Waiting with bated breath…

It seems as if every market is at a critical juncture and just waiting with bated breath. Which ones? Well, there are the important ones: currencies and bonds. Equities aren’t on the list of important ones right now, because they are just following the moves in other markets. The trade has been short USD, long equities – a reflation trade. The 10/30 spread has been blowing up as rates on the long end jump and rates on 10 years and shorter have been locked down. Great if you want to start a bank, not great if you’re poor and milk prices are rising at the supermarket.

Let’s start with the USD:

If the USD bounces here, it will generate an unwinding process where equities will have to be sold. It will be a domino effect that will cause one big Wall Street margin call. I’m positioned for this scenario. Many, if not most, investors are positioned for the USD to continue falling, believing the Fed can re-inflate the economy and seeking safety in equity earnings that they believe will rise with inflation.

If the USD doesn’t bounce here, then we can get some inflationary pressures. Equities might benefit, but the real beneficiaries will be the commodities and related companies. DBA certainly looks strong and has had a very nice move recently:

DBA, while a follower of the currency moves, also has something else going for it: geopolitics. With some freak draughts and weather related incidents causing additional strain to the already tense political maneuvering, DBA could benefit from increased protectionism as countries move to protect their domestic supplies. It could provide a good support, but this, again, is a critical juncture.

Meanwhile, the 10/30 spread, while off it’s historic lows is still at incredibly low levels:

In the meantime, EEM is possibly rolling over. I say possibly, because it hasn’t broken it’s uptrend, but with continuous inflows on the one hand, but emerging economies trying to dissuade those same inflows on the other, it can go either way – depending on the market’s view on the USD.

And on and on we go. The financials have been significant underperformers this year, and at some point (I think in the very near future), the large hedge funds holding the financials might be squeezed out. They’ll have to either liquidate their positions in BAC, WFC and the like, or they’ll have to liquidate in other markets (gold? USD? treasuries?). And let’s be real – can the equity market have a sustainable rally without the banks? I think not.

Every market I track is waiting to see what happens with the USD. I have been calling for a reversal day for a while, but I think it’s coming (maybe today is the day), which will signify the need to unwind the risk trade. That unwinding will involve USD getting stronger, equities and commodities getting hit hard. The real problem with that scenario is that there will be no place to park and hide.

Dynamic yield curve

Have you ever wondered what the yield curve looked like a few days ago, or a few years ago, and how the sape corresponded to the S&P? Well, if you haven’t seen this, definitely check out the tool provided by stockcharts.com.

http://stockcharts.com/charts/yieldcurve.html

Very interesting to not the flattening before the recession, the subsequent steepening, and the shifts.

10 o’clock update

All China all the time. China hiked rates by 25 bps because USD weakness is equal to Chinese inflation. Since China is the driver of commodity price demand these days, obviously commodities are taking it on the chin:

Meanwhile, between Chinese rate hike and Geithner making a “we won’t devalue the dollar” statement gold is feeling what happens when speculators get caught. Silver is taking it even harder. If you got in hoping to get catch the blast off, you should have remembered that “hope” is not a strategy.

And if that weren’t enough to keep you occupied, Apple is hovering back at $300, give of take $10, GS came out with earnings, that while good and keeping the stock up, weren’t as good as last year and in the meantime, the rest of the financial sector is back under some pressure.

Morning Update

Should have come sooner, but Citi is keeping me on the phones.

They need to do a SNL “REALLY?!” skit about Citi. Revenue dips, earnings surge. Really? Turns out loan loss provisions are down to where they were before the recession. Really? Citi sees less credit losses coming now than it forecast in 2007? And what about putting some funds aside for the whole mortgage mess? JPM put aside a billion dollars. Citi? About $300 million. Really? And on, and on…

Here’s Citi’s weekly chart.

Meanwhile, Apple continues it’s surge:

Why am I focusing on individual names (no position in either stock) when I usually focus on the bigger picture stuff? Well, because the individual companies are all that’s left to hold this market up. Apple is in essence the Nasdaq. Citi is driving the financials today. It certainly isn’t BAC nor WFC which got crushed last week. They’re barely holding on.

So the story is that the market is looking to these bits and pieces of mildly good news (although in my mind the news is awful and shows increased risk in the system) as reasons to rally. It won’t last. The turning point is upon us, and if I’m off, it’s by a matter of weeks or months, not years. It’s a bit scary to take the other side of the trade from Tepper & Co., but our continued focus on fundamentals and valuations warrants it.

S&P 500 – summary of valuation metrics

Prieur du Plessis has a great summary of some valuation metrics, from CAPE to q-ratio.

Here’s a quick summary, but the full article can be read here:

CAPE

Robert Shiller’s cyclically adjusted price earnings ratio (CAPE)
The CAPE ratio, defined as the ratio of the inflation-adjusted S&P 500 Index to the average of the past ten-year inflation-adjusted trailing S&P 500 annual earnings, is currently at 21.39. That compares to the historical average of 16.4 since 1881 and is at the top end of the range pre-2000. Barring the first quarter of last year when the ratio fell below 15, it is at the lower end of the range over the past ten years. So yes, the S&P 500 is expensive on a long-term basis but inexpensive compared to the past ten years.

Price-to-book ratio
The price-to-book ratio of the S&P 500 is 2.3 times and is inexpensive compared to the historical average of 2.9 times since 1981.

Tobin’s Q ratio
The Tobin’s Q ratio is calculated as the valuation of the whole market in relation to the aggregate corporate assets. It displays valuation patterns similar to those of the price-to-book ratio. According to dshort.com, the ratio is estimated to be approximately 1.0. It is at the upper end of the range since 1900 but at the lower end of the range since 2000.

Source: dshort.com.

In conclusion, the S&P 500 is in my view neither extremely cheap nor very expensive. The dominant factor is how dividend yields will pan out over the next seven years. If the average of the past ten years holds, the market is likely to return in excess of 6% and is therefore relatively inexpensive. However, the average dividend yield will rise if significantly higher inflation is on the cards, resulting in negligible returns over the next seven years. What is clear, though, is that investors should scale down their return expectations as the likely outcome is somewhere in between.

Good old-fashioned stock picking remains my favored approach to equity investment in developed markets. (I will devote a separate post to emerging markets over the next few days.)

Here was my response to Prieur on his site:

Thanks for this great summary and analysis. One point to add regarding the q-ratio. In their work on q-ratio (Valuing Wall Street), Smithers and Wright showed why q-ratio averages around .7 and why P/E ratios are q-equivalent.

By that measure, the equity markets are 30-35% overvalued at this point, and that’s assuming it doesn’t overshoot on the downside. It is also roughly the same valuation level as we saw around the pre-1970′s bear market.

Separately, based on work done by multiple academics and popularized by Ed Easterling, a move away from price stability (towards deflation OR inflation – doesn’t matter which) will probably lead to margin compression. Easterling called this the y-curve. That should lend itself to poor contribution to returns from margin expansion going forward.

Just some thoughts that I hope will add to the conversation as we muddle through the proverbial “interesting times”.

10 year:30 year

Last week we discussed this ratio: 30 year yields were blowing up vs. 10 year yields, perhaps in anticipation of inflation, or who knows. This ratio seemed extended at the time, but might now make a comeback. Here’s the 10 year yield vs. the 30 year yield.

The 10 year yield has a long way to rise against the 30 year yield to come back to it’s longer term averages. The chart above is a weekly chart going back to late 2007.

10 o’clock check up

We’re constantly trying out new ways to update our subscribers, so we’ll start with a few charts to review:

The USD was due for a bounce and it’s lucky we’re getting one. Why? Because holders of US assets, specifically bonds have been taking it on the chin. Even though bonds have stayed strong, they’ve been losing on the currency translations. How long would they be willing to pour money into our treasuries? Probably not long. The Fed recognizes this and is stepping in as the purchaser of last resort. Fine for US investors, not great for the bulk of our treasury holders who need the USD to strengthen or we’ll see massive dumping. Its the world vs. the Fed in trying to determine USD strength and I’m not sure any of the outcomes are good.

Commodities are hot and they’re all over the news, and I live my wheat as much as the next guy, but these things look stretched. How much of this move is fundamental, demand-driven and how much is a reflection of a weak USD? Not sure, but Dennis Gartman postulated that the recent corn report may have been the result of some government shenanigans to drive up prices:

The farming communities in the Midwest are going to be resurgent, and the equipment manufacturers, the fertiliser sales organisations, the grain elevators and perhaps most of all the small local banks will benefit manifest and continually. After a decade of weakness, strength returns to the farming Midwest.

Read about it in the FT.com here.

I wouldn’t be surprised, but regardless, I’m wary of taking new positions in the space.

And a last couple of notes:

• Pfizer buys King Pharma (KG) for $3.6 billion cash. Nice.
• Fed minutes come out today at 2PM.
• Thailand tried to cool their currency by imposing a bond tax.

Deflation in assets, Inflation in goods

I didn’t know what to title this post as it will contain links to a number of articles and charts that are meant to tie together some themes we’ve been exploring together and trying to get at the “end game”. The question on every investor’s mind right now is where are we heading with our current policy path? The question is not isolated to what should baby boomers do, nor China’s currency, nor movements in the corn market. It is all of it. So let’s attempt to put it together (albeit messy)…

Let’s begin with the most obvious crack – deflation in assets. In the entire G8, and certainly in the US, real estate is the single biggest asset for most households. In the wake of easy monetary policy this asset rose, then fell. We all know the story, so I won’t go too deep into it. (For reference IYR went from 92 to 24 in less than 3 years.) Easy monetary policy continued, and I was quite sure that inflation pressures would begin, but we didn’t see them. In fact, real estate hasn’t stabilized and luxury is under pressure from every corner.

In late 2009, as the world was pronouncing the death of the USD, I went long and shorted the euro and yen believing that there was no way the rest of the developed world would not be affected. I was right on the euro and wrong on the yen. What has been interesting this year is that the euro continues to face structural difficulties from its member-nations, yet investors have started believing that it still represents a safer haven than the USD.

The yen too “should” be crying uncle, and yet, even a commitment from the BoJ to defend the USD!!! has not forced any significant sell-off of the yen. What is going on here?

Bernanke must be happy to get a little USD weakness, but the rest of the world is starting to worry that their efforts at weakening their respective currencies aren’t working. I expect Germany to come out with slower economic numbers in the next two quarters and thereby face fresh calls for increasing efforts to weaken the euro.

Investors are aware that this is no longer zero-zum, but rather a negative sum game. Brazil is issuing debt to buy USD! This is competitive devaluation at its worst. Keynes must at least be enjoying the experiment, especially since he won’t have to pay for its fallout.

On the other side of the currency world are the commodities. Again, we’ve discussed corn and wheat and MOO ad nauseum. But it’s so important, not just for understanding input prices. After currency intervention, access to raw materials and food stuff is the next prong of the economic war being waged. China’s dependence on world gran has gone from 0% 10 years ago to 15% currently. Countries from Russia to Malaysia are putting limits on exports of certain goods and its only a matter of time before each government is forced in to increasing protectionist regulations. Commodity prices are up and I suspect they will correct, but the structural changes are in place to provide a base of support and a springboard for some commodity prices to soar. I’m on the lookout for talk of “strategic reserves”, “national security”, and s”trategically important industry” to increase across the world.

Throughout, competitive devaluation will continue. People will spend money on goods – generic foods, household necessities, etc. but they won’t spend money to bid up assets. Agricultural real estate will win, but commercial real estate will not recover in the near to medium term.

As promised, some links:

• This is a must read from Albert Edwards at SocGen.

…[T]he biggest threat is that this most recent invocation of the nuclear option is coming at a time when the world is least prepared to handle it – social imbalances are at unprecedented levels, and if, as many predict, the price of key food products is about to surge (courtesy precisely of these failed central bank policies) to a point where the great unwashed end up on the wrong side of hungry, from there, to armed conflict, the line is very, very thin.

From John Murphy Intermarket Analysis (1991):

Consider the sequence of events going into the fall or 1987.  CRB prices had turned sharply higher, fueling fears of renewed inflation.  At the same time interest rates began to soar to double digits.  The USD which was attempting to end its 2yr bear market, suddenly went into a freefall of its own (fuelding even more inflation fears).  Is it any wonder, then, that the stock market finally ran into trouble?  Given all of the bearish activity in the surrounding markets, its amazing the stock market held up as well as it did for so long.  There were plenty of reasons why stocks should have sold off in late 1987.  Most of those reasons, however, were visible in the action of the surrounding markets and not necessarily in the stock market itself.

I’m not suggesting things are the same as 1987, by the way. But Murphy touches on one of the most important issues we discuss in our newsletter – different markets that might seem far-flung are interconnected and investors need to understand or at least explore the relationships between them. To that end, commodity prices are telling a different story than bond prices. Commodities are telling us that CB’s may succeed in stimulating inflation, but it can come faster than they can control. (YTD CORN is up 30% – just one example.)

Throughout, the CB’s will probably continue to print money in a race to the bottom. Make no mistake – this is economic warfare, with national strategies (witness the Chinese buying JGB’s to force the BOJ’s hand), egos (witness “Helicopter Ben” needing to prove his theories right), and sacrificial pawns (witness 43 million Americans living below the poverty line).

Throughout it all, I continue to scream from the rooftops that the market is underpricing geopolitical risk. Chinese ship movement toward the Indian Ocean, Iran, North Korea, and the random sociopath (plenty of those out there) are just a few of the current “knowns”, not to mention the “unknowns” that will be coming out of the woodwork as social instability and civil unrest rise.

I started this post as an exploration, but realize now that it is incredibly depressing and negative. I’ll end on a positive note: Zynga, the biggest social gaming company in the world, moves 1 petabyte of data EACH DAY! and adds as many as 1,000 servers each week! They site is producing more information in a day than was available in the entire world just a few decades ago. Pretty astounding. And for those who WANT to end on a depressing note, read this in relation to the information on Zynga (I’ll give you a hint: Fahrenheit 451 and 1984 as dystopian novels are eery predictions of social gaming and reality TV.)

For a look at how the economy is really doing – CAG

While everyone was waiting and watching an incredibly boring session pre-Fed, then a 30 minute interlude of head fakes, the real story today was ConAgra.

CAG cut their fiscal year outlook due to consumers buying less of the high margin products and higher cost inflation. This is a continuation in the theme we’ve discussed where luxury at every level is going to get discounted. Premium milk brands at DF were our focus a few weeks back, but it’s happening at every level. On the flip side, generics should be relative beneficiaries and companies positioned as low-price brands.

This also made me come back to the restaurant business, which one of (in not THE) largest employer in the country. Consumers cutting back spending – not good for restaurants. Higher price inflation in everything from corn to cheese – not good for restaurants. In the meantime, investors in YUM don’t seem to notice, but I think they soon will. Restaurants might be like retail in 2007-2008 – when investors start heading for the exits, there will be a lot of spilled milk.

So while the Fed continues to be the focus of attention, I think the real story today is CAG. At its heart, the news from the company confirms what most people already know – this isn’t a recovery by any standards and everyday costs are rising while assets (homes being our collective largest investments) are declining.

For the record, at the time of this writing I have no position in any of the stocks mentioned, but that is subject to change. This is not investment advice in any way, shape, or form, and readers are encouraged to do their own research.

Around the world in 6 charts or fewer…

We haven’t done this in a few weeks, but it seems pertinent now, especially since today was surprising by the sheer inaction of virtually all markets except a one time move in JPY – other than that, ho hum, which is incredibly scary to me.

So the BoJ comes out to weaken the yen and all it could do was make a 3% move? I showed the chart earlier, so I don’t want to waste 1 out of 6 charts here, but come on! I’m not just saying that because I’ve been short the yen for almost a year. I’m saying it because the world has obviously gone bonkers. JPY should NOW be the ideal funding currency for any type of carry trade. Short the yen buy anything with yield, like BRL, AUD or anything else. The BoJ will limit any currency fluctuations against you. Now, the real question is who in their right mind would want to take the other side of that trade and short yield to buy yen? I just don’t get it.

On to our first chart: Silver – the poor man’s gold

Silver sure looks strong and I like it more than gold, but quite honestly, I spoke months ago about building a metals portfolio in gold, silver, palladium, platinum, miners, etc. and I continue to view them as a basket rather than trading them against each other.

On the other end of the commodity spectrum, energy has been holding up, even rising a little since we last checked in. Since I tend to prefer companies to the commodities, I’ve been looking at the oil space and not loving it here, except that I’m pretty sure the markets are underpricing geo-political risk and a nuclear Iran. The only solution I currently see at a reasonable price is nuclear. I mentioned it a few months ago and initiated a position in NLR:

It’s about where I bought it, but it’s a long term play, so the daily fluctuations will not influence my position. If anything, we might look to build individual company exposure as opposed to the ETF, but for now, it works.

I can’t look at metals and energy, without also talking about grains and agricultural related companies. CORN is all over the news, but once again, I don’t love trading commodities if I can invest in the companies. I’ll highlight MOO here, but I have no position in it:

It might pull back, but I expect it to outperform the equity markets in general and act as an inflation hedge if it comes to it.

We’ve covered some ground, but the real interesting plays in the market have been the relative movers. I’m going to highlight 3; they’re related to each other, but important:

DBA: GOLD

Could ags have bottomed against gold and are they starting to be THE safe haven?

SPX:GLD

Could both charts taken together provide support for a top (at least a short term top) for gold?

Lastly, here 10 year treasury yields vs. 30 year treasury yields (these are yields, not prices):

Could this have bottomed as well, implying 30 year bonds are about to go down faster than 10 year bonds? I think so. Bu then again, I’m still short long bonds and was early on that, so take it with a grain of salt – the direction is inevitable; it’s the timing that’s tricky.

Today is all about the yen!

The new Japanese government has no choice but to systematically debase the yen. Everyone, especially Japanese exporters, are convinced that it will save/stimulate the economy.

Let the grand experiment continue!!

Yet, we know how it ends. CB’s are incredible effective in one task – debasing the currency. I think the BoJ is going to prove that to everyone who thought the yen was a safe haven.

Has the government succeeded in breaking the USD?

I don’t know about completely succeeding – yet (!), but they sure are trying their hardest:

(daily USD index)

On the flip side, gold is rallying, but silver is the more interesting story in my mind:

(weekly SLV)

In the meantime, the S&P is  rallying, but taken on a longer scale, it has a lot of work to make up:

(SPX weekly)

Just some food for thought – this rally appears to be driven by the FX markets as investors shift out of the fiat currencies, some faster than others, but gold is showing highs in various currencies, implying a fear of all CB’s. The yen continues to astound, making fresh 15-year highs:

(yen weekly)

Scary times when there’s no place to hide.

Spoiled milk

The markets seem to be in a cheery mood, as does everyone on TV; so why am I still down? Spoiled milk.

Dean Foods came out with earning earlier today, and it wasn’t pretty. The company posted a profit of $44.79 million, or 25 cents per share, on revenue of $2.95 billion. That compares to a profit of $64.14 million, or 38 cents per share, on revenue of $2.67 billion during the same period last year. We’re talking a 30% drop in profits. The stock is down roughly 7% as I write this, but that’s not why I’m down (I have no position in the stock at the time of writing). I like looking at consumer staples for messages, and this one is loud a clear – consumers aren’t buying the brand name milk! They’re buying generic. They’re not buying less of it, just buying the cheaper version. That’s the problem, by the way, of selling commodities. When pressured, demand will flow to the lowest priced substitutes.

Anyway, if it was just DF, I’d hear the message, but not give it too much credibility. But Proctor & Gamble (PG) had the same message waiting. Earnings fell 12% from a year ago. Are people really switching out of their premium-brand toothpaste for the store brand generics?

DF already broke down a few months ago, so the market shouldn’t be THAT surprised. Could it go lower? Obviously. But in my mind, PG, which has held up well is even more vulnerable. It hasn’t participated in the recent rally, and its bretheren like JNJ, had a crappy month when the rest of the market was pricing in who-knows-what.

What’s next? Switching to generic drugs? Is there no end to the sacrifice? For all the inflation talk out there, these companies are sending us a message from the consumer. Spending is coming in, savings rates will rise, luxury and “wants” will be pressured, while “needs”-spending will flow to the lowest cost producers, pressuring margins and (I guess – eventually) valuations.

Disclaimer: no position in any stock mentioned. Not investment advice and should be used for informational purposes only.

Lots of noise

I know the market feels like it’s gone up – a couple of up days, even on low volume, make everyone feel giddy inside. But let’s review where we are:

The S&P 500 has done a lot of moving without getting anywhere. It’s about where it was at the beginning of the year, which is roughly where it was in mid 2008 (and by the way, about where it was in 1998 for those keeping longer term track).

Meanwhile, the 10 year yield is roughly where it was in mid-2009:

On the other side of the Pacific, we’ve been looking at the yen for a long time. And yes, I told my readers that I went short in late 2009. Guess what…I’m still short and the yen is pretty much right were I got into my position. Not that I’m proud of a slightly down position, but the reasons to get into the trade haven’t changed and none of the factors that would get me out have been seen. Can it get stronger from here? Of course and I wouldn’t even be surprised.

But all of this talk of yen being a store of value misses the point of the fundamental challenges Japan is facing with no easy way out. Multiple people have recently recommended books like When Money Dies: the Nightmare of The Weimar Hyper-Inflation by Adam Fergusson and Dying of Money: Lessons of the Great German and American Inflations (see for example this recent article HT MacroMan). I’m not opposed to the possibility, but surely Japan is in much greater danger of the hyperinflation mentioned than the US.

But I digress, because the point of this posting was to mention that we have had a lot of noise. I can show other charts, from EEM to different currencies, but the themes are the same. I continue to look to fundamentals as the critical guides for valuation and long term opportunities, and at least in equities, valuations are expensive – so we wait.

10/30 spread

The 10/30 spread continues to signal something…

Namely, yield on the 30 year bonds are rising relative to the yield on 10 year bonds. Could be inflation fears. Could be fears of sovereign debt in general. Could be liquidation by banks needing to shore up short term reserves (maybe even European banks needing euro liquidity since euribor is rising).