The Euro in One Sentence

What has happened, it turns out, is that by going on the euro, Spain and Italy in effect reduced themselves to the status of third-world countries that have to borrow in someone else’s currency, with all the loss of flexibility that implies. (H.T.

Silver

A lot of people are upset that they sold silver too early. I get it. It’s surging, all the blogs are talking about it taking out the Hunt brother’s high of $50 and shooting higher, and there’s little faith in global fiat currencies, so the hard stuff is getting bid up. Then you have analysts talking about how precious metals are a small portion of investors’ global allocation; put it all together, and you have the recipe for a parabolic move.

I own silver as part of our precious metals allocation. A few years ago, I made the decision to allocate a not-insignificant portion to the precious metals space, and without knowing which metal was more attractive at the time, I split the allocation evenly between gold, silver, platinum, palladium, and gold miners. At the time, pricing any asset in these metals looked attractive by historical standards – it was the fat pitch I like to wait for.

Take a look at this chart of IWM:SLV

Is silver the fat pitch now? Not for me. As of earlier today, I sold SLV. If I’m bearish on equities and have short exposure to IWM, why would I continue to hold silver at these levels? Could it continue higher? For sure. However, my strategy has been to look for undervalued opportunities, investments that look extended, where selling is furious. Is silver providing that profile of undervaluation? No.

Some might argue that silver is just a currency, and that it is undervalued relative to the dollar. I get it. I totally understand that argument. Global currency traders can make those determinations for themselves. For asset allocators, or macro traders, or any investor that can choose different asset classes, there are other options.

As for me, a portion of the proceeds will be going into XLU:

Utilities are the most undervalued sector in the S&P 500, and provide a nice 4% yield while we wait.

Relevant ETFs: XLU, SLV, IWM, RWR, UUP

Right and wrong…

…or yen and euro. Long time readers know that I have maintained short exposure to both the yen and euro starting in November of 2009 – pretty long by currency traders perspective. I am staying with both positions, but one has been more right than the other, I’m just not sure why.

After toughing a 77 handle right after the tsunami, the yen has gotten progressively weaker and is now trading with an 85 handle. I get that, and I also maintain that it is the most vulnerable developed market currency at this point in time, so I wouldn’t be surprised if we see a 100 handle soon. Easy enough to hold on.

The euro, on the other hand, is more perplexing. We shorted it at 1.5, held on as it went to 1.2, and now are watching it break back up through 1.43. At the same time, Portugal is falling apart, Greece is already undone, and Ireland is shaving all the debt holders. More importantly, Spain is facing 20+% unemployment and about to face a major financial crisis of its own. Trichet has commented that the EU will focus on inflation pressures, signaling that they might raise rates. Two things can happen, rates will rise and the peripheral countries will fail bringing about the breakup of the euro, or Trichet will fall under the pressure and ease. Either way, the markets should be discounting the fact that in both scenarios the euro is in bad shape.

Some have stated that the euro is an FX vent as investors flee the yen. OK, but that is a two-sided statement. I understand the “flee the yen” side, but why flee to the euro? Almost any other currency seems in better shape, including multiple emerging markets currencies. See, for example CEW (no position):

Yet, they’re not outperforming the euro recently. Perplexing, to say the least.

Relevant ETFs: FXY, YCS, FXE, EUO, CEW

Gold update

It’s certainly making it’s way across the different newsletters that gold and silver at at multi-year or all-time highs, but I don’t see as much about it in the popular press…yet. I assume most readers are probably aware of the moves, but here’s a quick look through (as usual, we note the weekly):

Now check out the same chart, but denominated in euros:

Silver is really taking out each successive new high.

Lastly, both gold and silver are hitting highs in yen:

Now, why focus on the charts? Well, for starters, we’ve been discussing the new dominance of currencies in the investing equation. Without understanding the relationships and money flows, I think investors and traders may be missing a key component of drivers of performance. The other reason is to highlight that of the 3, the yen looks the most vulnerable. Now, it may be confirmation bias, since I’m short the yen, but the peaks in gold and silver are at least confirming it, and while they are not predictive (necessarily), it still points to being the right view.

I’m not a precious metals perma-bull, by the way, but at the same time, I’m sticking with my precious metals portfolio (GLD, SLV, GDX, PALL, PPLT).

Relevante ETFs: GLD, SLV, GDX, PALL, PPLT

Currencies dominate

For those with long enough memories, the current currency wagging the markets is reminscent of 1987. There, I said it. Portugal gets downgraded. Ireland is gonna haircut every debt holder. Etc. And the euro…rallies? Meantime, all the repatriation in the world can’t help the yen rally? Expected, but still brutal in its swings. And gold, after touching all time highs is selling off. Hmmm. Curioser and curioser.

It feels like the carry trade is back in vogue: sell the yen buy anything else. Now, I’m all for selling the yen. Those who bought EWJ as opposed to DXJ (as I recommended) will come to understand that it’s not your daddy’s markets any longer. You cannot invest in an asset class without understanding the currency implications.

On the other side, you have Bill Gross out with a new piece on America’s $65 trillion unfunded liabilities and the inevitability of higher rates. So the equity markets are going up by default, but I don’t think of their own volition and certainly not on the basis of their fundamentals. To which, I’ll remind readers that without the fundamental backdrop, this will not end well. I don’t mean to be a downer and I know I’ve been saying the equity markets are vulnerable for a long time.

For the record, our concentration in energy has led us to significant outperformance. Our positions in precious metals continue to make new highs every couple of weeks. Etc. I don’t need to go there.

Regardless, I anticipate that an event will come after a close, or over a weekend, or from a different field, that will shake the foundations of this equity rally. After the fact, it will be called a black swan and be credited with the gravity to bring equity prices down. In reality, it will be a grain of sand that randomly fell on a system fraught with fingers of instability, and as in every power law distributed system, the implications will be far larger due to the foundations rather than the immediate cause. And again, currencies will be the markets that lead.

Relevant ETFs: GLD, SLV, EUO, YCS, EWJ, DXJ, UUP, FXE, FXY

The dollar

The dollar is once again the most hated reserve currency in the world. European peripherals are breaking down, with bonds hitting all-time high yields in Portugal, Ireland, Spain and soon others. The yen is getting printed so fast we should have bought printing presses in anticipation. And yet, the dollar continues to be the currency everyone loves to hate:

Congratulations, Bernanke! You are winning the devaluation race. Keynesians can breathe easy that people prefer almost any other currency and asset to our USD. It’s actually a pretty optimistic view of our economic leadership – namely, they set a goal and they are achieving it. You might disagree with the goal, but you’ll at least agree that they are effective. Except…

I might be the only one out there who believes that the Fed is actually IN-effective and WILL NOT achieve its stated goals. This is a pretty pessimistic view, both of our monetary leadership, and the inflation stimulation that the world central bankers are hoping (praying/planning /depending on?) for. In my world view, Bernanke & Co. will not succeed in stimulating long-term inflation. Why? Because for all of their efforts, they will not be as able or driven to make the dollar less attractive than the euro and yen. In my worldview, the Fed is so ineffective that they won’t even be able to devalue properly. Trichet, in the meantime, with his high-handed talk of raising rates, will be unable to strengthen the dying currency beyond periodic run-ups. Lastly, the Japanese CB will be the only one that will finally win (by losing). The Japanese will finally break the bank and drive the yen to new lows that will remind the world of what an economic disaster looks like.

Will the Fed get what it wants and stimulate long term inflation by trying to devalue faster than everyone else? I think not.

Relevant ETFs: FXE, FXY, EUO, YCS, UUP

I don’t want to write about gold

I don’t want to write about gold and silver, but I just can’t help myself. Gold is at all-time highs and silver is at all-time ex-Hunt brothers highs. I don’t want to write about them, first because I already have exposure, second, because I’ve had exposure, increased exposure, and am not changing exposure. Lastly, I write about precious metals often enough that it feels as if there is nothing new to say. And there isn’t. In the grand scheme, gold and silver have been the longest consistently-used currencies in the world and all that there is to say about them has probably been said already at some point in the past. So I will only add a little tidbit here: what is the message implied by the rise in precious metals? Is inflation getting worse? Is this the end of fiat currencies? Are other commodities going to follow and reach new highs? If so, why haven’t they done so until now?

There is nothing new in these questions. The Roman Empire faced hyperinflation as the bureaucratic machine to manage far flung regions buckled under its own weight and successive emperors had to devalue the currency, leading to massive food inflation. On the flip side, the Great Depression led to such widespread fear that cash AND gold kept their value, while the price of almost everything else went down. Of course there were differences, so it’s not a one-to-one comparison, but rather just an acknowledgment that the questions we face now are not new.

I have written before that gold will peak on fear, not greed. The next step is to try to figure out fear of what. Is it fear of the end of fiat currencies or fear of the destruction of value in other asset classes? Certainly, at some point, even gold bugs will have to admit that the S&P priced in gold can become cheap:

I’m not saying we’re there (I’m long gold, short equities), but that the day will come at some point. This entry is only to serve as a thinking point for what will the peak in gold look like. Will equities bottom out as gold peak? Or will gold and equities move in tandem against the USD? I’m not sure and a lot of the traditional analytical tools we have at our disposal are limited in their capacities to anticipate the unimagined. So we’re left with sentiment and gut. For now, my bias is that equity markets are the overpriced assets, even against fiat currencies. However, I’m not so confident that I’m adding to my short exposure. Limiting position size can be just as important as the position itself in these environments.

Relevant ETFs: GLD, SH, SPY, UUP, SLV

Euro holding up, all considering

Considering the fact that Portugal just lost it’s government after its Parliament rejected a deficit-cutting plan. What happens next? Well, some combo of Germany, IMF, US, and China comes to the rescue. My bet is that the Chinese have the biggest vested interest in holding the euro up, since they are trying to stimulate without stimulating and the need Europe as their biggest trading partner to continue purchasing their overcapacity. I’m not optimistic about the euro. Then again, I haven’t been optimistic about its prospects for a long time (yeah, I prefer looking at the weekly chart):

And here’s gold in euro:

I have been short euro since November 2009 and have not added/subtracted to/from the position in that time. I’m now analyzing whether this is a good opportunity to add to either a short euro/USD or short euro/gold. I’ll keep you posted.

Relevant ETFs: FXE, EUO, GLD, UUP

Always looking for the ugly duckling

And right now, there’s one asset that looks pretty ugly…

What if I told you there was an asset that was sitting at 52-week lows. It has some negative fundamentals, and a few relative positives, but no foreseeable absolute positives. Long term, this asset has very little cashflows, is difficult to value, and everyone thinks is worthless. It has the potential to become a huge value trap. It has a brand name which has lost global appeal. It is vulnerable to macroeconomic whims of politicians. I can go on and on about the negatives and positives, but will say one final bit: almost everyone has some long exposure to it already and almost everyone believes that it will go down in the near future.

The asset, of course is the US dollar:

While I don’t know that this is the absolute low for the dollar index, I do have to wonder: how much of the bad news is already priced in? How much of the inflation fears are already priced in? How much more strength can the yen and euro (which together account for around 70% of the index) exhibit? I’m already short yen and euro in various vehicles, and I have to admit that I thought dollar strength would become evident as geopolitical turmoil generated a flight to safety mentality. The fact that this did NOT happen leads me to believe that either the US dollar is no longer the safe haven recipient or investors did not actually seek safe haven storehouses at all. The latter is hard to argue, since gold, the other safe have stand-by, continues to approach all-time highs.

Maybe that’s the end of the story. Investors have flocked to gold as the de facto reserve currency and are expressing their fear through the yellow metal rather than the greenback.

The flip side of that is that the dollar is still just a fiat currency and as it has gotten weaker, the euro and yen got stronger, presumably on weaker fundamentals and weaker demographic and tax bases. So I’m not that quick to draw the above conclusion.  There is nothing for me to do with this view right now, but – in line with our thoughts on everything being relative – we can wait and watch, because I believe there is an opportunity forming.

Relevant ETFs: UUP, FXY, YCS, FXE, EUO, GLD

Which is the risky currency?

What if the Swiss Franc becomes the risky asset? Crazy? Perhaps, but stick with me for a moment. Readers know that I don’t like the euro long term. Structural problems between fiscal and monetary policy, rich vs. poor, etc. all make it an unviable alternative for the long term. And yet, the Swiss, in their efforts to weaken their own currency, have bought a lot of euros. For starters, they’re sitting on a ton of losses as the CHF became the asset class of choice as global turmoil in the Middle East and Japan has unfolded.

Now, what happens, when the Swiss realize they’re sitting on a pile of worthless euros. Sure, they’ll repatriate, but what about the rest of the world that used them as a safe haven? Well, they’ll have to find something else, and I don’t know that they’ll rush into US treasuries any longer. I think this will end up being an ongoing discussion going forward. For now, check this out:

Sure looks like in the flight to safety, emerging market currencies were seen as the risky ones, while CHF was the safe haven. Again, what if it’s the opposite? Just a thought.

Relevant ETFs: CEW, FXF, EUO, FXE

Japan down 14%

Yes, you read that correctly. Japanese stock markets are down 14% and have in 2 days experience more than half a trillion dollars in wealth destruction. There are separate conversations to be had…

First, there is the human tragedy. On top of losing homes, jobs, schools, etc. in terms of infrastructure, millions are left stranded without water and electricity. To really top it off, now millions will lose invested wealth and face an investors worst-case scenario – permanent loss of capital. No amount of standard deviations does that type of risk justice on the human level.

Second, and a distant second at that, is the conversation about the investment implications. I have viewed Japanese companies as undervalued on their own after being down roughly 75% from their peak in the late 1980′s. On top of that, they are facing favorable headwinds with a relatively strong currency (relative to their tax base, demographics, etc.). So a currency hedged investor should do well in the long term. I continue to view those shares as an opportunity and will look for selective entry points to add exposure.

Lastly for tonight, there are the additional implications felt globally. Nuclear energy firms, a portion of my energy overweight, are under significant stress, while on the flip side, my exposure to natural gas has benefited. Overall, I am maintaining my exposure to energy and will look to gain exposure to specific uranium related companies in the next few days and weeks.

The US equity futures, on the other hand, are pointing to a significant gap down tomorrow morning, and assuming they don’t rally may provide a bounce for the active trader. However, I am short the US indexes, and will not be covering. I will not add to the position here, but my valuation metrics continue to point to increased P/E compression. In a scenario where we face a worldwide economic slowdown, coupled with relatively high energy costs and continued margin compression, inflation fear mongers will look silly. Deflationary pressures continue to be the main risk, and in that scenario, we will first have significant margin and valuation compression, and then will actually bottom on high P/E (low q-ratios). The reason for this counter-intuitive statement is that in a deflationary environment, the E goes down, and for a while the P goes down fast. Eventually, the P stabilizes, while the E continues to go down. In that scenario, P/E will no longer be a good valuation measure, and investors must focus on q-ratios to understand replacement cost, return on assets, and the setup for the eventual price stability and upticks in inflation.

We have years for that to happen. I am not a buyer on the dips.

Relevant ETFs: DXJ, FXY, NLR, RWM, SH, SPY, IWM

Asia is the real story

The world is worried about oil, and rightfully so. The Middle East is in turmoil – I get it. However, as an investor, now is the time to focus on the marginal buyers and sellers, and while securing energy supplies is a key theme for my energy focus, I am now more focused on the stories that are being under-reported in Asia.

Yesterday, I mentioned the social unrest that is happening in China, which few are talking about. The day before we pointed to the bank runs in South Korea. Today, Bloomberg ran a story with the following heading: “World’s Biggest Pension Fund ‘Will Likely’ Sell Japan Bonds” (h.t. Mish’s Global Economic Analysis). Here are the opening paragraphs:

Japan’s public pension fund, the world’s largest, said it may become a net seller of bonds to cover payments in the world’s most rapidly aging society.

The Government Pension Investment Fund, which oversees 117.6 trillion yen ($1.4 trillion), in September forecast that it would sell 4 trillion yen in assets in the business year ending March 31 to fund payouts. Sales may be less than that in the year starting April as bonds reach maturity, said Takahiro Mitani, president of the fund, known as GPIF.

Why is this important? Because internal purchasers, most notably the pension system, have allowed the Japanese government to continue printing endlessly, and have made Japan the single most vulnerable developed country (in terms of finances, not politics). If Japan’s pension plans will become net sellers, the governments printing will only exacerbate the increase in yields and will force either a massive cut in spending, massive cut in entitlements, or massive inflationary pressures. This is zero hour for Japan. It also does not bode well for local Japanese sellers as they’ll face ever-higher input costs. It could be OK for exporters who will benefit from currency differentials, although that might be negated by internal taxes and politics. I’m staying short the yen and will look to increase the position in the next few months.

Japan’s example should serve as a warning for governments and inflation-mongers alike. Governments can print endlessly and still face deflationary pressures for years and decades, with no net benefit, and with huge eventual costs placed on their citizens.

Relevant ETFs: YCS, FXY, DXJ

Nothing to add

The US markets are closed for Presidents Day – and what a day it is. There are endless stories going around about Qaddafi escaping to Venezuela with gold and what-not in tow. I don’t know. I have no good sources for that kind of information. What I do know, is that our concentration in precious metals and energy was prescient. I have continually written that geopolitical risk and global social unrest are being underpriced – and I continue to believe that. Industrial commodities, which depend on marginal demand staying high and rising (read: China) seem to be a risky speculative punt right now. Copper is only a NEED when housing is ramping up alongside production. Right now, it’s just a want. The 4 staples (wheat, corn, soy, and rice) along with energy, are the NEEDS. Meanwhile, safe havens are becoming NEEDS as well. Silver is hitting $34 and heading towards the all-time Hunt-brothers high of $50, except this time, it’s widespread. Gold, too, is heading up. I’m just holding (remember, we ended up allocating our precious metals portfolio to gold, silver, platinum, and palladium, along with some gold miners).

Lastly, equity-land should start shuddering a little. Aside from the market going higher on ever decreasing volume, the fundamentals and prospective fundamentals (with decreasing margins) are horrible. When the coming correction finally arrives, pundits will talk about the triggers as black swans. While no one I know could have predicted the specific order of events, social unrest and instability was a given. In fact, I think it could go further, as dictatorships and extreme market manipulators face increased pressure. This will be a direct threat regimes in Africa as revolts start spreading southward, to the Chinese political power structure, and South American strongmen. We’ll just have to see how it plays out.

Relevant ETFs: PALL, PPLT, GLD, GDX, SLV, PHYS, PSLV, USO, XLE, NLR, KOL

Have we seen the top in Yen?

I’ll admit that I’m biased. Japan’s macro-economic picture has looked bleak for years, and in late 2009, after months of researching, I determined that I wouldn’t be able to find the absolute top, so I initiated a short position in the yen. My timing was early – not unusual – but the data continued/s to support the thesis that Japan has finally reached a point where tax revenues aren’t covering interest payments, demographics aren’t improving, and the government policy is working against any yen strengthening. Taken together, these factors have given me confidence in my position.

Some might argue that G3 currencies are all doomed together, but I still believe there is a relative advantage to the USD. That being said, I am also short yen versus Japanese equities, with the thinking that when the yen finally breaks, equities might benefit, especially given their current undervaluation on an absolute level.

Here’s the weekly chart for the yen:

Relevant ETFs: YCS, FXY, DXJ, UUP, UDN

Short euro position

I haven’t touched this position since March 2009! How’s that for taking a position. We sold the euro well at around 1.49-1.50. I’ve been bearish on it the whole time and continue to only get more worried about the structure. I saw the position work in my favor and then come back, with talk of the euro regaining reserve currency status abounding. Today, for the first time since 2009, I changed my position: I shorted the euro, again, adding exposure (or initiating it for newer clients).I’m not big on trading in and out, so positions are always limited and within our risk parameters to allow us to hold on through a lot of volatility.

Relevant ETFs: FXE, EUO