Currencies and 1987

Remember the fateful day in 1987? Judging by the profile of most of our readers, probably not, but you may have read about it. So let’s review. Market gyrates. Currencies are exhibiting massive dislocations. Government officials step in (over a weekend) to talk one currency down. Globally, everyone believes that an Asian country will buy up the US (remember the movie Gung Ho?), that US manufacturing is done, and that US workers are fat and lazy. We have the largest housing crisis imaginable looming with the S&L crisis. Yikes! Sounds eerily similar. For those of you who looked into Boom Bust http://www.amazon.com/Boom-Bust-Prices-Banking-Depression/dp/085683243X/ref=sr_1_1?ie=UTF8&s=books&qid=1255459441&sr=8-1 the 18-20 year cycle with mid-cycle slumps should come as no surprise.

And so, while I’m not convinced by this rally in equities at all, I’m equally unconvinced by the decline of the dollar. There is a big disconnect between bonds holding up, declining dollar, rising gold, rising equities, and the macro picture (jobs, real estate, govn’t spending). Some market is sending the wrong signal…I just don’t know which one yet.

Connect The Dots: Week Ending 06.12.2009

Last week was full of charts. This week, let’s discuss some of the main themes we’re witnessing.

The equity markets were relatively tame this week. Gold, oil, and agribusiness industries showed big moves, but not in the same direction. All eyes were on interest rates and more specifically the steepening yield curve. As I mentioned throughout the week, the US’s ability to garner the worlds savings a plow them into our ever increasing supply of Treasuries will end at some point. For a long time, my focus was on maintaining a short Treasuries position through TBT and futures positions. I am no longer comfortable with that trade. The long term position still makes sense, but the implementation has become more difficult. There are now endless pundits talking of inflation risks, hedge funds piling into TBT, and short US dollar positioning. I just don’t like it when so many people agree in such a short period of time. Just a few months ago, we were in the minority as survey after survey showed most money managers believing deflation was the main problem. I can’t help but believe that most of them will end up being squeezed. Look at the 2-10 spread below. The steepener trade has been all the rage of late hitting ALL TIME highs early last week. Things settled down a bit toward the end of last week and the steepener has continued its correction this week closing at 2.50. Thatsabet and I disagree on how long the correction could last. He is looking at around 2.30-ish as the limit; however, I believe that it depends on who is going to get caught on the wrong side of this move. We might see some big names being squeezed and have to push yields on the 10 year back down significantly.

(source: Bloomberg)

It will be interesting to see this unfold in the next few weeks. What we are witnessing is a two-faced market. On the one hand, there are clear signs of inflation. Oil has doubled off its $35 lows and is now above $70. The steepening yield curve can signal inflation expectations rising (as investors don’t want to hold long term fixed income instruments). And, since inflation is always and everywhere a monetary phenomenon, dollars continue to be pumped into the system through the ballooning of the Fed balance sheet (quantitative easing) and the USD is facing significant strain.

On the flip side, we have deflationary pressures continuing. Job losses and recessionary pressures are continuing. Real estate deflation continues in virtually every segment as rental yields continue to decline. Companies face continuing pricing pressures with no ability to raise prices. The best business to start these days appears to be a bank, with government subsidies and a steep yield curve, a regional player with no legacy portfolios is a no brainer.

Can the Fed increase interest rates here? I don’t think so. Can they stop buying 20-30% of every auction? I doubt it. So the inflationary pressures will continue. Yet simultaneously, I don’t see margin expansion and earnings power returning to companies. So I’m wary of the pure inflation story.

Some other notes we made from conversations this week. Some advisors out there are encouraging clients to move into credit and high yield, even as they are warning against investing in equities. This seems somewhat incongruous. For high yield bonds (junk bonds) to provide adequate return, these advisors must believe that the yield and capital appreciation available will make up for the higher default rates we have been witnessing. If they believe that these companies will be able to pay back the 15-20% interest rates on some of these bonds, they must believe that the companies are going into an earnings environment that will support those payments. Additionally, these same advisors are now mentioning gold and inflation protection in the same presentations. Hmmmmm. If inflation is indeed coming, I wouldn’t want to be in a fixed income instrument. If earnings and margins will improve, I’d also rather be in stocks than bonds. Separately, if earnings won’t be improving, then the junk bonds won’t provide me with the returns I seek. High yield spreads need to get wider in this kind of environment for me to find them attractive enough.

Paulson is buying CBRE. I don’t like being on the other side of the trade from Paulson. The Ultrashort Real Estate ETF, SRS, a favorite of day traders and amateur traders, has gone from $60 to $18. For those still holding on, just know that the numbers from daily compounding are working against you. Say thank you for the $18 and walk away. There are other ways to short real estate if you want to take the other side of Paulson.

Lastly, I just want to note a couple of important points we can’t take our eyes off of.

In the currency markets the USD has continued its correction but the possible basing pattern continues. Should DXY hold 79 and proceed to take out 81.5 we could have a target toward 84. Thatsabet believes this would be a negative for equities, but I think it would be a positive as money flows back into the equity market from abroad. Overall, higher yields will be USD positive.

 (source: Bloomberg)

On another note, any recovery will probably need financials to stabilize and lead the way. Below is the XLF relative to the SPX. This continues to be an important and leading indicator for the direction of the markets. For the past several weeks the banks have been going nowhere RELATIVE to the markets. They have issued 85B in securities and that is currently being digested by the markets. Underperformance by the banks is usually a precursor to overall market weakness. We’ll keep following it with you to look for signs of a real recovery.

(source: Bloomberg)

And for those of you keeping track of our weekly standards:

Our market monitor…looking at various indices for the week, month, quarter, and YTD…

(source: Bloomberg)

And our relative monitor – Looking at the changes of various sectors relative to the S&P 500…

(source: Bloomberg)

S&P heads to first quarter ever of negative earnings Financials the biggest factor in decline, but ConocoPhillips a big hit as well

NEW YORK (MarketWatch) – As Wall Street tracks Washington’s moves to help the beleaguered banking sector and pass more economic stimulus, nearly 400 of the S&P’s 500 companies have weighed in and reported a collective loss — even excluding financials.
“This is the worst, after the sixth quarter of negative growth, it will be the first quarter ever of negative earnings,” said Howard Silverblatt, senior index analyst, at Standard & Poor’s.
A sixth quarter of negative growth ties the prior record set when Harry Truman was president, and ran from the first quarter of 1951 to the second quarter of 1952.
“And next quarter we’re expected a new record of seven quarters of negative growth,” Silverblatt said.
As of the close of business Thursday, Silverblatt calculates S&P earnings-per-share, on a reported basis, at a loss of $10.44 for the quarter. If financials were taken out of the equation, that EPS deficit would drop to $2.35.

http://www.marketwatch.com/news/story/SP-heads-first-quarterly-earnings/story.aspx?guid={A077A0AC-3404-42D2-843E-19706D565667}