Some of the charts I’m looking at

Egypt is still reigning supreme over the news channels, perhaps rightfully so; however, there are a lot of economic crosscurrents being felt, either as a result, or at least concurrently, that it’s worth stepping away from Al Jazeera.

For starters, let’s look at the 10 year yield:

What’s interesting to note is that it is not capturing the flight to safety. For that matter, neither is the USD:

The geopolitical instability, then, has not led investors into some traditional safety havens. Instead, the flight to safety has been captured by commodities:

Is this then the confirmation that inflationary pressures are rising? I read a quote somewhere yesterday (not sure of source) that said something along the lines of: “Going long commodities is shorting human ingenuity.” Maybe. Maybe people are just shorting the every-increasing rates of human ingenuity, or just taking a break from ingenuity. It’s an interesting way to describe the situation, and is pretty depressing.

The VIX meanwhile continues to languish has hope of equity stability and ever rising prices continues:

I have to admit that I am taking the other side of the trade. Insurance is relatively cheap and complacency rampant.

Delving into commodities more specifically, we mentioned rice last week as the only one of the four staples (wheat, soy, corn, rice) that hasn’t gone up significantly. It’s starting to now, but I think if it keeps going, China will step in to force it down. It’s one thing to have social unrest in Egypt, it’s a totally different scenario to have the staple of China go up too much.

Lastly, check out the percentage of stocks in the S&P 500 trading above their 200 DMA:

That does not look sustainable to me.

Relevant ETFs: FXE, EUO, GLD, SLV, GDX, TLT, TBT, SPY, IWM, RWM, SH, VXX, OIL, XLE, EGPT

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.

Ships Tread Water, Waiting for Cargo

http://www.nytimes.com/2009/05/13/business/global/13ship.html?_r=1&src=twr&pagewanted=print

SINGAPORE — To go out in a small boat along Singapore’s coast now is to feel like a mouse tiptoeing through an endless herd of slumbering elephants.

One of the largest fleets of ships ever gathered idles here just outside one of the world’s busiest ports, marooned by the receding tide of global trade. There may be tentative signs of economic recovery in spots around the globe, but few here.

Hundreds of cargo ships — some up to 300,000 tons, with many weighing more than the entire 130-ship Spanish Armada — seem to perch on top of the water rather than in it, their red rudders and bulbous noses, submerged when the vessels are loaded, sticking a dozen feet out of the water.

Libertarians under attack…

Henry Kaufman writes an op-ed piece in today FT (http://www.ft.com/cms/s/0/705574f2-3356-11de-8f1b-00144feabdc0,s01=1.html) that I just can’t ignore.

He writes:

My second major concern about the conduct of monetary policy is the Fed’s prevailing economic libertarianism. At the heart of this economic dogma is the belief that markets know best and that those who compete well will prosper, while those who do not will fail.

He goes on to lists 6 points of failure on the part of the Fed that were the results of the Fed’s “dogma”. I don’t even know where to start with this one, so let’s start with his six points.

First, it explains to a large extent why the Fed did not strongly oppose the removal of Glass-Steagall restrictions.

You cannot take Glass-Steagall out of context. The act, also known as the Banking Act of 1933, placed a separation between commercial banking activity and investment banking activity. Kaufman’s contention that a libertarian mindset led to repealing the act implies a few things: first, it implies that the act wouldn’t be repealed without the mindset. Second, it implies that it is specifically this mindset that prompted the repeal of the act. Third, Kaufman wants to blame someone for the current situation, so the Fed and Libertarians with it are a good association. There were banking crises before the act, there were banking crises after the act, there will be banking crises in the future. The act didn’t stop the S&L crisis, not the lending crises that came before. Kaufman’s association of the act being repealed and then his implication that it’s libertarianism that cause it are naive at best.

Second, it also helps explain why the Fed failed to recognise that abandoning Glass-Steagall created more institutions that were “too big to fail”.

Libertarianism would have prompted the Fed to let companies fail. Thinking that market forces have corrective mechanisms is economics. Thinking that government is not the right arbiter of who should fail and who should survive is capitalism, libertarianism, democratic, and liberal (in the positive sense of the word).

Third, it diminished the supervisory role of the Fed, especially its direct responsibility to regulate bank holding companies. To be sure, the Fed’s supervisory responsibilities have never been very visible in the monetary policy decision-making process. But its tilt toward an economic libertarian approach pushed supervision a notch down just at a time when financial market complexity was on the rise.

I don’t think this is a result of libertarianism. It’s a result of an entire culture built on lack of responsibility and a whole host of factors which history will judge. Is he really saying that a Fed (which many libertarians would criticize for even existing) didn’t regulate enough due to libertarianism? He sees no other causes?

Fourth, as hands-on supervision slackened, quantitative risk modelling became increasingly acceptable. This approach, especially quantitative modelling to assess the safety of a financial institution, was far from adequate. But it worked hand in glove with a philosophy that markets knew best.

Again, is he blaming libertarianism for the use of quantitative modeling? The next time he’s performing a transaction maybe he should think twice before using Excel. Using mdoels is not libertarianism or any other “ism”. The problem is not using models, it’s relying on models, and that’s not an “ism”, it’s just common sense. 

Fifth, adherence to economic libertarianism inhibited the Fed from using the bully pulpit or moral suasion to constrain market excesses. It is difficult to believe that recourse to moral suasion by a Fed chairman would be ineffective. Such public pronouncements about financial excesses are hard to ignore, reaching the broad public as well as market participants.

The Fed led the way to excess through manipulating interest rates. That’s not libertarian – it’s exactly the opposite! He’s criticizing the Fed for not being involved enough, when in reality, they were a main source of the problem. I’d like to take Kaufman out for a cup of coffee (my treat) and explain to him how his anger is misdirected. He recognize that the Fed couldn’t do a good job even if it wanted to (debatable) and that this is a reason to give the government less authority, not more.

Sixth, the Fed’s increasingly libertarian philosophy underpinned its view that it could not know how to recognise a credit bubble but knew what to do once a bubble burst. This is a philosophy plagued with fallacies. Credit bubbles can be detected in a number of ways, such as rapid growth of credit, very high price/earnings ratios and very narrow yield spreads between high- and low-quality debt.

Indeed, Kaufman and I would once again look at the evidence and come to different conclusions. I think the Fed didn’t and couldn’t know that there was a market bubble, which is why they should have stayed away from manipulating and trying to predict. He thinks they should know and then should control.

Dr. Henry Kaufman is probably a brilliant man. I, sadly, am not, so take my criticism for what it is. Kaufman seems to be angry and not know who to blame, so he lashed out at the Fed (partially rightly) and “Libertarianism”, a catch-all “ism” for him, which he misdefined, misanalyzed, and mmitakenly blames for our current woes. Disappointing that his argument is both oversimplistic and completely mistaken in the entire cause and effect relationship.

From RGE (Roubini) Global Monitor

This is from the RGE 2009 Global Economic Outlook. It does not paint a pretty picture. My main question is whether the markets are alreadypricing in all this information or are they pricing in a too-early recovery based on their numbers?

The global economy is in the middle of a synchronized contraction that will push global growth into negative territory in 2009 for the first time in decades. . This will be the worst financial crisis since the Great Depression and the worst global economic downturn in decades. Global trade volumes face their sharpest contractions of the postwar era – trade is expected to contract 12% in 2009 due to the severe and prolonged global demand slump, excess capacity across supply chains and the continued crunch in trade finance.

Many analysts and commentators are pointing out that the second derivative of economic activity is turning positive (i.e. economies are still contracting but a slower rather than accelerated rate) and that green shoots of an economic recovery are blossoming. RGE Monitor’s analysis of the data suggests that the global economic contraction is still in full swing with a very severe, a deep and protracted U-shaped recession. Last year’s economic consensus forecast of a V-shaped short and shallow recession has vanished. While the rate of economic contraction is slowing compared to the free fall rates of Q4 of 2008 and Q1 of 2009, we are still a long way away from the economic bottom and from a sustained recovery of growth. In particular, in Europe and Japan there is little evidence of a positive second derivative of economic activity.

However by the end of Q1 2009, there were some signs that the pace of contraction had slowed in many economies especially in the U.S. and China, where policy responses have been more significant and leading indicators in the manufacturing sector may have bottomed before they did in Europe and Japan. However, major economies including all of the G7 will continue to contract throughout 2009, albeit at a slower pace than at the beginning of the year.

Moreover the global recovery might be sluggish at best in 2010 given the overhang of credit losses of financial institutions, lingering credit crunch, need for retrenchment by overstretched and over-indebted households in current account deficit countries and a slow resumption of demand prompted by extensive government stimulus.

Some key elements of RGE Monitor’s outlook include:

• Global economic activity is expected to contract by 1.9% in 2009. Advanced economies are expected to contract 4% in 2009. Japan and the eurozone will suffer the sharpest downturns. U.S. GDP will continue to contract, albeit at a slower pace throughout 2009, with negative growth in every quarter.

• Emerging markets will slow down sharply from the stellar growth rates of the past few years, with the BRIC economies growing at half their 2008 pace.

• Deteriorated terms of trade, slower capital flows and tighter credit will push Latin America into recession from the 4.1% growth of 2008. Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela will all shift to negative territory on a year-over-year basis while smaller countries, like Peru, will experience a significant slowdown.

• Countries in Eastern Europe and the CIS will experience some of the sharpest contractions given the withdrawal of foreign credit and the risk of a severe financial crisis. The reduction in oil revenues and financial stress will contribute to a 5% yoy contraction in Russia and some countries – especially in the Baltics – are at risk of double-digit contractions.

• Export-dependent Asia’s growth will slow significantly to less than 3% in 2009. China will have a hard landing with GDP growth falling to 5.5% while India will slow sharply to 4.3%. All four Asian Tigers (Singapore, Taiwan, South Korea and Hong Kong) as well as Malaysia and Thailand will experience recessions.

• The Middle East and Africa will mark much slower growth, half of their 2008 pace, given the reduction in capital inflows, reduced demand from the U.S. and EU and decline in commodity prices and output. Israel and South Africa will suffer slight contractions.

• The unprecedented fiscal and monetary stimulus may help alleviate the substantial contraction in private demand and reduce the risk of a global L-shaped near-depression. Debt financing may be a challenge for many countries though, especially emerging markets or the most vulnerable Western European economies.

• Job losses during the current global recession might exceed those in recent recession, contributing to increases in defaults and posing additional risks to banks. The unemployment rate in developed countries will reach double-digits by 2010 (as early as mid-2009 in the U.S.) and push more people in developing countries into poverty. Moreover, despite new funding from multilateral institutions, severe contractions will raise the risk of social and political unrest.

• Commodities as a class are likely to come under renewed pressure in 2009 despite some support from production cuts. RGE expects the WTI oil price to average about $40 a barrel in 2009 as demand destruction continues to outweigh crude supply destruction.

Bonds and the Ag Complex…

Yields are approaching zero and many have been saying it’s the short of a lifetime. I’m not sure. If we’re going into a deflationary environment, yields can at least stay here for a long time. However, wouldn’t that, coupled with the increase in government spending we are witnessing put a floor (at least) in gold? But gold is a retail product. It is not a necessary commodity, but rather just a currency play. In an environment where “need” trumps any currency, I believe it might actually provide a floor for the ag complex. Not sure how to play it, but just some food for thought.