I hate to bring this up again…

Over the past two years I've brought up 1987 periodically as just a mere possibility that has to be factored. I don't want to think back to those days of currency wars, political grandstanding, and crazy volatility, but alas, every time I try to clear my mind . . .Viewing the remainder of this article requires a Subscription

It’s Not About Greece

For weeks, the media outlets have been streaming news about Greece - analysis, opinion, etc. - with the intention of shedding light on the internal situation.Viewing the remainder of this article requires a Subscription

Europe revisited

It’s back – although, for some of us it was never out of sight: Europe is in trouble.

Greece is facing gdp growth rate of -3.5% and is now officially beyond low double digit unemployment (and rising).

Spain, in the meantime, is facing another liquidity crunch.

And the only thing saving the credit markets from freezing up is a quickly eroding common fund that is going to face some huge losses in the very near term. (See article here.)

What to expect going forward

So much news, but let’s simplify:

1. Bankruptcies will continue to rise.
2. Rents will go down, causing owners equivalent rent to go down in the CPI, deflationary pressures continue.
3. Europe falls apart: Hungary needs a bailout. How much more will the German taxpayer take on? What about Austria? Remember Spain and Portugal and Ireland? Yikes. Additional deflationary pressures on the USD (devaluation vs. euro).
4. Europe is big problem for China. Net negative for UST, but we are early on our call to short the 10 year, but the end of the bond bull market is upon us.
5. Unemployment doesn’t look good. Weeks searching going up. Temp is the only work out there. Lots of people giving up makes the numbers look good, but watch out for credit card defaults going up. Negative for the big card issuers (C, BAC, COF, Mastercard/Visa/AMEX) and retailers.
6. Politicians will downplay all of it, talk about stability and strength. Increased stimulus? From where?
7. Look for additional municipal cuts in budgets, employees, etc. Again, negative for jobs outlook, real estate, etc.
8. Geopolitical risk remains high. Forget North and South Korea. Look for something like the conficker virus making big headlines. We are always fighting the previous war, in this case small-group, armed guerrillas, terrorists, etc. Cyberwars will make the big headlines soon.
9. Yen is toast. Again, I’m probably early, but the demographics make their debt load unbearable. Some serious restructuring will need to occur – and someone will have to lose.
10. BP is in so many pension funds, the month end and quarter end numbers will be painful.

These are not black swans. They are just a matter of timing.

Positioning happens before the fact

As a long term value-oriented investor, I often find that much of my research focuses on events and possibilities that do not come to fruition. I spend a lot of time hypothesizing about different scenarios and planning “just in case”. Lest you think that I can plan for every eventuality, let me assure you I can’t. What I can work through, however, are the triggers that need to be in place for an investment to look attractive. For technicians, these set-ups tend to be focused on charts, time and price indicators, or specific patterns. For me, it focuses on valuation, spread/ratio analysis, and long term trends.

To that end, I thought it might be worthwhile to share some of the relationships we’re focusing on, though not necessarily acting.

1. Gold/Silver: This ratio should could get out of line if gold becomes the safe haven leaving its cousin in the dark. The 12 month average is hovering at 64, and the ratio currently stands at roughly 68, but it could get much wider. If it does, we’ll be looking to determine if there is a structural shift or an overextended move.

2. EUR/USD

This is an example of a ratio that in our mind will continue to move for structural reasons and may not revert to any mean. Even with short-term intervention, the structural problems of a unified monetary policy without a unified fiscal policy are obvious and require sacrifices that disparate politicians cannot make.

3. S&P 500 vs. Russell 2000

Until recently, small caps handily beat large caps. In the search for performance, investors looked towards small caps, and even RSP and EQL got a boost vs. the market cap weighted SPY. We anticipate that ratio to go back towards it’s average. Lots of ways to implement it, but for it continues to be a telling sign of risk reduction in the equity space.

So these are on radar screen right now. Where will we look for opportunities in the future? For starters, we are in a deflationary period, so absolute levels in financial assets globally will be under pressure. That’s OK by me, since I’ll be looking to pick up cheap assets.

1. Thailand: Not ready to take the plunge on an absolute basis, but this is one market I anticipate will have some good long term opportunities. Valuations, demographics (internal and increased tourism), and wealth transfer from west to east all play into it.
2. Europe: Eventually, Europe will look attractive. I purchased NBG and OTE (Greece) after posting about it last week. We’ll be looking for over-reactions in other European countries as the fear increases (euro exposure will be hedged out).
3. Japan: Same as Europe.
4. US markets: we get questions about the US markets all the time. We view them as 30-50% overvalued, but once valuations come in line, the US may end up being well positioned as the continued dominant player.

Let me be clear, I do not believe these are good values here. However, I believe you have to start thinking about positioning before it becomes obvious. Attractive valuations are a necessary but not sufficient pre-condition. An understanding of the macro environment must play a role in analyzing a long term investment.

Once again, all eyes on currencies

Structural deficiencies make the euro vulnerable (and the US a safe haven), but demographics, savings rates, and fiscal policies will make the emerging markets currencies more attractive once the dust settles.

The emerging markets are not the place to be these days, but then again, neither are the developed markets. As risk trades get taken off the table emerging markets, small caps, high yield, etc. will continue to come down significantly. At some point we will look in those areas for the potential opportunities. For now, we wait.

As long time readers know, we have continued to build a cash position, and we maintained our short euro and short yen positions. Additionally, we have a diversified metals portfolio, which we anticipate will actually decline (except for gold) as financial assets face a correction regardless of class.

Europe continues to be the focus, but soon I believe it will shift to China and determining how it will sustain its growth. We will write more later today, but copper should be one of the main signals to look at.

U.S. Share of World GDP Remarkably Constant

Good piece from “Carpe Diem” about US share of world GDP. And another reason why I’m short Euro and do not believe they will outperform mid/long-term given their structural problems.

Bottom Line: World GDP (real) doubled between 1969 and 1990, and has increased by another 60% since then, so that world output in 2009 is more than three times greater than in 1969. We might mistakenly assume that the significant economic growth over the last 40 years in China, India and Brazil has somehow come “at the expense of economic growth in the U.S.” (based on the “fixed pie fallacy”) but the data suggest otherwise. Because of advances in technology, innovation, and significant improvements in U.S. productivity, America’s share of total world output has remained remarkably constant at a little more than 25%, despite the significant increases in output around the world, especially in Asia.

http://mjperry.blogspot.com/2009/11/us-share-of-world-gdp-remarkably.html

Niall Ferguson: Dollar may drop another 20%…

This came out earlier today. I’m not saying I disagree, I’m just not convinced it’s easy to know “against what”. The euro? Why? Fundamentally, the other currencies in the world don’t seem that appetizing to me, especially at these levels. Now, if you said drop 20% against specific commodities, then it’s a definite maybe, but at least we can discuss the underlying supply/demand issues. Against the Euro? They are in worse shape than we are, they just don’t understand it yet. The Chinese yuan? They’ve been keeping it artificially low for decades just to get a little export going. Do you think they can afford to let it drop 20% from here? Doubtful, or there will be mutiny on the Chinese seas.

Enjoy…

(By the way, I like Ferguson a lot and try to pick up anything he writes. Phenomenal writings on history, history of economics, and tying everything to the geopolitical landscape.)

Dollar May Drop 20% More on Deficit, Harvard’s Ferguson Says

By Cordell Eddings and Thomas R. Keene

Oct. 16 (Bloomberg) — The dollar will extend its drop versus the euro over the next two to five years, falling as much as 20 percent to an all-time low under a widening U.S. budget deficit, Harvard University’s Professor Niall Ferguson said.

Policy makers favor the dollar’s slide as a means of supporting a recovery from the worst economic slump since the Great Depression even as they voice support for a strong greenback, Ferguson said in an interview on Bloomberg Radio.

A weak dollar is “the simplest solution to most of America’s problems right now,” said Ferguson, author of “The Ascent of Money: A Financial History of the World.” “We are likely to see 1 percent to 2 percent growth unless exports take off, and that’s what everyone in Washington is quietly hoping: If the dollar keeps sliding, then maybe we can get some traction on exports.”

The dollar increased 0.4 percent to $1.4887 versus the euro today after depreciating yesterday to $1.4968, the weakest level in 14 months. The U.S. currency touched $1.6038 on July 15, 2008, the weakest since the euro’s 1999 debut.

The world’s largest economy shrank at a 0.7 percent annual rate in the second quarter, the Commerce Department reported last month. Gross domestic product contracted at a 6.4 percent pace in the first three months of 2009.

Economists forecast the current-account deficit will rise to 3.2 percent of gross domestic product in 2010 and 3.3 percent in 2011, compared with 2.9 percent this year.

‘Terrible News’

The weakening of the dollar is “terrible news for practically all of the rest of the world’s economies,” except the U.S. and China, said Ferguson. China, which manages the yuan’s appreciation, will “intervene to make sure the dollar does not weaken” relative to its currency, Ferguson added.

Treasury Secretary Timothy Geithner said on Oct. 3 after attending a meeting of Group of Seven finance officials that it’s “very important” for the U.S. to have a strong dollar.

The administration of President Barack Obama pushed the nation’s marketable debt to an unprecedented $6.78 trillion in an effort to spur economic growth and support the financial system. The U.S. government ended its 2009 fiscal year with a deficit of $1.4 trillion, the biggest since 1945, the Congressional Budget Office reported.

Europe on the Ropes

Article argues that Western European banks (or whole countries, i.e. Austria) might collapse due to their Eastern European exposure. I agree.

I would like to point out though that European banks commonly insure their portfolios. Hence, American insurance companies might have significant exposure to this space as well. Anyways, the whole thing is quite troublesome.

http://www.arpllp.com/core_files/The%20Absolute%20Return%20Letter%200309.pdf

“According to the latest estimates from BIS, Eastern European countries
currently borrow $1,656 billion from abroad, three times more than in
2005 and mostly denominated in foreign currencies (ouch!). 90% of
that can be traced to Western European banks. About $350 billion
must be repaid or rolled over this year. Not an easy task in these
markets. Austrian banks alone have lent about $300 billion to the
region, equivalent to 68% of its GDP according to the Financial Times.
A default rate of 10% on its Eastern European loans is considered
enough to wipe out the entire Austrian banking system. EBRD has gone
on record stating that defaults in Eastern Europe could end up as high
as 20%.”

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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