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.

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.