Milestone of Contrary Indicator?

Net assets in the gold fund Friday were $76.7 billion vs.

Inflation fears are back

Inflation fears and fear-mongering are back in full swing, but I don’t buy it. I have to admit that I have benefited on multiple levels from the inflation fears making their rounds, as I have short exposure to treasuries, and long exposure to precious metals including palladium and platinum, which have outperformed gold and silver. I’ve also faced some headwinds, as I have been long the dollar versus the euro and yen for a long time. Separately, I’ve been overweight energy for a whole host of reasons, but inflationary pressures have certainly helped keep the price high.

So why am I doubting the recent fear mongering over ever-higher corn prices and the run up in everything from lean hogs to cocoa? My main reason is the consumer. First, on an anecdotal level: Go into any department store. These days, they’re seeing more traffic than in the recent past, a positive. Yet, almost everything is on sale. 30-50% sales are now the norm, and quite honestly, I don’t know why anyone would buy without the sales, especially given that you can buy so many things pre-sale, namely, buy it now, put it on hold, and get the sale price, while the store gets the carry. That’s fine for cashflows, but it’s only borrowing from future revenue; I guess it’s a cheap loan. Second, inflation in staples can seep through, but we’re not seeing it keeping up with the rise in inputs, which necessarily means a squeeze on margins. Don’t believe me, just check out MCD, which just came out with earnings. This is great for the midwestern farmer (voter) and land owner, fine for the coastal consumer, and crappy for everyone in between. Certainly it’s not a net positive for stocks that won’t be able to keep up earnings and meet these valuation expectations.

But back to our mongering…The question remains of what happens to the firms in between that are getting squeezed? For starters, I don’t think employment can pick up, which in turn will lead to continued low savings. In fact, numbers just released show that consumers are dipping into their savings at unprecedented levels. Considering the fact that these funds aren’t coming from HELOCS, they must come out of investable and liquid assets. That can only go on for so long. In a debt deleveraging cycle, which we are facing, the main problems will be margin contraction coupled with more difficult financing. Inflation fears today will end up being ephemeral and much deeper, scarier structural problems will surface. For traders playing the rotation, this is a fine time to look at underperforming commodities and just consistently rotate into them. For investors, the commodity space, except some very specific exposures, will not provide the anticipated returns.

Relevant ETFs: MOO, COW, DBA, GLD, SLV, PALL, PPLT

Quick note on the euro

Brazil and Chile are both intervening to buy USD (weaken their currencies), but who cares…the important news is in the euro. Portuguese, Spanish, Greek, etc. spreads are all shooting higher, and Europeans should (rightfully) be scared. In the meantime, I read somewhere (I wish I had the source) that 41% of Germans no longer want to be part of the euro. Not surprising, and I anticipate that it will only get worse.

Some might argue that the USD is not the best alternative. Perhaps. Euro-Gold has come in off its highs; maybe that’s the right trade. I have exposure to both (USD and GLD against short euro):

Update

Here are the things I’m watching:

Obviously equity is getting hit. Let’s call it down 1.5% so far today, but I expect the S&P to take out 1165 before not to long.

Everyone is talking about seasonal strength and consumers shopping more than expected. Maybe. Valuations are already pricing that in, and they are NOT pricing in geo-political risk, downside surprises, etc.

Gold:

We didn’t sell, and have long discussed the idea of gold peaking on fear, not greed. As expected, it’s holding up well. More importantly, gold in euro terms is manifesting the problems on the continent.

Dollar Index:

I like it when everyone tell me I’m wrong – it means they are all positioned on one side of the trade. That’s what happened with the dollar index. Even Bernanke can’t overcome the structural problems of the euro and yen.

Is anything down today? Oh yeah, our sanity.

If the Fed was targeting stock prices, which seems to be the case, then at least for the time being he was successful. So let’s review, in a situation where money is already dirt cheap but not lending is happening, the Federal Reserve decided to target stock prices (call it, asset prices in general to give it the benefit of the doubt) that are held by relatively few people. Hmmm.

Gold is close to an all time high and certainly at a 20 year high:

Meanwhile, the dollar is down, although not at it’s lowest point:

But it doesn’t matter where you look today, it seems like the reflation trade is back on, deflationists be damned. Except, the yield on the 10 year is going down. What gives?

This is the result of investors front-running the Fed purchases.

I hate sounding like a downer, and I hate that I keep beating the negativity drum, and I’m certainly not any perma-bear. But this is not sustainable, valuations are not where you’d expect for any long term decent return on investment, and any quantitatively driven excess returns will be met with a more serious downside impact that will show up in future returns, but more importantly show up in future standards of living. We will look back at this period with astonished incredulity at our own lack of foresight.

In 1999, a relatively few advisors and analysts were pointing out that valuations were unsustainable. Then we pointed out that accounting gimmicks, such as recognition of revenues, channel stuffing, etc. were unsustainable and only represented “borrowing” sales from the future. We now have the same two factors in play. In terms of the latter, we are borrowing from future consumption and GDP growth, but eventually we will need to pay it back. We see it on the macro and the micro level. Financial institutions are “borrowing” earnings from reserves, while on the macro front we are literally borrowing some GDP growth.

Could it be my own bias that is keeping me from fully participating in this rally? I’ve been examining whether my own stance has led me to a position that is difficult to back down from, and therefore all the analysis is skewed to confirm my hypothesis. The answer is – maybe. I say maybe because maybe we are in a new world, but I seriously doubt it. ZIRP might mean that stocks are undervalued, but I don’t think so. $600 Billion might stimulate job growth that will compensate for the cost of the program, but I doubt it. The Fed might be effective in reaching their goal of a weaker dollar, but I don’t have any faith that they can be effective in anything other than causing uncertainty. Japan’s currency might continuously get stronger, but I doubt it. China might grow endlessly and not have a real estate bubble, but, again, I don’t think so. No matter where I look at the underlying fundamentals and money flows, there are disconnects that will need to correct. Certainly, some big investors disagree with me, so it is not without hesitation that I take the other side of their trades. However, as a disciplined fact-based investor, I can’t allow myself to be dissuaded from the research – and for now, all signs point to trouble.

Contango and backwardation

A few days ago, FTAlphaVille reported on a strategy whereby hedge funds hold GLD and sell futures to lock in the contango spread:

In a nutshell, you buy GLD (perfect proxy for gold, but with no storage costs) you create a hedge by selling front month gold futures. You then lock in the spread further down the curve, and sit and collect the contango premium.

As long as the premium covers your financing costs to hold the futures, it’s happy days. You’ve put your potential $3.4bn worth of GLD shares [referring to Paulson & Co.'s position] into constant yield generation.

Read the full article here.

The problem, obviously, is that the risk of liquidation once the contango doesn’t cover the financing charges rises as more and more hedge funds get in on the same trade. That could certainly spell trouble in the short term for GLD investors.

Yesterday, in an aptly titled article: Is ‘cash for commodity’ the biggest trade in town? the FT noted that the trade has gotten so large that some smart money is starting to move to the other side in anticipation of backwardation. If this move is the beginning of an unwind, it might bring the GLD ETF down substantially, and might provide an entry point for those waiting to get into it at more reasonable prices.

Euro and Pound

It’s been relatively quiet on the equity front, even with the market going up – but the currency front continues to be a big focus.

The euro continues its slide:

I’m still amazed that the yen has continued to stay strong, but I guess this is part of unwinding various carry trades. Still, I can’t help but think that once those unwinds occur, the yen will completely fall apart. (Short yen positions.)

Today, though, the story is GBP. The pound has been weak recently, but not as weak as it should have been, and today it looks like the pound is showing increasing signs of stress:

These moves are providing some support to the Treasury market with safe-haven buying, but we’re wary of the long bonds for security. So are other people, with gold as the original safety outlet, and now silver looking like its receiving some of the flows.

We’re maintaining our positions in silver, gold, gold miners, palladium, and platinum, along with our short euro, short yen, and short treasury positions.

Around the markets in 6 charts or less

Markets have been moving so fast and long standing relationships and correlations are being called into questions, but we’ll try to highlight a few of the areas we think are worth watching

CHART 1 SPX

Today intraday, the S&P broke 1185 support and fell directly to the top of our target area. The euro is driving the global markets on an absolute level, but the S&P continues to OP most global mkts. It’s now testing 50dma, while volume and $$ traded are inline from yesterday. The good news (so far) is that we held ABOVE panic opening lows. Rotations were clearly evident from the opening print – XLU XLV XLP were all positive out of the opening gate.

CHART 2 IWM

Meanwhile, the Russell 2000 intraday broke 72 support level and touched first target at 70.  This “SHOULD” act as a support area. If we bounce towards the 72-73 range, it will provide a great shorting opportunity. We believe that if global markets bounce (and that’s a big IF), EU may be the receiver of investable funds and the EZU/IWM spread should close up.

CHART 3 TNX

The 10-year yield closed below the 3.6% support level. We believe that the UST is no longer a safe haven on an absolute basis. In a world of competitive devaluations, we expect the US government to issue debt at unprecedented levels, yet, interestingly enough, they announced that they’ll be cutting issuance. We believe this will be temporary. Should the euro bounce on new bailout talk, we expect UST will weaken.  For the time being, safe haven bid remains.

CHART 4 DXY

The US dollar index is up 3.7% QTD and 8% YTD. Simultaneously,  secondary FX starting to get thrown out as EU problems spread. Safe haven bid in USD remains – Target seems to be 85-87 area – its anyones guess. Should we get to those levels I would recommend buying AUD, CAD, and the other resource based FX, but only after the euro has a bounce toward 1.32-1.35 area.

CHART 5 Gold: S&P

Bounced off the lows and continues to move north: Gold is THE safe haven in a global. Resistance in spread 1.5% away. GLD above 116 – 120 would signal new highs with a 135 tgt.

CHART 6 SPX vs IWM

YTD, we see IWM strengthening vs SPX (big) – rotations within SPX are starting to favor lagging sectors. Still, we have time before the all clear signal. We believe any rally in the EUR which causes Europe to rally will most likely come at the expense of IWM.

This market has absolute moves that are making headlines, but it is the RELATIVE moves that are the keys to understanding the markets. Rotations between regions, rotations between laggards/leaders, and rotations between large and small continue to drive turbulent moves. The Keynesians running the show didn’t account for sovereign defaults, but the CDS markets continue to offer clues. Tomorrow, Spain and Britain may be in the crosshairs. Again, the questions are no longer whether one is short or long, but what one is short or long.

Goldman’s plight might be the spark, but it ain’t all that

If you live in a cave and haven’t heard, the SEC came out in the middle of the day on Friday to charge Goldman with fraud over a securitization deal it helped underwrite for Paulson. Lots of nuance and many details to follow, but the gist seems to be that Paulson materially influenced the collateralized assets that he was trying to short and GS may have mislead ACA, the outside management firm hired to lend the deal some credibility. Now, the SEC isn’t charging Paulson (yet?) nor ACA (yet?), but rather is focusing on a single deal and a single senior VP at GS. In the worst case scenario for GS (best case for the SEC), GS misled and committed the fraud and will pay a fine. In the best case scenario for GS (worst case for the SEC), GS was marginally ignorant, and the SEC will once again look like it doesn’t understand the firms and securities it’s supposed to oversee.

Did the SEC really need to come out with this news in the middle of the day? By focusing on one transaction and not a pattern, will financial reform ever be effective? Is this politically driven by higher-ups?

Goldman will end up figuring this all out (and probably finding a way to profit from it), but this story shouldn’t be the focus going forward. The real focus is GLD and Paulson’s positions. Gold lost 2% on Friday. Why? Some are speculating that Paulson will need to raise cash in anticipation of redemptions, or other reasons. If that is the case, the market might be front-running Paulson by selling off any positions in which he is a large investors, GLD being one of them. Check out this news story. If that is indeed the case, then the following weeks could see a lot of volatility in Paulson’s names:

Top 10 Holdings as of 12/31/09

SPDR Gold Trust

GLD

NYSE

31,500,000

$3,380,265,000

17.08%

FINANCIAL

Bank of America Corporation

BAC

NYSE

151,034,229

$2,274,575,000

11.49%

FINANCIAL

AngloGold Ashanti Limited

AU

NYSE

42,849,864

$1,721,708,000

8.7%

BASIC MATERIALS

Citigroup Inc.

C

NYSE

506,700,000

$1,677,177,000

8.47%

FINANCIAL

Boston Scientific Corporation

BSX

NYSE

99,135,000

$892,215,000

4.51%

HEALTHCARE

Comcast Corporation

CMCSA

NASDAQGS

44,000,000

$741,840,000

3.75%

SERVICES

Sun Microsystems, Inc.

JAVA

NASDAQGS

74,000,000

$693,380,000

3.5%

TECHNOLOGY

Capital One Financial Corporation

COF

NYSE

17,000,000

$652,800,000

3.3%

FINANCIAL

Suntrust Banks Inc.

STI

NYSE

30,380,700

$616,424,000

3.11%

FINANCIAL

Kinross Gold Corporation

KGC

NYSE

31,500,000

$583,322,000

2.95%

BASIC MATERIALS

Source: DaveManuel.com

Lots of gold exposure and lots of financial exposure. One thing that’s particularly telling was how quickly and how far GS fell on the news, while the market stayed relatively firm. Both sides are telling, depending on whether you’re a bull or bear. The bears will point out that a minor piece of news sent GS down 13%, meaning there are no buyers out there. The bulls will point out that the market was relatively stable and held up well, showing resilience in the face of bad news. I’m biased in that the valuations of the market lead me to look for weaknesses. GS is just one example yesterday and it overshadowed GOOG, which was down 7.5% despite positive earnings.

It will take time to understand the full ramifications of the case, but at first go, it looks like the SEC might be focusing on the trees over the forest (disclosure issues are minor compared to the prop trading conflicts of interest – which this case doesn’t have!!). That being said, eventually the market will continue to use the news as an excuse to realign valuations, so it’s only a matter of time.

What we’re watching unfold…

Warning: This post has nothing new for readers of our newsletter. It’s just that things are unfolding almost according to plan, so we thought we’d put some of today’s headlines and moves in front of you, all in one place…

In no particular order:

• Italian derivatives draw scrutiny as Greece tensions heighten: Yes, Italy used currency swaps. It will turn out that others did as well. Are you surprised? 6 months ago, before anyone had coined the term PIIGS, we were discussing the crowded short USD trade, and the feeling that the markets were overconfident in Europe, even though it faced structural issues. The euro continues to face headwinds. Greece was the canary, but the real issue is Italy and Spain. We continue to be short the euro vs. USD.
• Coming Soon: Chapter 9 Municipal Bankruptcies: This was an interesting post about a little know quirk in bankruptcy law regarding municipalities. In essence, Chapter 9 gives municipalities protection from creditors as they work out payment plans. Guess who holds muni’s…yup, individual, taxable investors.
• PEW Study Shows Trillion Dollar State Pension Gap; Can Anything Be Done?: As if muni problems weren’t enough with tax revenues falling faster than expenses, Mike Shedlock highlights the looming pension shortfalls. If governments accounted for their liabilities like any corporation (other than Enron), they’d already be insolvent. We continue to hold no direct exposure to muni’s. When the stampeded out the door starts, every mutual fund and laddered portfolio will take a massive hit (and will form the basis of a once in a lifetime opportunity).
• Gold: I don’t want to write to much about this, but suffice it to say that Soros came out saying gold was in a major bubble (obviously hoping to talk the price down) as he accumulated one of the largest positions in the world. Read the full article on Soros here. Simultaneously, the IMF is selling some more gold (I won’t even link to it since it’s all over and is old news) and the market is waiting to see if India buys more (and front runs China again?). We’re maintaining our position in GLD, GDX, SLV, PALL, PPLT.
• Meanwhile, 10-yr yield is over 3.8%. We continue to have exposure to short Treasuries. Fun little graphic from Mike Shedlock here.

None of these are specific recommendations, since we do not know your particular situation. These are our thoughts and positions ONLY.

Bank of England Halts Bond Purchases, Obama Supports Free Trade, where we went wrong, and more

The carnage from yesterday masked a lot of interesting news bits, some good, some bad, some just plain confusing:

• For starters, CBS Marketwatch ran a story about Bank of England Halts Bond Purchases. As central banks around the world face up to the reality that even they are not bigger than the markets, quantitative easing programs are likely to be pulled back. We’re seeing it in England, but as the PIIGS come under continued fire, they’ll also be mandated to cut back fiscal spending. Unlike the US, the PIIGS are closer to states in that they have limited leeway on deficits and printing. It might actually end up being their saving grace if they can get their PR story straight.

• On our side of the pond, President Obama made a step in the right direction by going against his party, and coming out in support of free trade. The NY Times ran the following story: White House Unveils Plan to Double U.S. Exports. While encouraging, the language did not contain the commitment that we’d prefer to see, and I’m afraid that this is all just talk.

But in announcing the new strategy, the commerce secretary, Gary Locke, did not say when the administration might send Congress three completed free-trade accords — with Colombia, Panama and South Korea. Many trade specialists say that is essential to prod other countries to negotiate with the United States. But the move is likely to cause a rift with Mr. Obama’s liberal supporters in the Democratic Party, as well as free-trade opponents in the Republican Party.

So we’re left holding our breath. I don’t think the Obama administration will have the political will or power to go against their base of unions and left and right wing protectionists. In fact, I wouldn’t be surprised to see protectionist measures implemented over the course of the year.

• Obviously, Australia left it’s interest rates unchanged. Screwed the carry trade for a lot of people yesterday, but was not that surprising to us. Remember, we’re long USD vs. JPY and vs. EUO. We just believe that USD will still be the beneficiary of the unwinding of risk as must happen. We should have been like Wells Fargo, who shorting the carry trade on the yield curve, and taken more aggressive positions in long USD.

• Where we went wrong: We’ve allocated a small portion of our portfolio to a metals portfolio. We built a position in gold and maintained it. We increased our exposure by building positions in SLV, PALL, and PPLT. We got in too late and should have diversified some of our gold holdings earlier. We are down between 8-18% on the positions. While it’s painful, we continue to hold these positions. First, the individual positions are small. Second, the entire position in metals is relatively small. Third, we maintain that the reasoning behind owning exposure to physical metals continues and we’re happy about the diversification into metals other than gold. We’re not in copper at all. Additionally, today we added a small exposure to GDX as the spread between GDX and GLD seems to imply that there is more potential for outperformance in the miners than in the physical. Here’s the chart from StockCharts.com:

This is the ratio of GLD:GDX. It’s not at the hyperextended levels of Oct. 2008, when the ratio was over 4, but it still looks like the valuation of the miners is low relative to the price of gold.

• Lastly, I want to discuss Treasuries. In 1992, as Soros was breaking the Bank of England, the trade was a simple understanding that no entity nor government is stronger than the market on a long term basis. We have been getting comments and notes about how we can see a continued debt deflationary environment, with a stronger dollar, and lower Treasuries. In the 1970′s, the thinking was that inflation and growth went hand in hand. Stimulate inflation and you’ll get to full employment (sound familiar?). Instead, we had a previously unimaginable situation where we had inflation and no growth, and with it a new term: stagflation. In my mind, we can enter a period where people will want to hoard dollars and not lend it out to the government. It’s the worst possible world for the Fed, whereby they will face higher borrowing costs without stimulating any inflation since the velocity of money will go down. If fiscal policy doesn’t cut government spending, we will be in a very weak position with very few places to hide. Once spending does start, we will face the specter of inflation that will continue to put downward pressures on Treasuries, this time on the short end. We are stuck and the losers will be the holders of long-dated Treasuries. For the Treasury market to rally from here, an investor would have to believe that the Fed, Treasuries, and government can orchestrate a “soft-landing” where domestic savings rates inch up, foreigners continue to want to finance our deficits, trade balances magically and incrementally improve, etc. I’m not a big believer.