“So much news”, or, “Are we living through a modern war?”

Confirmation bias is a tricky thing: how do you know if you’re picking up on news because of your confirmation bias or because there actually is a confirmation of your beliefs? That’s what I’m facing today. After yesterdays post discussing continued deflation in assets, the coming inflation in goods, and the end game – economic war (starting) and maybe (not a prediction) physical war, I was struck by the different news coming out today:

1. Starbucks is raising prices on some of its more complicated drinks (not the regular ‘ol coffee – for now). Again, inflation in coffee is starting to flow down the chain. This was a mild story, so I didn’t even link to it.
2. Then I saw this from the FT.com: The Great Race (to the bottom) – OK, a definite case of confirmation bias.
3. But then I also saw this in the FT.com: Ireland’s subordinated bond ATTACK! What struck me was not the content, which is old news (Ireland may default, CDS spreads rising, etc.) but the choice of language (“ATTACK!”). OK, so it’s probably still my bias looking for confirmation.
4. How about China blocking rare earth shipments to Japan? Is that still just my bias? Read about it here. Politically, it might be China testing the limits and ultimately might prove to be a disastrous move as now the world will look for alternative sources of rare earths. By the way, rare earths are available in other parts of the world, they’re just difficult (read: expensive) to isolate, but they’re available. China just made it more political and more strained.
5. Maybe it’s no longer my bias, but I (along with many, many others) discussed the possibility of German growth stalling with the recently stronger euro. Lo and behold German Economic Contraction Begins As Both Mfg And Services PMI Prints Miss Expectations. Now it’s starting to fall into place.
6. Then, here’s the clincher. Yahoo News discusses Stuxnet – new cyber security threat designed to make the crossover from malware to physical destruction.

I hope I’m wrong and that all these stories will turn out to be unrelated and of little significance, but if nothing else, investors should at least price in the possibility that I’m right and that the economic damage will continue and eventually show up in the repricing of risk and in turn, asset classes globally.

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.)

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.

Must read from Jeremy Grantham

As always, Grantham brings an astute, experienced eye to a host of global issues, from the risks of global warming to the burdens placed on our working population to the financial sector zero-sum games. This series of essays, summer readings, are a must. Click here to download all six essays.

Connecting the Dots 7-15-2010

We haven’t done that in a couple of weeks, but the time has come…

Let’s start with the Baltic Dry Index ($BDI) which continues to head down:

Call it triple top, call it Stanley, call it whatever you want, but recognize that it is weak. It’s true that it’s backward looking, so we also want to keep an eye on forward shipping rates. Comments from a subscriber:

ShippingOcean freight rates for the C4 route (capesize vessel from Richards Bay to Rotterdam) were down $0.10 to $10.90/MT for Q4 2010, unchanged at $11.00/MT for 2011, and unchanged at $11.88/MT for 2012

A pretty flat curve.

Certainly not inducing inflation fears.

Next up, we look at mortgage applications, which continue to show weakness:

Just how bad is the U.S. housing market? After falling off a cliff in May, due to the expiration of the home buyer credit, sales continue to decline further and further. Last week, mortgage applications for home purchases fell by 3.1%, according to the Mortgage Bankers’ Association. That broke through the worst levels seen in 1997, to hit a point not seen since 1996. They’re now down 69.1% compared to their 2005 peak. (Source: The Atlantic Monthly)

Certainly not encouraging. 2 months after government support evaporated, we see that the real estate market has not stabilized.

With household formation running at just 0.9 million while the US is still building 0.6 million new homes annually, only 0.3 million of the oversupply will be absorbed per year. As there are currently 4 million too many homes, it may take years to mop up the huge oversupply of houses. (Source: The Big Picture)

While I’m a value guy through and through, I can’t help but look at the global environment on a relative basis as well. So it’s no surprise that currencies are perplexing:

Once again everyone is talking about the death of the dollar, and how Europe saved itself. P-lease. Spanish banks are toast. Portugal is toast. And Germany is going to be called on in the next couple of months to pay up for the next installment of financial chicanery from one of it’s partners.

But the most dangerous currency in the world, continues to be the almighty yen!

Heading towards a new high, this is the currency with one of the worst fundamental pictures in the world. The only explanation I have is that the carry trade was SO big that this represents an unwinding of risk – EXCEPT that risk assets have gone up in tandem?! It’s a conundrum that I don’t understand. There is a disconnect there that will get flushed out and in my mind, the yen’s support is limited. I remain short via YCS – not my favorite implementation tool, but it’ll do the trick for the magnitude of moves I believe are coming.

Lastly, I have to comment on JP Morgan (JPM):

The Wall Street giant posted earnings of $4.8 billion, or $1.09 cents a share for the quarter, compared to $2.7 billion, or 28 cents in the same period last year.

Excluding the reserve release and a $550 million charge to cover the U.K. tax on banker bonuses, J.P. Morgan (JPM) earned 87 cents a share in the latest quarter.

Analysts polled by FactSet Research had, on average, been expecting earnings of 74 cents a share. Net revenue on a managed basis fell 8% to $25.61 billion. Analysts had expected the group to report revenue of $25.81 billion. (Source: CBS MarketWatch)

We should all be so lucky as to get a 30% boost to earnings from accounting changes. In the end, though, the market is smarter than that, and anyway, accrual accounting has a wicked bite when it needs to be reconciled with cash. These games are one of the reasons that I avoid financial companies in valuation comparisons and accounting-based screens – they look great on paper, but tend to be misleading.

Oh, yeah, and another couple of odds and ends: retail sales fell 0.5% in June (CalculatedRisk), PPI fell by 0.5% (TheAtlantic.com), and if those didn’t convince you that we still had a recession in our future, ShadowStats has this for you:

Plotted below is the year-to-year change in real (inflation-adjusted) M3 (updated for the Fed’s revisions) versus U.S. recessions, as recognized  by the National Bureau of Economic Research. Whenever annual real change in M3 has turned negative, the economy always has fallen into  recession, or if already in recession, the economy has entered a period of intensified downturn, usually within six to nine months of the initial M3  downturn. The signal for economic trouble ahead is the annual real M3 growth first turning negative, as happened in December 2009.

(For the full article, click here.)

While I really don’t want to be a Debbie Downer, connecting the different dots should at least highlight the fact that significant risks remain, that the threat of recession is far from over, and that calls for economic recovery, at best, misguided. While different analysts have been talking about the markets recent moves higher as signs that conditions are improving, I think they are premature. During every big recession, analysts and government officials continually claimed an end, with short lived rallies that brought in new buyers (think Japan for the past 20+ years). I continue to underweight equities, continue to hold my short euro and yen positions, and continue to be wary of equity run-ups.

Random Thoughts

• 7 year auction comes in at a low bid, but 10 years start selling off? How come?
• Hugh Hendry‘s wants to take Soros down and believes the euro is doomed because there’s a structural problem of maintain fiscal vs. monetary interests. He must be reading The Hard Trade site.
• If financials and energy and retail and tech are all heading lower, who’s left to lead a rally?
• Is the Baltic Dry Index spelling trouble for the CRB space? Does anyone even care that rail traffic is improving?
• Is SNB going to break with their ever-growing euro position? They’re setting themselves up for some trouble down the road – but then again, I’m short the euro.
• Gold continues to hold up as the vent, but silver might be the ultimate winner.
• I’ll admit it, I sometimes like to say “I told you so”. For months we’ve been telling our readers that real estate is not stable, that the numbers are being manipulated by government stimulus, and that the current crop of speculators will be crushed. So, it was with no surprise that the sales numbers came in so low. And we ain’t done – commercial real estate along with residential is still being mispriced on bank balance sheets (and on Freddie and Fannie balance sheets). We continue to stay away.

Around the world in 6 charts or less

As a value guy, I spend a lot of time trying to understand behavioral biases and my own limitations in analysis, so it is with skepticism that I write about a funny feeling I’m getting. I’ve been mulling it over for the past few days, trying to come up with the sources of this “feeling” and have come up with the following:

The numbers aren’t lying. The ECRI Leading indicators has been rolling over:

(source: zerohedge)

The baltic dry index looks like it might have just finished it’s triple top formation:

How about those unemployment numbers?

(source: Calculated Risk)

How about the Swiss Frank?

This is using the ETF as a proxy. If you drill down vs. the euro it’s even more extreme.

What about gold in euros?

q-ratio. CAPE. What else do I have to say?

This isn’t just a funny feeling. And I don’t think it’s just confirmatory bias. Global markets are signaling something that the equity markets are not factoring. The message is in the CRB complex, in CDS spreads, in intermarket relationships that are blowing out to new highs and lows. I know summer is starting and everyone is away for 8 day weekends, but the messages are there for all to see. And when equity prices reflect these realities, vacations will get cut short. (Come to think of it, maybe we should short luxury hotels in anticipation of bankers cutting family vaca’s?)

Where is money made?

There is so much daily noise in the market, that sometimes its easy to lose sight of the big pictures and trends taking place right under our noses. Earlier today, I wrote about Alvin Toffler and the waves of transformation. For me, there is a connection between “the waves” and money flows. In each of Toffler’s waves, money flowed to the new wave, only to create bubbles, financial collapses, debt spirals (up and down), yet often the older industries were left as significant beneficiaries of the new advancements. As a quick example, agricultural productivity was able to soar after the industrial revolution introduced new tools, transportation, materials, etc.

As an investor, I’ve been thinking that Toffler’s waves had (have? His book, The Third Wave, was written in 1980) vast implications if one was able to invest in them. Instead of just thinking in terms of technological or developmental “waves”, I think we should also consider the waves of money flows around us. In my mind there are 3 big waves occurring and money will be made by individuals, firms, and countries that can place themselves strategically.

The first transfer-wave is between developed to developing countries. Wealth is invariably being transferred and the gaps in quality of life will eventually close. For developed nations, it will probably mean a slowing of the rate of increase in quality of life, while for developing nations it will mean an exponential growth. Without discussing whether this is good or bad for any individual group, the companies that can take advantage of these shifts, both in terms of manufacturing and distribution, will win.

The second transfer-wave is between old and young. Baby boomers were not a US phenomenon. The Western world is facing an aging population that will at first require assistance, then slowly be forced (by nature) to transfer its wealth to a new generation. Again, those countries and companies that understand this demographic shift will win. As an example, countries able to attract and retain young talent, or encourage their populations to grow faster than others, etc. will benefit in the long term. A classic counter-example is Japan, with it’s fast-aging population, low birth rates, and relatively closed borders.

The third transfer-wave is from men to women. While it’s occurring more quickly in the developed nations, developing nations will face it as well. “The postindustrial economy is indifferent to men’s size and strength. The attributes that are most valuable today—social intelligence, open communication, the ability to sit still and focus—are, at a minimum, not predominantly male. In fact, the opposite may be true.” This was from The Atlantic which is running a cover story on this specific topic and is a must read (click here for the full article).

None of these transfer-waves are bad nor good – they are obvious and necessary. The key, as investors, is to understand the dynamics involved, evaluate the opportunities and pitfalls, and translate these trends into investable themes and ideas. That’s what we’ll be referencing in the upcoming weeks, months, and years, as we try to understand the implications for households, companies, and countries.

Around the markets in 6 charts or less

With so much noise and conflicting news, we’ll try to boil it down to some of the interesting areas (by no means an exhaustive review). While we’re not technically inclined, a picture is often worth a thousand words, so without further ado:

Chart 1 Gold:Euro

As troubles in the eurozone mount, markets are looking for outlets – heck, Europeans themselves are looking for outlets. We’ve mentioned the euro:yen pair and have maintained our usd:euro position, but gold in euro terms is hitting new all time highs and is acting as a real fear gauge for the European markets.

Chart 2 EEM

Speaking of fear gauges, the emerging markets were all the rage just a few short months ago, with strategists discussing divergence and internal growth metrics. Money poured into EEM as the USD was going down. Oh, how the world is changing. EEM now looks like it’s rolling over and while I am not posting it, Chinese equities, long the poster children of emerging growth, look poised to continue their downward spiral. Turns out valuations matter and government direction of the economy isn’t all that great.

Chart 3 IWM

I have to admit that IWM has been surprisingly strong and stable so far. I guess everything is up for interpretation: either you believe the markets are always right and the strength in light of bad news is a bullish signal, or you believe that markets are inefficient and haven’t yet priced in just how bad things are. Guess where I am…

Chart 4 10 year yield ($TNX)

I have a long term fear of the government inflating our way out of debt, but in the shorter run, treasuries are still offering a safe haven. I have a small exposure to short treasuries (through TBT), but it has moved against our portfolios; yet, I am not changing it. I believe longer term, treasuries are in a very dangerous position. While deflation might be in our future, I don’t think there is too much upside here. That said, I have been wrong so far. I’ll be looking to add to this position if levels go to the extreme levels of late 2009.

Chart 5 Oil

As we continue to think about the inflation/deflation debate, oil is a good place to start looking. At least at the moment, it doesn’t look like it’s pointing to rampant inflation. Might this be the final deflationary play? Maybe, but I’d at least point out that it can go a long way down and stay down for much longer than inflationary-minded investors would have you believe – peak or no peak.

Chart 6 Agriculture:REIT

And then, as if I wasn’t confusing you enough, I’ll refute my own deflationary assessment, and point out that agriculture has been lagging REITS. At first blush, this might suggest that agriculture is poised to rebound relative to the REITS sector, which sounds quasi inflationary. Au contraire… There is a big disconnect which we’ve pointed to before. In this new world order we can have deflation AND increasing yields. We can have inflationary pressure from ags AND deflationary pressure from real estate as credit gets unwound.

Lastly, I don’t have a chart for it, but I do want to highlight one other thing: geopolitics have been surprisingly calm in the news, pictures of civil unrest from Greece notwithstanding. But…Thailand is facing civil unrest, Israel and Iran are at a critical juncture, Russia is getting bolder, and today South Korea officially held North Korea responsible for the sinking of their boat a couple of months ago – just to name a few situations ready to provide fodder. Geopolitical risks remain and getting more contentious with the eurozone teetering, the US administration inwardly focused (misfocused?) and perennial troublemakers like Russia stepping it up.

Connecting the dots

There are so many things happening in the past few days, that it’s been hard to make sense of how they’re all related – but they are, and the signals are not good. In the end, we have to go back to valuations and relationships.

Equity markets are overvalued. No matter what valuation methodology I look to, the market looks overvalued by 30-50%. CAPE, Q-ratio, dividend yields, whatever. They all point to the same thing. I could be early. P/E ratios could expand from their current low 20′s. In 2000 they expanded to the 40′s. But the end result will be the same. Then there is the top-down approach. Stocks preform well coming from price instability toward price stability. Price instability can be either inflation OR deflation. Both are unstable. In the early 1980′s with rampant inflation (instability) we moved towards stability and stocks were able to perform well. We have now built a base of stability, which unfortunately means we will move towards instability. The longer we stay in this stable environment (ironically), the greater the danger that the developing fingers of instability will crack. P/E expansion cannot happen in this environment, so it won’t.

Treasury yields are heading higher. It doesn’t matter whether we move towards deflation or inflation. The worlds central banks are on a path of competitive devaluation and long-dated Treasury yields will have to rise (homegrown inflation and foreign countries no longer willing/able to finance our debts). Even in a deflationary environment, we will face higher rates. Economic books will have to be re-written, just as they were after the stagflation of the 1970′s. Bill Gross’s current piece is a must read, but I just want to highlight 2 paragraphs:

…In the U.S. in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don’t matter. Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.

The trend promises to get worse, not better. The imminent passage of health care reform represents a continuing litany of entitlement legislation that will add, not subtract, to future deficits and unfunded liabilities. No investment vigilante worth their salt or outrageous annual bonus would dare argue that current legislation is a deficit reducer as asserted by Democrats and in fact the Congressional Budget Office. Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money and that it is being “paid for” in the current bill with standard smoke, and all too familiar mirrors that have characterized such entitlement legislation for decades. An article by an ex-CBO director in The New York Times this past Sunday affirms these suspicions. “Fantasy in, fantasy out,” writes Douglas Holtz-Eakin who held the CBO Chair from 2003–2005. Front-end loaded revenues and back-end loaded expenses promote the fiction that a program that will cost $950 billion over the next 10 years actually reduces the deficit by $138 billion. After all the details are analyzed, Mr. Holtz-Eakin’s numbers affirm a vigilante’s suspicion – it will add $562 billion to the deficit over the next decade. Long-term bondholders beware.

Click here to access the full article.

Then we get to currencies. Competitive devaluations, entitlement programs, protectionism, tariffs, quantitative easing, and the rest of the games central banks and governments play are long-term inflationary on a global scale. However, on a relative basis, which the currency markets are, funny things are happening. The euro is getting hit from all sides, so the eurozone countries have to talk about its stability, even though they are probably secretly happy that the currency is depreciating. Good effect, bad reason. That puts pressure on the US, since a strengthening dollar is deflationary. Meanwhile, the Chinese are holding the yuan steady, but are getting pressure to revalue it upwards. The US is hoping that by getting the Chinese to revalue the yuan (and thereby devalue the dollar) they’ll get a bit of inflation pressure and maybe some uptick in exports. Slim chance. If anything, the Chinese recognize the US position and might devalue the yuan in a bold economic strategy to bolster their own position on the world economic stage. So the dollar is strengthening, even as no one really wants to hold longer term Treasuries. So where do you park billions of dollars when you don’t want to go out on the curve? The shorter the better, which leads us to one of the steepest yield curves in history, with funny inversions happening on the short end as money moves around and attempts to hedge other short end positions.

I can’t just leave the euro there. I continue to think it’s completely flawed. Worries over Greece have (finally) started to materialize. The initial pressure on the euro abated for a while, which I just couldn’t understand, since the problems were never about Greece (a small Euro member), but about Greece’s larger brethren. So now Portugal is in the crosshairs. (Read about the Fitch downgrade here.) We shorted the Euro and Yen in mid-November of 2009 (bought EUO and YCS – admittedly not the best implementation vehicles), but we were early.

That leads us to the yen. I must admit, I don’t get it. I’m short the yen, but I’ve been wrong for the past few months. It’s continued strength seems counter-intuitive (at best). The only explanation I have is that there is still some domestic support (which will end as the aging population uses it’s savings) and support from China and Europe who are uncomfortable with their own currencies. Otherwise, the Japanese might just be manipulating all the numbers. Either way, it’s will all end poorly for the yen, and I don’t think it will be long.

We haven’t even begun talking about commodities (bullish on some, negative on others), real estate (negative across the board; even more negative on Chinese real estate), and US Banks (still negative; think CRE).

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). The essence of the logic is that a profits increase, real estate owners will charge higher rents, thus limiting growth in profits. This increased rent leads to higher real estate valuations. On the downside, the same is true. Combined with 4 to 1 or more leverage, the moves have large implications for the economy, investments, etc. Thus, I was encouraged to read one of my favorites (Calculated Risk) write about exactly this topic: Housing: The Best Leading Indicator for the Economy. I wasn’t surprised that the conclusion was that our best case scenario is that “these leading indicators suggest any growth will be sluggish and choppy.” I will actually take it further to note that these figures don’t even account for the shadow inventory of homes (foreclosures at different stages, and people who have held off selling due to climate) and they do not account for the coming pressure on margins at each level of the chain. So I am even more concerned.The above post refers to an academic article, which you can download here. From that paper we can see the importance of being proactive when trying to contain a real estate bubble and the danger of powering it with easier and easier monetary policies.

Then, in the same breath, I read that mortgage rates are going over 5%. Read the full article here. They are still insanely cheap, but from a psychological perspective, or from a rate of change perspective, this doesn’t bode well, especially considering that the governments MBS buying program is supposed to end soon.

Gold is a favorite topic for readers, and I think discussions of gold end up leading to some interesting additional investment implications (we own gold in client accounts, along with other metals and mining shares). Well, I’m a bit confused. On the one hand, ft.com reported on Feb 18th that:

“For China, directly buying IMF gold has become far too sensitive an issue because it would send such a strong negative signal about the dollar and that would be extremely dangerous for their own holdings of US Treasuries,” says one senior dealer. “The publicity generated by India’s decision to buy gold from the IMF last year could have scared off other central banks.”

Read full article here.

Then, this morning, I read the following headline: Confirmation Of Chinese IMF Gold Purchasing Intentions? on zerohedge.com. And at the same time, Treasuries are rallying. So either the Chinese are not purchasing the gold or they are. If they are, it is not (not yet?) sending any negative message to the market about Treasuries. Should it? I thought so.

In the meantime, California canceled it’s $2 billion GO bond offering. Obviously. The state is on the verge of bankruptcy, so who wants to bid?

Separately, some of you may be following the double-standards and moral questions being faced by Apple over it’s wishy-washy policies over sexually explicit content on its apps. The main hypocrisy is that large firms, like Playboy and SportIllustrated’s swimsuit pictures and apps are OK, while smaller developers are getting censored, even when they’re not promoting sex. As a further insult, any user can go to safari and surf for porn directly, so it’s the app programmers getting squeezed. Anyway, I don’t really want to discuss the hypocrisy of our society’s view of porn, but something did catch my eye today: Wal-Mart bought Vudu, and online purveyor of movies. Now, Wal-Mart never pretends to be open minded like Apple, so it was without much fanfare that they decided to shut down Vudu’s adult section (Hot And Bothered: Walmart Shutting Down Vudu’s Adult Section). What is interesting here for me is whether Vudu will be as profitable for WMT without that section. I know nothing about Vudu’s financials, but I just have to assume not.

In the meantime, we have the healthcare summit, struggling markets, and weaker euro. We’ll have more on these later.

What we’re watching unfold…

Warning: This post has nothing new for readers of our newsletter. It’s just that things are unfolding almost according to plan, so we thought we’d put some of today’s headlines and moves in front of you, all in one place…

In no particular order:

• Italian derivatives draw scrutiny as Greece tensions heighten: Yes, Italy used currency swaps. It will turn out that others did as well. Are you surprised? 6 months ago, before anyone had coined the term PIIGS, we were discussing the crowded short USD trade, and the feeling that the markets were overconfident in Europe, even though it faced structural issues. The euro continues to face headwinds. Greece was the canary, but the real issue is Italy and Spain. We continue to be short the euro vs. USD.
• Coming Soon: Chapter 9 Municipal Bankruptcies: This was an interesting post about a little know quirk in bankruptcy law regarding municipalities. In essence, Chapter 9 gives municipalities protection from creditors as they work out payment plans. Guess who holds muni’s…yup, individual, taxable investors.
• PEW Study Shows Trillion Dollar State Pension Gap; Can Anything Be Done?: As if muni problems weren’t enough with tax revenues falling faster than expenses, Mike Shedlock highlights the looming pension shortfalls. If governments accounted for their liabilities like any corporation (other than Enron), they’d already be insolvent. We continue to hold no direct exposure to muni’s. When the stampeded out the door starts, every mutual fund and laddered portfolio will take a massive hit (and will form the basis of a once in a lifetime opportunity).
• Gold: I don’t want to write to much about this, but suffice it to say that Soros came out saying gold was in a major bubble (obviously hoping to talk the price down) as he accumulated one of the largest positions in the world. Read the full article on Soros here. Simultaneously, the IMF is selling some more gold (I won’t even link to it since it’s all over and is old news) and the market is waiting to see if India buys more (and front runs China again?). We’re maintaining our position in GLD, GDX, SLV, PALL, PPLT.
• Meanwhile, 10-yr yield is over 3.8%. We continue to have exposure to short Treasuries. Fun little graphic from Mike Shedlock here.

None of these are specific recommendations, since we do not know your particular situation. These are our thoughts and positions ONLY.

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.