What if we’re wrong?

When managing portfolios, understanding our personal biases is crucial and we need to continually question our own framework. To that end, I pose the simple question…”What if we’re wrong?”

Here’s the current thesis/set of themes/framework I and some of my colleagues are working under:

• The US overconsumed. Trend is ending. World trade plunges.
• Overconsumption was funded by the international community, and they get fed up and are unwilling to sell to US on credit any longer.
• Real estate crashes. Credit crunch. Asset deflation globally.
• World tries to inflate through printing money, quantitative easing, misdirected Keynesian government spending. Fails in the short-term, so governments borrow more.
• Long-term, the world governments will succeed and fiat currencies around the world will face inflation or hyperinflation. Hard assets, such as gold will rise, Treasuries will go down.
• US debt spirals out of control, while the debt-to-equity ratio buries future generations leading to massive tax hikes or devaluation of USD or both. Europe…who knows if the euro will even survive. Asia is the worlds hope, but not a dependable one. Social unrest globally is not unlikely, maybe even war.
• In a decade or two, the world finds a new stabilization point. Baby boomer generation begins decreasing in size and prominence on the world stage. New technologies and trade will emerge. Some Asian countries will benefit, others will fall behind. Europe and the US will find firmer footing.
• Another cycle begins.

So, with that in mind, what if our view is totally wrong. What if…

• US consumer increases savings rate to 25% overnight. World trade takes a one-time hit. Deep recession ensues. Governments stop funding US, but savings rate makes up for it.
•  World trade plunges, but so does the pressure on any protectionist measures.
• Severe recession, with very limited demand for credit, but it stays cheap!
• Mild inflatioin takes root, but excess capacity that has been building up in the past 18 months absorbs the shock.
• Technological advances reach more industries as they try to increase productivity.  
• Voters demand that the federal government follow state government procedures and balance the budget. This leads to a stable USD, and maintains the USD as the world reserve currency.
• Medicare and Social Security benefits begin at at 72. AARP decides NOT to revolt because they planned on working a few more years anyway and they don’t want to screw over their grandchildren. Funding gap is narrowed overnight.
• A virtuous cycle is started.

There are other scenarios. The thought exercise is to highlight that there is a chance that the US economy and the world economy are more resilient than doomsday scenarios would have us believe. I do believe that the US economy is long-term resilient, but I worry about the direction we are heading.

Check out this chart from Casey Research:

It will be difficult to come out of these exponentially increasing debts without an eventual increase in long term rates. If Bill Gross is questioning the triple-A status of the US government, surely China, the Middle East, and the rest of the world are questioning the rates their getting on their paper. Even in the best case scenarios, federal tax receipts are declining by anywhere from 15-30%. In the meantime, the administration is focused on increasing government expenses rather than investments (the former is money that, once spent, has very little multiplier effect and is expensed immediately, while the latter has a large multiplier effect and the costs should be amortized over the life of the project which would help the budget).

So there is a chance we are wrong and we need to keep questioning our framework. However, at this stage, it’s tough to see the framework being challenged. When placing not just probability, but expected returns on different scenarios, the risk is still to the downside for the markets and the economy.

Cute but contagious

First it was Colony Collapse Disorder amongst the bees.  Now, we have White Nose Syndrome in the bat population. Stay long Agriculture and related themes.

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SWINE flu may get the headlines; but white-nose syndrome, a fungal disease that shows as a powdery pattern on the face, wings and legs of bats, is moving far more swiftly across America. Bat colonies have been decimated in at least seven states: New York, Vermont, Massachusetts, Connecticut, Pennsylvania, Virginia and West Virginia. At least half a million bats have died, depriving the country—particularly in the spring and summer months—of a natural pesticide. Bats consume huge quantities of insects: as much as their own body weight during a night aloft. The Forest Service estimates that the die-off from white-nose syndrome means that at least 2.4m pounds of bugs (1.1m kg) will go uneaten.

The effects of the disease, though, go beyond an itchy evening in the garden. Without bats, farmers may have to use more insecticide, raising environmental worries and pushing up grocery prices. And white-nose syndrome could threaten already endangered species, such as Indiana bats, tiny creatures with pink noses that flutter from the north-east to the mid-Atlantic, and the big-eared bat, the official state bat of Virginia.

http://www.economist.com/world/unitedstates/displaystory.cfm?story_id=13702854

Quoatable

“We are short Moody’s Investor Service,” he said. “Imagine yourself the head of Moody’s a decade ago. If your goal was to destroy the brand, would you have done anything differently?”

David Einhorn – Greenlight Capital

Pimco’s Gross Questions Investments of Harvard, Yale Endowments

“The Yale and Harvard portfolios, which have succeeded enormously over the past 10 or 20 years in terms of the emphasis on illiquidity and private investments and risk-taking — you have to question that model,” Gross said today at an industry conference in Chicago.

These “new normal” economic conditions will force people to question traditional methods of investing, such as putting 60 percent of their money in riskier stocks and hard-to-sell assets, and 40 percent in bonds and cash, Gross said today.

http://www.bloomberg.com/apps/news?pid=20601087&sid=alRUkB9N1mVs&refer=home

Pimco’s Gross sees “green shoots” of recovery

Looks like Gross and Buffett’s right hand man are on the same page.

CHICAGO (Reuters) – Bill Gross, the manager of top bond fund Pimco, said he expects 1 percent to 2 percent growth in the U.S. economy in the next few years, and at the moment he only saw “green shoots, but not much more” of a recovery.

He attributed a slide in the U.S. government bond market on Wednesday to a fears there won’t be enough buyers for the $3 trillion in recent U.S. borrowing. “There’s a gap because the market is worried who’s buying these” securities, he said.

Yen Falls as Japanese Investors Raise Overseas-Asset Purchases

This is the Carry Trade.  YIELD will remain the focus for global investors as the policies to repair the crisis unfold.

May 28 (Bloomberg) — The yen fell the most in eight weeks against the dollar after a report showed demand for overseas assets among Japanese investors is growing and U.S. data added to evidence the global recession is moderating.

“Higher yields coupled with falling volatility may now begin to entice more outflows from Japan,” Derek Halpenny, European head of global currency research at Bank of Tokyo- Mitsubishi UFJ Ltd. in London, wrote in a report today. “We did not expect such a surge in U.S. 10-year yields, which is certainly dollar-yen supportive.”

Japanese investors bought 641.1 billion yen ($6.61 billion) more overseas bonds and notes than they sold in the week ended May 23, the biggest net purchases in a month, according to a report today from the nation’s Ministry of Finance.

Businessmen, housewives and pensioners held 153,326 margin contracts at the end of last month that will make money if the yen declines against currencies ranging from the euro to the Australian and New Zealand dollars, according to the Tokyo Financial Exchange. Japan’s target rate of 0.1 percent compares with 3 percent in Australia, 2.5 percent in New Zealand and 1 percent in the euro area.

“It’s guaranteed that carry trades will return as an interesting story as soon as investors have to search for yield,” said Lutz Karpowitz, a currency strategist at Commerzbank AG in Frankfurt, Germany’s second biggest bank. “We’re still very pessimistic for the yen because there’s no indication at all that they’ll be able to raise interest rates at some point.”

http://www.bloomberg.com/apps/news?pid=20601087&sid=auv3uTOluK6Q&refer=home

Toronto-Dominion Bank, CIBC, Scotiabank Top Estimates

May 28 (Bloomberg) — Toronto-Dominion Bank, Canadian Imperial Bank of Commerce, Bank of Nova Scotia and National Bank of Canada reported second-quarter results that were better than analysts expected, adding to stock gains for Canadian banks that have outshone U.S. rivals.

Canadian banks topped analysts’ estimates for the second straight quarter on higher trading fees and lending revenue. Tighter government restrictions and capital requirements also limited credit writedowns, leading to a 21 percent gain in the Standard & Poor’s/TSX Banks Index this year. By contrast, U.S. lenders in the KBW Bank Index dropped 18 percent.

http://www.bloomberg.com/apps/news?pid=20601087&sid=adPXPc89NWdM&refer=home

Buffett Aide Sokol Says Housing, Economy Aren’t Near Recovery

May 28 (Bloomberg) — The U.S. housing market is nowhere near recovery and signs of stabilization are premature, said David Sokol, a top aide to billionaire investor Warren Buffett who oversees the nation’s second-largest real estate brokerage.

“We’re not seeing the green shoots,” said Sokol, head of MidAmerican Energy Holdings Co., which owns HomeServices of America Inc. “We don’t see improvement.”

MidAmerican is owned by Buffett’s Berkshire Hathaway, and Sokol is considered a possible successor to Buffett as head of Berkshire. Sokol spoke before reports today showed new-home sales posted their second increase in three months during April, and mortgage delinquencies and foreclosures rose to records in the first quarter.

http://www.bloomberg.com/apps/news?pid=20601087&sid=as5eaFiSGc5I&refer=home

Plastic Logic Previews New E-Book Reader

I have a hard time thinking that the technology companies are going to allow another IPOD to occur without a fight.

—-Plastic Logic’s CEO Rich Archuleta previewed a prototype for their thin touchscreen e-reader targeting business readers.

http://online.wsj.com/video/d7-plastic-logic-previews-new-e-book-reader/121E22EA-F9B6-42DA-B9C8-17E24D290D0B.html

US committed to defending ROK, Japan

Throw it on the pile!

WASHINGTON — US Secretary of State Hillary Clinton reiterated on Wednesday that the United States will defend the Republic of Korea (ROK) and Japan when the two countries face threats from the Democratic People’s Republic of Korea (DPRK).

“I want to underscore the commitments the United States has and intends always to honor for the defense of the ROK and Japan,” Clinton told reporters two days after the DPRK conducted its second nuclear test since 2006.

http://www.chinadaily.com.cn/world/2009-05/28/content_7950269.htm

Quotable

Cause change and lead; accept change and survive; reist change and die.

Ray Norda (Former CEO of Novell Corp)

WaterBoarding (Video)

http://link.brightcove.com/services/player/bcpid1579920046?bctid=20047560001

Russia Diamond Monopoly Seeks to Avoid Market Flood

Alongside GOLD I think that high quality diamonds will once again be thought of as a tangible.  But, I am more comfortable in with more main stream assets.  A miner or two in a portfolio might make sense.

May 28 (Bloomberg) — Russia will avoid flooding the world diamond market, as it did in the 1990s, with the stocks it has been building up since demand slumped last year, the nation’s monopoly producer ZAO Alrosa said.

More than a decade ago, Russia began offloading rough, or uncut, diamonds as its need for hard currency became acute, leading to a rift with distributor De Beers. This time, the state and Alrosa will coordinate to avoid a repetition of events that “crushed the market for a very long time,” Vybornov said.

Polished gem values have fallen by an average 31 percent since peaking in August, according to PolishedPrices.com, as the global economic slowdown prompts consumers to curb spending on luxury goods. Gem Diamonds Ltd., the operator of the Letseng mine in Lesotho, said this month that first-quarter diamond prices collapsed 52 percent from a year earlier.

“Prices and sales appear to be stabilizing as consumers realize that the sky has not fallen in,” Avi Paz, president of the World Federation of Diamond Bourses, said in an e-mailed statement from Antwerp yesterday. More than 1,500 international diamond companies have their headquarters in the city in an area called the Diamond Square Mile, which has four diamond bourses.

http://www.bloomberg.com/apps/news?pid=20601109&sid=aYC86X_KsPdE&refer=home

Japan May Scrap 50 Trillion-Yen Plan to Prop Up Stock Market

I am desensitized to what the governments are willing to do in order to manipulate financial markets.

May 28 (Bloomberg) — Japan’s ruling Liberal Democratic Party may abandon a bill that would set aside 50 trillion yen ($520 billion) to buy shares from the market because stocks have rebounded from a 26-year low, lawmakers said.

“But stocks have been stable, so the measures aren’t necessarily that essential.”

“I don’t think there’s really a crisis in Japanese stocks to begin with,” said Naomi Fink, Japan strategist at Bank of Tokyo-Mitsubishi UFJ Ltd. in Tokyo. “It might even undermine Japanese equities because foreigners are going to say ‘wow, the government is propping up prices and how do we know whether it actually reflects the value of the firms or not?’”

http://www.bloomberg.com/apps/news?pid=20601087&sid=a_MWEZS.CDr8&refer=home

U.S. Inflation to Approach Zimbabwe Level, Faber Says