Where to look?

There is so much noise that sometimes it’s difficult to focus. Today has seen some big moves across different asset classes, but I have to point out a couple:

• Silver making new highs. Without the fanfare of gold, silver continues to shine. I’m sticking to my original recommendation of splitting your precious metals exposure to silver, gold, platinum, and palladium. If it was happening by itself, I would say that it’s just a speculators game now. But it’s not. The precious metals are sending central banks a message. The metals were just a step ahead of bonds.
• Treasuries. Treasuries have rallied recently, but they’re struggling. Like a flurry in April, which signifies the death of winter, so too the recent rally is a fool’s bounce. Treasuries cannot be the refuge they once were; government policies have ensure that for the foreseeable future.
• Oil. Energy is a necessity, integrally tied to a country’s ability to produce good, but more importantly food. Instability in the largest energy producing region in the world will continue and provide a supply-shock-bid to the complex. I prefer the second derivative beneficiaries, namely, the domestic suppliers of coal and nuclear. Government policies will start bolstering these players as energy self-sufficiency will once again come to the front of the political debate.
• Emerging markets. Risk in EM countries has been underpriced for the past 10 years. Investors who piled into regions with no democratic and capitalistic foundations will have a tougher and tougher time getting out. Hopefully, investors aren’t holding large allocation to the region. Long term, I’m looking for opportunities to invest in India, not China; Brazil, not Russia.
• US equities. I have to throw in a mention. I am short IWM. Have been for a few weeks. Will stay for a while. Yes, I have long exposure in specific sectors and companies, but the overall market is unhealthy. I’ll have more to write about the specifics of equity valuation later in the week.

Relevant ETFs: GLD, GDX, PHYS, SLV, PSLV, IWM, RWM, TBT, TLT, INP, PALL, PPLD

Of carry trades and unwinds

As the euro vol spikes, not to mention every currency pair imaginable, we continue to look to the currency markets as THE story of the day. I’ve often discussed the carry trade, the systematic leverage, and the deflationary impact of the debt reduction. The next level of analysis is to try to measure the size of the carry trade globally. As funds reduce their risk positions, funding currencies become stronger (witness the yen) against the risk assets funded. But if we could measure the extent of the unwind, we’ll be able to know when the yen should stop appreciating, since no speculator would be purchasing the yen for yield (virtually 0%).

While there are numerous ideas we’ve explored, I would like to share 3 articles (one general, 2 academic) that might interest our readers:

1. Fears rise for dollar carry trade future, by Peter Garnham at FT.com

At the World Economic Forum in Davos last month, Zhu Min, deputy governor of the People’s Bank of China, spoke openly about his biggest fear for global financial markets in 2010.“To me, the big risk this year is the dollar carry trade,” he said “It is a massive issue. Estimates are that the dollar carry trade is $1,500bn – which is much bigger than Japan’s carry trade was.”

2. Risk and return in carry trade, by Imad A. Moosa:

By using six currency combinations involving two funding
currencies and three target currencies, analysis of historical
data from the recent past and Monte Carlo simulations show
that carry trade can be profitable if conducted over a long
period of time, but the risk involved can be high. The riskreturn
trade off does not exist in the rational sense (a high
interest differential is not necessarily associated with a high
volatility of interest rates, and vice versa), since there is no
clear-cut relationship between the interest rate differential
and the movement of exchange rate. With a positive interest
rate differential the exchange rate is as likely to rise as
to fall, thus a positive differential (no matter how big) is no
guarantee of positive return. A significant adverse movement
in the exchange rate could wipe out the carry trader
on a single occasion.

The results show that carry trade may or may not outperform
stock market investment, but on average the former
seems to fare better than the latter. However, there are
caveats that must be taken into account when one attempts
to reach a conclusion of this sort. …
Other caveats pertain to two points raised by Burnside et al.
(2006). The first point is that although the Sharpe ratios associated
with carry trade may look high, the amount of money
that can be made out of this operation is relatively small. On
the basis of their results, they find that to generate an average
annual pay off of one million pounds, the speculator must bet
28.6 million pounds every month. In general, very large sums
of money are needed to generate profit of reasonable magnitude,
which limits the usefulness of carry trade for individual
investors, who are typically unable to raise this kind of money.
In the aftermath of the subprime crisis, not even most institutional
investors can raise this kind of money. What makes
things even worse is that the bid-offer spreads are increasing
functions of order size, which means that the rate of return on
carry trade declines as the transaction size increases. A factor
with a similar effect is price pressure, which drives a wedge
between average and marginal Sharpe ratios. This means that
as the transaction size increases, the marginal Sharpe ratio
declines towards zero, although the average Sharpe ratio
remains positive. Big transactions are needed to earn more
money from carry trade, but the rate of return declines as the
transaction size increases because of the bid-offer spreads
and price pressure.

Another problem with carry trade is that, unlike stock market
investment, high Sharpe ratios do not necessarily represent
compensation for risk because the payoff is not associated
with standard risk factors. If we consider the interest rate
differential as the source of return and the volatility of the
exchange rate as the source of risk, then (as we have seen)
the risk-return trade off in a traditional sense disappears.
Finally, we must not forget that returns on stock market
investments do not only come from capital appreciation (rising
stock prices) but also from dividends, which are ignored
in this exercise.

Carry trade has become very popular because of the perceived
profitability of the operation. However, it seems that
carry traders have been oblivious to the risk inherent in
such an operation while concentrating on the interest rate
differential. Excessive enthusiasm about carry trade has
been a reflection of herd behavior, similar to what happens
in any market bubble (although carry trade is not necessarily
associated with a bubble). However, it seems that taste is
changing away from carry trade, as reports surface about
large-scale unwinding of carry trade positions by institutional
and individual investors. If Dennis (2007) is correct in saying
that “carry trade falls out of favour,” then it is likely that a
lot of people have realized, in hindsight, that carry trade is
not as lucrative as it once appeared to be.

3. Evidence of carry trade, by Gabriele Galati, Alexandra Heath, and Patrick McGuire at BIS

Interest rate differentials have been a driving force behind exchange rate movements in
recent years. This has focused market attention on the role of currency carry trade
positions, and on the possibility that a sudden unwinding might adversely affect
financial stability. However, carry trades are notoriously difficult to track in the available
data. This special feature first outlines the investor base and trading strategies used in
carry trades, and then explores various sources of data to gauge activity.

(This article points to some data sources at BIS for measuring size of carry trade activity.)

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.

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).

Notes from underground – Yra Harris

Holiday markets are in full swing and the lack of liquidity makes the financial arena treacherous to say the least. If you must trade be patient and wait for your levels as many opportunities arise in these types of markets. Most of the responses that we get on a daily basis are in reference to the DEBT markets. Most traders want to play the short side as they fail to see the logic of investors wanting to buy the LONG END of the curve. We always stress that as a trader one should not confuse Ought with IS. When a market won’t break on neutral to bad news it is telling you not to sell it no matter what you think ought to take place. Some group of investors see value in ten year notes at 3.4% or lower so just let the market find its next level of resistance. Everything in the world points to higher BOND yields except the daily action. No matter how bad the fundamentals, prices continue higher and that is to be respected. Remember, “markets can remain irrational much longer then you and I can remain solvent.”

Gold,equities, and currencies all rally–while the bond follows; and not just U.S. bonds but DEBT worldwide. Yes indeed, 2+2=5. Today we saw the release of the FOMC minutes and there was no great surprise. The monetary hawks were thrown a bone by the FED saying there was some concern that low interest rates could possibly cause an asset bubble and they would be vigilant. This is a meaningless statement as from Bernanke on down there has been constant reprise that monetary policy is too broad an approach to halt an asset bubble. So we pass this off as no great concern. Tonight the commerce reported that they were cutting the average duties on CHINESE STEEL PIPE [$3 billion worth] from 21.3% to 13.2%–throwing the CHINESE running dogs a bone–we will watch to see if there is any response from HU JINTAO and company. Also today we received word that WEST LANDESBANK had in fact been bailed out by the German government. They will infuse 3-5 billion euros and set up a good bank, bad bank format to offload the stressed debt. Short term effect has been to give some short term rally to the EURO but this is still a work in progress.

As we give thanks for all the good health and prosperity we have been blessed with, we will offer our thanks to all our readers and the high quality of discourse these NOTES have started to generate. Thank you everyone! One last thing we want to put on everyone’s radar screen. Two years ago we heard the constant drumbeat of how Sovereign Wealth Funds were going to be the scourge of America. The holders of U.S. dollars were going to come a calling as their depreciating asset [the DOLLAR] was going to return to its source for that is the only place it truly has any real value. Well the early movers into the U.S. markets were either blocked under the guise of strategic interests or else were badly burned on the assets they were able to acquire. If the DOLLAR continues lower and commercial real estate and other assets continue to decline in value these sovereign wealth funds will return in search of hard assets with a high return in mind. The question is not if but when–this well may the biggest story of 2010.

Notes from underground – Yra Harris

Notes from underground – Yra Harris

Notes from underground – Yra Harris

Europe on the brink of currency crisis meltdown

The financial crisis spreading like wildfire across the former Soviet bloc
threatens to set off a second and more dangerous banking crisis in Western
Europe, tipping the whole Continent into a fully-fledged economic slump.

Currency pegs are being tested to destruction on the fringes of Europe’s
monetary union in a traumatic upheaval that recalls the collapse of the
Exchange Rate Mechanism in 1992.

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/3260052/Europe-on-the-brink-of-currency-crisis-meltdown.html

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