If you look at nothing else today

If you look at nothing else today, you must look at bonds.

Let’s go from shortest:

All the charts are weekly to give you a sense both of the magnitude of the current move and the potential for a continuation in the rise in yields. The short end has the most to catch up and we can see the historic steepness starting to come in:

Equities, in the meantime, are either blind to the turmoil in bondland or else have become the safe-haven trade. Really? Equities as the safe haven? BBY should at least give us a clue that valuations are priced for growth, increased leverage, etc. which probably will not happen. Any miss will be punished brutally at these levels. This is a set up. Even if we break through upside resistance, my estimation is that we are extended and overvalued, and that any rally is an opportunity to lighten up exposure.

What’s surprising today?

Markets are down, European liquidity is strained (check out LIBOR-OIS), oil is under $74 (under $73 as I update this), Spanish banks are sick, and more, all of which we’ve been discussing the past few months, and none of which is surprising. I thought that instead of talking about the same stuff we already know, I’ll point out some surprising moves today (in no particular order):

• Treasuries are going higher in a safe-haven bid (or maybe deflation sign), but gold isn’t. Gold has gotten the safe haven bid along with treasuries for a while, but today, that relationship isn’t holding. Who’s liquidating and why?
• The euro is acting much stronger than I would expect. Up 1.7%? What’s the unwind? Are investors covering euro shorts here or initiating new USD shorts? Not sure, but it’s surprising given the bad news out of Europe.
• Yen’s continued strength is surprising. The carry trade continues to get unwound and the yen is finding a bid. Will it break below 84? I’m short the yen for fundamental reasons (including bad demographics, insane debts, and lower exports due to world slow-down), but maybe the unwind can provide more support for a long time coming.
• Goldman staying strong is surprising. XLF is weak, but somehow GS is bucking the trend.
• AAPL upgraded by JP Morgan. Are they dumb? Or am I so behind in my understanding of tech that when I see all of Apple’s products as luxury retail I’m being the dumb one?
• I don’t want to jump on the bandwagon, but I am pretty surprised that BP can’t get a handle on this leak. I’ve heard reports that there are thousands (yes, thousands) of suck and salvage ships waiting to be deployed but being held up for political reasons. I’m not deep enough in the space to know if that’s true, but if it is, it’s an embarrassment for BP but even more so for our leaders (on all sides). The entire situation (except the accident) is surprising.
• Anyone buying Tesla shares is surprising.
• 3x levered bond ETF’s? Now? That’s surprising, but maybe I shouldn’t be.

I’ll stop there for now.

Ratios, gold, and reflation

For most people, thinking in terms of absolute returns is natural, thinking terms of relative returns to a benchmark has become acceptable, and thinking in terms of relative returns between asset classes is far off. At it’s simplest, by making an investment from cash holdings investors are making a relative consideration: the investment should outperform cash over the anticipated holding period. Sounds pretty straight forward.

In the past 5 to 10 years, charts showing the Dow vs. gold have been floating around. While it sounds simple, this basic premise is actually at the heart of investing and a focus for macro traders. Currency investors are used to thinking of investments as relative between pairs of currencies, or in complex strategies, relationships between multiple moving yet interrelated parts.

Why all the intro?

Recently, I’ve been speaking to a number of traders and investors about the inflation/deflation debate and it’s implications for investors in the future. One trader (H.T. Macro Man) in particular prompted me with a seemingly simple thought: it’s not whether you’re long or short – it’s WHAT you’re long and short, as massive rotations, rolling bubbles, and inflation/deflation get implemented across and within asset classes.

So today, I want to highlight a couple of the ratios we’ve started exploring with some of the implications:

Everyone knows that gold has been going up.

As it has, if we start looking at other assets priced in gold (I’ll use GLD as a proxy for our conversation) we start seeing some potentially undervalued opportunities.

(Source: The Big Picture)

It doesn’t mean the S&P is cheap, nor gold expensive, but the S&P priced in gold is certainly not as expensive as it was just a few short weeks ago.

But to continue our exploration…

Check out the agricultural sector (DBA used as proxy) priced in gold:

In 2005, Marc Faber discussed asset inflation vs consumer price inflation in his Gloom, Boom, and Doom Report and included a discussion of gold as an inflation hedge. The conclusion was that gold was a better hedge for deflation, perhaps as we’ve seen in the recent action, while agriculture was a better inflation hedge. Could the extension of this ratio signify the end of deflation and the beginning of inflationary pressure?

What about moving away from commodities and looking at some other relationship? As readers know, I’m not a big fan of the euro. Traditionally, bad political structures lead to significant underperformance over the long term. In that light, we have distrusted China, Russia, and the euro (the currency not all European firms). Last week we looked at putting money to work in Greece (while short the euro), which has turned out OK so far, with both NBG and OTE holding up nicely from our entry point. But what about the larger picture of the eurozone countries? I’m still pretty negative long term on the euro, but look at the relationship between EZU vs. SPY:

There is a good chance the relationship will get more extended before reverting, but it’s worth noting that at some point the eurozone countries will become a significantly undervalued relative to the S&P.

Lastly, Gartman brought up this relationship recently and it’s one a lot of traders I know have been looking at: euro/yen. While I’ve been focusing on the euro/usd, and anticipate that it will continue to weaken, euro/yen has broken down after having been in a relatively tight range:

What does it tell us? Money is coming out of the euro and going into yen. Risk is being taken off the table as carry trades are unwound and money is going back into funding currencies. This has obviously been a problem for both the US and Japan which are themselves trying to stimulate inflation. Japan has already announced additional quantitative easing, and the US is sure to follow…which leads us back to where we started…

Money will need to find a home in an environment of competitive devaluation, and while deflationary pressures have “won”, I believe that we are close to a turning point. I anticipate that it will translate into a challenging environment for bonds (increasing rates) and a potential opportunity for agricultural related investments (certainly relative to other asset classes, if not on a local currency basis). I’ll continue exploring implementation methods in the upcoming weeks, but I’ll certainly be looking at the ratios to find the undervalued assets.

Signs from the 7-yr auction

Not a good auction might be the understatement of the week. Bonds are telling us something, and it ain’t good. For starters, we’ve seen the benchmark 10-year yield rise to the highest it’s been in weeks, and it could easily approach 4% in the next few days at the rate it’s moving. We’ve been bearish on Treasuries for a while, but maybe the market is starting to agree. Watch the 10-yr for signs.

Throughout it all, the equity market seems to be completely oblivious to the implications of higher rates. Is the market piling into equities as a pressure release on expectations on inflation? I don’t know. The move higher in equities might just be month/quarter end buildup and nothing more.

Treasury Sees Tepid Demand for 7 Year Notes

By Deborah Levine

NEW YORK (MarketWatch) — The Treasury Department sold $32 billion in 7-year notes on Thursday at a yield of 3.374%, higher than traders anticipated. Bidders offered to buy $2.61 for every $1 of debt being sold, compared to an average of $2.83 at the last four sales, all for the same amount. Indirect bidders, a group that includes foreign central banks, bought 41.9%, versus an average of 49.7% of the last four. Direct bidders, a class that includes domestic money managers, purchased another 8.1%, compared to 11.3% on average. In the broader market, long-term bond yields, which move inversely to prices, turned higher before the auction results were released. Yields on 10-year notes rose 3 basis points to 3.89%, after jumping by the most since last summer on Wednesday.

Also, see this article from ZeroHedge yesterday about the move in 10-yr. I’m not a technician by trade, but for those out there who lean that way, this has some interesting insight. Click here for the article.

First on the daily triangle chart for the 10Y future, we show that we are potentially in a triangle formation and are approaching the support which I see at 115-24 here. The reason why the triangle formation is seductive because as highlighted for other markets, AUDCAD is in a massive triangle consolidation, and so is the Shanghai composite (more on this lower). Hence a similar configuration in rates does make some sense. Should we break below this level, the two key levels below are 114-30 and 114-13. As  can be seen on the daily chart, they correspond to the 2 necklines of 2 huge head and shoulders. These support levels are the key boundaries I indicated in my annual letter at the start of 2010. I personally do not think we will bypass them to the downside, but beare if we do, it would open the flood gates. Given how equities perform under higher yields and the pile of debt accumulated, I think yields rising in itself would bring back some risk aversion that would defeat the yields move up. Think of it as a dog biting its tail.The other consideration is that if we are indeed in a triangle formation, then the next leg is in theory up as this is a continuation pattern within the trend. Therefore I think shorts who have accumulated money on the downside should be careful as we move close to this cluster o supports, the next 20 bps will be hard to get through.

News, News, News – Ignore it all

The story is in the Treasuries. Equities, currencies, commodities, real estate…they are all secondary to bonds. If you want to read something, read this: http://www.simoleonsense.com/?s=montier (James Montier interview from yesterday).

It makes me uneasy when too many people agree with me…

All over the place, I see signs that people agree with me, and it’s making me increasingly uncomfortable:

1. The End of the Bond Bull Market: Barry Ritholz writes in The Big Picture that the bond bull market we’ve been seeing since 1981 looks like it might be ending. He uses charts to like this to make his point:The problem is that I agree with his assessment. The model for the monetary authorities was Japan, which was able to ramp up QE, keep zombie banks alive for 20 years, and borrow at 0%. The US, however, is not in the same position. We are not a nation of savers, like the Japanese, so we can’t self fund our low rates, for starters. Our QE will not end with low rates.
2. We spoke weeks ago about going long the dollar versus the Euro and the Yen. Part of the motivation of that trade was that speculative positions had gotten too one-sided against the dollar. Another part was the insight that Europe and Japan were not in better economic positions as the currency market was implying. Well, that too seems to have become more mainstream as the DXY has gone from low 70′s to high 70′s-low 80′s. And then I read that there are the largest ever speculative short positions against the Euro: http://www.ft.com/cms/s/0/0330ba78-149f-11df-9ea1-00144feab49a.html. Now $8 billion might not sound like a lot given the numbers our Congress throws around, but it is a large floor (implied bid) for the Euro as these shorts need to cover at some point.

Just some morning thoughts.

Pimco’s Gross boosting cash position

Yes, cash is an asset class. And yes, some of the best managers use it, especially if they see opportunities on the way. This move by Gross (to raise cash) is actually incredibly deflationary on his part. It’s saying that cash will outperform bonds. Cash hoarding in anticipation of lower prices is a deflation bet and I believe others are moving in that direction more and more, not willing to lend out their cash, even to sovereigns…even to Uncle Sam.

http://www.bloomberg.com/apps/news?pid=20601087&sid=afujGCGEdlp8&pos=3

The fact that Congress is raising the debt ceiling, certainly doesn’t lend confidence to the Treasury market, especially given last weeks performance : http://www.marketwatch.com/story/house-aims-to-pass-debt-increase-jobs-bill-2009-12-16

Notes from underground – Yra Harris

Fed’s Evans: Rate Hikes ‘Some Time Down the Road’

This is from the WSJ today … speaking at the Council on Foreign Relations, the Fed’s Chicago President, Evan’s, stated that interest rates will rise at some point, by some amount in the future. Is this even news? Is that surprising? The question for investors now, as always, is what predictive value does this contain? We will always point to the three requirements for predictive value: does it give us insight into timing? magnitude? or location of impact? Any 2 out of 3 are not sufficient!!! So let’s look…timing: sometime in the future. magnitude: he’d be a fool to quote that at this stage of a recovery. where will it impact: well, first order will be the bond and fixed income world, second will be everything else that depends on financing. Hmmm. Can’t take that anywhere.

While interest rate hikes lie some time off, it’s likely a future tightening cycle will have to be more aggressive than what was seen over the last cycle of raising rates.

 

“We are going to want to be more aggressive” compared with the tightening cycle that occurred between 2004 and 2006, Federal Reserve Bank of Chicago President Charles Evans said Wednesday.

 

That tightening cycle was referred to as gradual and occurred in modest, steady increments. Evans said the pace of action then was not a major driver of the housing and financial market problems that ended up causing the recession. Instead, the official said that the Fed could have likely reached the end point of its rate hike cycle more quickly and that bigger rate hikes would not have been particularly harmful to the economy.

 

Evans also said that when it comes to rate hikes and major unwinding of other emergency support programs now, a shift lies “some time down the road.” In reaching a determination of whether rate hikes are needed, Evans said that “we are going to be looking very carefully at how the economic recovery is preceding,” and will be watching inflation and unemployment measures.

 

“As the economy continues to improve, and when we see rising inflation pressures, Fed policy will respond aggressively,” Evans said. When the time does come to raise rates, “we could have a pretty reasonable withdrawal of accommodation.”

 

Most Fed officials who have spoken recently have offered similar sentiments, and indicated the current zero percent interest rate policy stance will be maintained for some time, likely into 2010.

 

Evans added that he would prefer to see inflation at 2% and noted “at the moment we are under-running that,” amid price pressures that are “relatively muted.”

 

Evans sees inflation ranging around 1.5% and said expectations for future price gains are “pretty anchored.” He also said “neither a harmful deflationary episode nor a repetition of the Great Inflation [from 1965 to 1982] is very likely.”

 

The official said more broadly, the recovery “is beginning to start” and growth is likely to range around 2.5% to 3% into next year.

 

Evans was speaking before a gathering held by the Council on Foreign Relations in New York. The policy maker is a voting member of the interest rate setting Federal Open Market Committee. He spoke as the economy appears to be emerging from the worst recession since the Great Depression, amid continued trouble in labor markets.

 

He foresees continued trouble in the employment sector, and reckons the unemployment rate, now at 9.7%, will breach 10% before moving downward.

 

Evans expects the central bank to buy all the mortgage-backed securities it said it would buy, even as the economy shows signs of recovering.

 

“It’s a fair question” to ask if the Fed needs to buy all the securities it had originally planned to buy. “I would expect we continue with the entire amount” given the beneficial impact the program has had so far, Evans said.

 

He was referring to the Fed’s plans to buy up to $1.25 trillion in agency mortgage-backed securities and $200 billion in agency securities. The Fed will wind up a program to buy $300 billion in Treasury debt in October, having extended the buying period but not the size of the effort.

http://blogs.wsj.com/economics/2009/09/09/feds-evans-rate-hikes-some-time-down-the-road/

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.

More thoughts on TBT

For starters, I received a lot of feedback on my post 2 weeks ago where I mentioned feeling uncomfotable with TBT. We didn’t get out much higher than here, but I can tell you that I still feel uncomfortable with TBT as the vehicle of choice. There are 3 questions that we ask ourselves at each juncture:

1. What is the investment thesis?
2. Is this thesis the best allocation of our cash at this time?
3. Is this the right vehicle to implement our thesis?

The thesis behind TBT (for us, at least) is that at some point foreign governments will require higher interest rates, that at some point investors in general will want to sell some of their Treasury holdings, that at some point government spending will outstrip the US borrowing capacity, and other variations of the same theme. That thesis may or may not be right at these levels, but at some point in the future there is a good chance (again, in our minds) that this will occur. Second, is this thesis worth an allocation? Yes. Simply put, there is a higher return associated with this thesis than keeping our money in cash. Lastly, is TBT the right vehicle? Not for us. Multiple things are working against TBT as our vehicle of choice. For starters, the levered nature and daily resets work against us and eat our returns. Next, TBT has been the vehicle of choice for hedge funds and retail investors alike, and we don’t like being in the same trade as so many others. Lastly, there is more return available in understanding why Treasuries will rally or sell-off and implementing THAT thesis rather than just taking a short Treasuries (long TBT) position.

THAT thesis that I’m mentioning is more convoluted, and has been the ongoing debate on these pages of inflation vs. deflation, currency death sprials, etc. Until we get a handle on THAT thesis, we’re staying on the sidelines. For us, that’s the right trade; maybe because it is also the hard trade.

Moody’s may downgrade California…

This shouldn’t be a surprise to any of us. It’s been in the works for a long time and advisors who reached for yield in muni’s will get withdrawals at the wrong time. It might lead to interesting opportunities in some of the closed-end levered muni funds.

http://www.marketwatch.com/story/moodys-may-downgrade-california-a2-rating-20096191144270

Connect The Dots 06-05-09

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

ECB’s Bini Smaghi Says Market Mistrust May Hit States

GOVT BONDS (over 2yrs in duration) should be avoided imho.

Feb. 12 (Bloomberg) — European Central Bank board member Lorenzo Bini Smaghi said he’s concerned investors could lose confidence in governments unless they contain spending, raising the threat of a crisis in national finances.

“There is a risk that the mistrust that there is today in financial markets, in the banking system, is transformed into mistrust in states,” Bini Smaghi told the European Parliament in Brussels today. That could hobble the ability of some countries to issue debt, which would be a “financial crisis of the state.”

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