impacts on different asset classes: Aftermath. The basic conclusion: in the aftermath of a financial crisis, asset classes show higher correlation and there are very few places to park. Equities and real estate and bonds and whatever all face severe headwinds. All of that was to say, watch out for the 8% bonds. It might just be a trap.

Connect the Dots 6-5-09 – Market Monitors

Here are the market monitors for the week…

Market Monitor:

And the relative performance monitor:

Connect the Dots 6-28-09 Part I

Connect the dots for this week will be in two parts. Part I, will be our usual weekly monitors and a some thoughts from me on how we’re positioning some portfolios and our considerations. Part II will be posted by Thatsabet and will provide a top down view of the market, including some major charts to consider and actionable ideas.

Connect the dots 6-28-09 Part I:

We’ll start with the monitor. Green shoots. Brown shoots. Who knows? The answer…no one. We are at a point where the markets can go either way and I wouldn’t be surprised. Why? They can go down easily as the economic recovery is not realized. Fear can grip this market in a heartbeat. On the other hand, we can have a liquidity generated pop that will force cash into equities, and squeeze any shorts. Which means, if you are going to play, now more than ever, choosing your spots is critical. We’ll see it more when we look at the relative returns, but even looking at the YTD numbers, the interesting numbers are not the ones in green, they’re the ones that are in the red or flat.

The SPX and DOW Industrials are flat for the year. Utilities and transports, negative. The next most interesting mover is UNG, down 36%! In the meantime, we see Treasuries going down significantly, with yields rising 56% (10-year) while emerging markets EEM up 30%. Does this continue? Hmmmm. I’m now looking at the laggards for opportunities: utilities, water, Japan, and natural gas for starters. I’m staying away from currency bets, although there seem to be significant opportunities there. The reason I’m staying away is because I doubt I’ll be able to take a position and hold it with the recent volatility we’ve seen and the large players involved. Every government is now trying to bolster exports with a weaker currency and they are all losing. To me, the beneficiary will end up being Japan…they’ve already gone through the domestic cleansing and equity fallout while still maintaining the manufacturing capacity.

The relative view tells us an interesting story. YTD the SPX is flat, but that is not the whole picture. By looking at the sectors, we can see that there have been significant movers underlying the flat facade. The story of the week (on a relative basis) was definitely energy. Yet, I can’t help but feel that the fact that oil has held up and gone up in the face of a severe recession will signal positive news for the associated stocks. Natural gas is trickier. Speaking to funamental guys, I’ve heard both stories, and don’t hear a concensus at these levels. Some are pointing to reserves and long contracts as the investment opportunity, not UNG. I think there is something to it, since UNG is forced to buy the current contracts.

In my mind, the story of the week is the changing face of Iran and now the coup in Honduras. Iran is The Soviet Union before the fall. Very soon there will be a choice forced on the leadership: close up or open up. They will not be able to stay in between any longer. If they choose to close up, they will go the way of North Korea, Cuba, China circa mid-1400’s, and an array of others from history. It will be incredibly painful for their citizens, but the only way for the ruling class to maintain power. On the other hand, if they open up, the ruling party will go down and probably go down quickly. They will not be able to manufacture a quasi opening such as China and will lose control. In the chaos, anything can happen, probably, net good. Obama need not do anything right now. It’s a lose-lose situation for him, but I worry that he will become complacent.

Separately, there was a coup in Honduras, and contrary to the limited coverage on CNN (http://www.cnn.com/2009/WORLD/americas/06/28/honduras.president.arrested/index.html), I think it does not bode well for the US relations in the region, albeit in a twisted way. Follow me here: the coup was led by militants against a president that was anti-American. There are rumors that the US was aware and tacitly approved of the coup. Hopefully, this will have no lasting impact on the way the US is viewed in the region, but I tend to think that it will have a net negative impact on US-Latin American relations.

Lastly, I can’t NOT mention Michael Jackson, since everyone else is…on second thought…that’s precisely the reason to leave it off there.

Stay tuned for Part II from Thatsabet.

Connect The Dots: Week Ending 06.12.2009

Last week was full of charts. This week, let’s discuss some of the main themes we’re witnessing.

 

The equity markets were relatively tame this week. Gold, oil, and agribusiness industries showed big moves, but not in the same direction. All eyes were on interest rates and more specifically the steepening yield curve. As I mentioned throughout the week, the US’s ability to garner the worlds savings a plow them into our ever increasing supply of Treasuries will end at some point. For a long time, my focus was on maintaining a short Treasuries position through TBT and futures positions. I am no longer comfortable with that trade. The long term position still makes sense, but the implementation has become more difficult. There are now endless pundits talking of inflation risks, hedge funds piling into TBT, and short US dollar positioning. I just don’t like it when so many people agree in such a short period of time. Just a few months ago, we were in the minority as survey after survey showed most money managers believing deflation was the main problem. I can’t help but believe that most of them will end up being squeezed. Look at the 2-10 spread below. The steepener trade has been all the rage of late hitting ALL TIME highs early last week. Things settled down a bit toward the end of last week and the steepener has continued its correction this week closing at 2.50. Thatsabet and I disagree on how long the correction could last. He is looking at around 2.30-ish as the limit; however, I believe that it depends on who is going to get caught on the wrong side of this move. We might see some big names being squeezed and have to push yields on the 10 year back down significantly.

(source: Bloomberg)

It will be interesting to see this unfold in the next few weeks. What we are witnessing is a two-faced market. On the one hand, there are clear signs of inflation. Oil has doubled off its $35 lows and is now above $70. The steepening yield curve can signal inflation expectations rising (as investors don’t want to hold long term fixed income instruments). And, since inflation is always and everywhere a monetary phenomenon, dollars continue to be pumped into the system through the ballooning of the Fed balance sheet (quantitative easing) and the USD is facing significant strain.

 

On the flip side, we have deflationary pressures continuing. Job losses and recessionary pressures are continuing. Real estate deflation continues in virtually every segment as rental yields continue to decline. Companies face continuing pricing pressures with no ability to raise prices. The best business to start these days appears to be a bank, with government subsidies and a steep yield curve, a regional player with no legacy portfolios is a no brainer.

 

Can the Fed increase interest rates here? I don’t think so. Can they stop buying 20-30% of every auction? I doubt it. So the inflationary pressures will continue. Yet simultaneously, I don’t see margin expansion and earnings power returning to companies. So I’m wary of the pure inflation story.

 

Some other notes we made from conversations this week. Some advisors out there are encouraging clients to move into credit and high yield, even as they are warning against investing in equities. This seems somewhat incongruous. For high yield bonds (junk bonds) to provide adequate return, these advisors must believe that the yield and capital appreciation available will make up for the higher default rates we have been witnessing. If they believe that these companies will be able to pay back the 15-20% interest rates on some of these bonds, they must believe that the companies are going into an earnings environment that will support those payments. Additionally, these same advisors are now mentioning gold and inflation protection in the same presentations. Hmmmmm. If inflation is indeed coming, I wouldn’t want to be in a fixed income instrument. If earnings and margins will improve, I’d also rather be in stocks than bonds. Separately, if earnings won’t be improving, then the junk bonds won’t provide me with the returns I seek. High yield spreads need to get wider in this kind of environment for me to find them attractive enough.

 

Paulson is buying CBRE. I don’t like being on the other side of the trade from Paulson. The Ultrashort Real Estate ETF, SRS, a favorite of day traders and amateur traders, has gone from $60 to $18. For those still holding on, just know that the numbers from daily compounding are working against you. Say thank you for the $18 and walk away. There are other ways to short real estate if you want to take the other side of Paulson.

 

Lastly, I just want to note a couple of important points we can’t take our eyes off of.

 

In the currency markets the USD has continued its correction but the possible basing pattern continues. Should DXY hold 79 and proceed to take out 81.5 we could have a target toward 84. Thatsabet believes this would be a negative for equities, but I think it would be a positive as money flows back into the equity market from abroad. Overall, higher yields will be USD positive.

 (source: Bloomberg)

 

On another note, any recovery will probably need financials to stabilize and lead the way. Below is the XLF relative to the SPX. This continues to be an important and leading indicator for the direction of the markets. For the past several weeks the banks have been going nowhere RELATIVE to the markets. They have issued 85B in securities and that is currently being digested by the markets. Underperformance by the banks is usually a precursor to overall market weakness. We’ll keep following it with you to look for signs of a real recovery.

(source: Bloomberg)

 

And for those of you keeping track of our weekly standards:

Our market monitor…looking at various indices for the week, month, quarter, and YTD…

(source: Bloomberg)

 

And our relative monitor – Looking at the changes of various sectors relative to the S&P 500…

(source: Bloomberg)

Connect The Dots 06-05-09

This issue of CTD was written with significant input from Thatsabet and others. All charts and tables are from Bloomberg.

 

Equities:            The week started off with the much anticipated official bankruptcy of GM. A clear case of sell the rumor, buy the news, the market shrugged off the immediate implications and started higher. Yes, GM and C are going to be replaced in the Dow Industrials by TRV and CSCO. The academic literature would suggest that GM and C will now go on to outperform TRV and CSCO, but this is a recap of the week. For those interested, check out New Evidence on Stock Price Effects Associated with Charges in the S&P 500 Index, by Anthony W. Lynch and Richard R. Mendenhall (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1298790) and countless others.

 

The main story this week in the equity markets was the 2-10 spread in bonds (see our bonds summary). The moves in bonds and FX are signaling some big mispricings (adjustments?). For starters, check out this chart:

 

This is the SPX and EUR/JPY. EUR/JPY is the ultimate carry pair and has been a pretty good barometer of risk in the global markets. While the rise of EUR/USD is at politically sensitive levels after the recent rise, the JPY is also at critical levels. Thatsabet believes that should the 94.5 level be violated, it might lead to an unwind in the EURJPY which in turn could cause an unwind and lead to pressure on global equities.

 

Thatsabet also points out that many people like Japanese equities here for a long-term investment. The Japanese are 20 years ahead of us in their path to clear the imbalances of bubbles. The chart below shows the correlation of the US 10-year yield and the NKY. Depending on the cause of the rise in US yields, the JPY could get stronger as Japanese repatriate their currency and drive their local markets higher. Full disclosure, I have been increasing exposure in client accounts to small cap Japanese equities for the past few months for fundamental, valuation reasons, but this confirms some of our initial hypotheses. The Japanese small cap stocks represent some of the best value opportunities globally at this juncture. We have been buying JOF and other yen exposure.

 

This week is full of charts because the pictures really capture a thousand words. So three more charts:

 

First, SPXFX – This is the SPX from the March lows until now valued in different currencies. In USD terms, we have experienced the biggest rally since the 1930’s, yet in AUD terms, the market is only up roughly 5%. The currency markets are not confirming the equity strength and are calling into question the US’s ability to fund its future liabilities.

 

Second, XLFSPX – This is what the banks (XLF) have done relative to the SPX since 07. This spread is still trending lower until we see that .15 is decisively taken out. More time is needed in order to determine the validity of this rally. Thatsabet compared buying XLF here to buying XLK (technology) in 2001.

 

Lastly, let’s head to the emerging markets. From 2003 to 2007, with reflation and decoupling a virtual given, the emerging markets continued to outperform relative to the SPX. Then, the world stopped. EEM fell off a cliff (at a rate significantly faster than the SPX – remember this is the ratio of EEM:SPX). Just as violently, the ratio shot right back up. Thatsabet defines himself as a cautious decoupler. I personally don’t believe the decoupling trade or mentality. I believe that the interconnected nature of the currency, bond, and equity markets along with labor mobility, decrease in international trade barriers, etc. means that decoupling is not the driver of the trade. It’s the reason we look at NKY and TNX and examine the interconnectedness of markets now more than ever. Decoupling will be a topic we discuss at greater length in the next few weeks.

 

 

Bonds:              LQDTLT – This is what being long LQD (Corporate Debt) and short Treasuries has produced:                           

 

Since the break in 4Q07, corporate debt has been in a bear mkt. What is now occurring is either an “exhale” and corporate debt is cheap (concur) or the markets are realizing that the US government has taken over the leverage from the private citizen and will have to issue more debt to fund the fiscal gaps. Thatsabet goes so far as to think that over the next several years, US GOVT yields will be higher than corporate debt and emerging market debt. I tend to disagree in the near to medium term, at least.

 

Looking at US 10-year yields, we are approaching 3.9% and may test the 4% levels. What are the implications for home refinancings, which have already slowed? What about asset allocation models for big institutions? At what point will they be comfortable with the yield and move from stocks to bonds? At what point will the higher yields be an impediment to any imminent growth? Just as critical will be the shape of the yield curve. A flat or inverted yield curve often signals a coming recession (it also makes it extremely difficult for banks to make money). We have been seeing a steepening yield curve with the 2-10 spread rising to levels not seen since the 70’s or longer. A steep yield curve implies that investors do not want to own long dated fixed income securities, often because of fear of inflation. Julian Robertson (article posted) is playing this for size. Pretty amazing seeing that it is already historically wide. He thinks yields are headed to 7% and possibly as high as 18%.

 

 

Currencies:       The sentiment this week has been one of mixed messages. Dollar negative news continues, with gold rallying, yet no clear winner on the other side. The Euro continues to face its own headwinds, despite some recent strengths, and no viable alternative to the USD. The GBP is going through its own issues with Gordon’s government facing mounting pressures. Safe havens are becoming scarce.

 

Commodities:   Check out the CRB in USD and EUR since Mid Feb (prior to rally). Broad index is up only 10% vs 25% in USD. The affects from USD weakness is being felt more by the US and USD fixed currencies. Either the USD catches a bid and fast or the world better quickly adjust to ever higher CRB prices.

 

This is gold in USD AUD EUR JPY since the start of the 4Q08 selloff. Gold is positive in every FX to the tune of 20% except JPY which has been bid due to the carry unwind. I expect the XAUEUR to be the next blast off as the EURUSD is bound to correct. With everyone focused on DXY and the 78-80 level one needs to understand that the index is 57% EUR. The EU members will be finding it difficult to export with such a strong FX. A correction is in the cards.

 

On the energy front, oil is hitting the $70 mark and being used as evidence of a recovery. This is a chart of Mexico’s Oil Production. Their production seems to have peaked in 2003 and has been steadily declining since. Can they ramp up production or is the peak theory crowd correct? If the peak oil crowd is correct, what will happen to energy prices when demand really does rebound?

 

Economy:         Jobs. Jobs. Jobs. US Initial Jobless Claims: We are currently at the highest level since 1979 (give or take). With today’s figures out, the unemployment rate is at 9.4%. That’s almost 1 in 10 people unemployed AND that’s with the numbers calculated very differently than 30 years ago. At the same time, Steve Ballmer of Microsoft threatened to move jobs abroad if the current administration continues to move towards making it prohibitively expensive to hire workers in the US. With labor movement into the US reversing as opportunities in emerging markets relative to the US increase, where will the growth come from? From where will we get the young people needed to balance our aging population. Note this chart was from yesterday and doesn’t include this mornings numbers.

 

And to top it off, our usual performance tables…first, are the major markets we’re following, and second are the main sectors’ performances relative to the S&P500.

 

 

Connect the Dots: Our weekly roundup

This was written with significant input from Thatsabet and others.

Equities:            A lot of movement, but not a lot to show for it. S&P down 1.8% for the year. The real interesting story comes from where we find pockets of relative strength: energy, ags, and tech.

 

Bonds:             US 10-year Treasury yields have been moving up and are edging towards 3.4%. At the same time, 90-day yields have stayed low, leading to a steeper yield curve. Two main implications are that banks should have an easier time making money (borrow short and lend long) and that we would expect inflation expectations to rise as well – the steeper the curve the higher the inflation expectations. And, indeed, that is what we have seen, as implied by the TIPS yield.

 

                       

Corporate Debt has had very strong MTD and but is lagging YTD. See table below for exact figures. Overall, corp debt as measured by LQD is up 3% QTD but down 4.6% YTD, while high-yield debt as represented by HYG is up 13% QTD and 1% YTD – a huge run and showing significant outperformance. This is also part of the theme we have witnessed in the past three months that James Montier has mentioned as The Dash to Trash, where trash was the best performing asset class.

 

Currencies:       JPY and GBP getting downgraded. They print and won’t be able to pay it back, with demographics that work against them, etc. – all the same things we see around the developed world.

 

USD – Bill Gross comments on AAA rating. (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ar8YIRE7VxUA) His views continue to be out front and as one of the largest money managers and one of the most significant players in the fixed income space, his views help create the reflexivity or self-fulfilling prophesies that are key to watch. Has he lost his touch this year, or does he know something the market doesn’t? In the meantime, the world is still long the USD, but for how long? With increased government spending around the world, governments will be forced to use any reserves and that means reducing long USD positions. Is there an opportunity to front run the Chinese and Middle East holders? The increase in yield suggests that some players are positioning for just such a move, despite the potential for muted inflation in the near term.

 

EUR – When is the ECB going to complain about the strength of the Euro? Spain is broke. Italy is similarly broke. The German economic machine depends on exports, which have gotten hammered in the global slowdown. France…well, the truth is that France is not big enough nor flexible enough to make up for lost German exports. Soon, nationalistic policies will trump inflation targets. The ECB will be forced to pursue a weaker EUR policy, if only to appease the Germans. As noted by Thatsabet, the real interest is going to come with the GBPEUR. The FX markets need to find a new vent outside of FX and bonds, almost setting up for a DO OVER in pricing of everything.

 

 

BRL Continues to sign deals with China cutting out need for USD. Manufacturing and protection offered by Chinese, while Brazil supplies food and energy.

 

Commodities:   GOLD getting ever so close to $1000. Seems that a lot of fund managers are coming out in 13D filings as large holders of gold (Baupost and Greenlight to name a few). Will a weak EUR make for an even stronger bid in gold as gold becomes the only alternative to USD?

SPX has only 1 or 2 GOLD stocks in the index so they are never held by closet index portfolios. Seeing as how gold stocks will be off the radar of the large-cap managers, GLD and GDX are the easiest way to gain exposure. When gold breaks 1000 in USD it may see a significant move as managers with no exposure will find it necessary to play catch up.

 

OIL – hanging in very strong right below resistance in the 60-62 level.

OIL SERVICE – should demand issues be resolved supply issues will resurface. This should benefit integrated cos. – PBR just found new OIL off the coast and signed a deal with China (again). Finding sustained reserves in politically stable/friendly areas will command premiums. Follow SU and STO, but be wary of XOM as it is seeing problems on maintaining its supply line.

 

NATGAS – had an incredible rip and an unbelievable collapse. It’s either someone blowing up or it’s the market saying the US economy is going to come to a grinding halt.

 

AG – following along with OIL.  Same trade but DBA (AG ETF) was is less then 1% from new highs. MOO is an easy way  to gain exposure and others have mentioned COW.  MOO seems extended, with a move up >50% since March 9.

 

Politics:            CA voting no on higher taxes.

Bank United closing its doors. http://www.google.com/hostednews/afp/article/ALeqM5jryDly_bMC_UfoFJGhOWtTLk7tzg )

FED giving another 7B to GMAC (when does it end). http://www.drive.com.au/Editorial/ArticleDetail.aspx?ArticleID=63038&vf=12

AIG CEO stepping down? Really? Now? http://breakingnews.iol.ie/news/business/aig-ceo-to-step-down-411807.html

PELOSI: 3rd in command was unaware about torture? “My experience was they did not tell us they were using that, flat out. And any, any contention to the contrary is simply not true,” she said. Perjury within the first 100 days? We can’t make this stuff up! http://www.huffingtonpost.com/2009/04/23/pelosi-bush-administratio_n_190661.html

 

Economy:         GS came out with the report (May 20, 2009) regarding OER and the CPI. The point was that falling rents will continue to drag housing prices lower. Vicious circle. We need stabilization of rents to lift us out of this mess. In the meantime, it might give mis-readings on the CPI. Goldman Sachs tracks the rents at a large number of apartment REITs – and rents are now falling for the first time since 2004. We’ll wait for this to stabilize as one of our signs for a broader stabilization.