Stocks, Bonds, and Currencies, Oh My!

Why You Don't Want Government Controlling Social Security

2011-07-27T09:03:00.000-07:00

First, they promise to take care of you and your future financial welfare:

The National Pensions Reserve Fund was established in April 2001 to meet as much as possible of the costs of Ireland's social welfare and public service pensions from 2025 onwards, when these costs are projected to increase dramatically due to the ageing of the population. The Fund is controlled and managed by the National Pensions Reserve Fund Commission. The Commission's functions include the determination and implementation of the Fund's investment strategy in accordance with its statutory investment policy. This policy requires that the Fund be invested so as to secure the optimal total financial return provided the level of risk is acceptable to the Commission.

(source: NPRF Home Page)

Then after they make a mess out of protecting your current financial welfare, they threaten your future welfare to compensate for their screw-ups.

In the first six months of 2011, the Government liquidated €10bn worth of National Pension Reserve Fund assets in order to contribute money to the EU/IMF bailout package.

Including this €10bn set aside for the support programme, the total fund size at the end of June was €20.8bn. This also comprises of the discretionary fund and directed portfolio, as well as bank investments of €5.5bn.

The discretionary fund has now been reduced in size to €5.3bn as a result of the liquidation of assets, according to the quarterly portfolio and performance update published today.

Including shares held in Bank of Ireland and AIB, the directed portfolio is worth €15.5bn.

(source: Business Leadership News)

If you're thinking, "That's ridiculous, that would never happen here" you must be twelve years old.

Let the Trade Wars Begin

2010-11-08T10:24:00.000-08:00

Global anger swells at Fed actions

One can only wonder how this can end up good for the peons on every continent subject to the dictates of the global power mongers. If someone has some evidence to show how democracy benefits the commoner better than monarchies and dictatorships, we'd love to read it. Until then, we'll have to settle for finding ways to protect our ass-ets from the consequences of wars over national sovereignty.

The Democratic Process of Money Meddling

2010-10-29T11:25:00.000-07:00

"...it is prudent of the central bankers to get a feel for where disappointment would actually set in."
(Source: E-piphany)

Our friend Mr. Ashton picked up the hints from a Bloomberg report. It is important to realize prices are never objective. It's true for houses, cars, and even U.S. Treasurys. So while one can despise the actions of the central bank, it's not exactly honest to claim they are stupid. As Bloomberg reports:

The New York Fed survey ... asks about expectations for the initial size of any new program of debt purchases and the time over which it would be completed. It also asks firms how often they anticipate the Fed will re- evaluate the program, and to estimate its ultimate size.

That appears to be a pretty good line of questioning! Before they make any announcement next week (or not) they better figure out what kind of a statement is least likely to create a panic. One might even consider the expectations are so strong, if they don't announce QE2 next week we'll have a clear and noticeable collapse in something on Wednesday afternoon and on into the week. It is the fall, after all.

So it looks like the fed is actually working out the plan by getting surreptitious "feedback". It's prudent to presume an event has already been priced in by the time it happens. Even if one is skeptical of that principle, given this kind of clear signaling, the pros obviously know and are already preparing their portfolios.

Therefore, the fundamental questions investors need to get right are these:

a) What prices will rise when this happens? Obvously Treasurys, except the inflation factor may counter the whole supply/demand factor.

b) If profit taking kicks in at the announcement, where have those profits been accumulating?

Without the results of the survey, we peons are at a grave disadvantage trying to get those answers right. The one thing we can be sure of though, is that at 2 pm EST on November 3rd, being at your terminal with fingers nimble and ready is the wise plan.

Hindenburg Omen - Not!

2010-08-18T12:34:00.000-07:00

It would be hard to find someone or group that can beat the quality of data that comes out of Bespoke Group. Today they made an astute observation that trumps the low quality blogosphere hype about the Hindenburg Omen. In typical fashion, Zero Hedge made another biased emotional appeal:

"Today, we just had another (unconfirmed) Hindenburg Omen."

As Bespoke Group points out, the facts of the matter refute the present perceptions.

"Call us crazy, but an indicator that measures the internals of the equity market should probably avoid using fixed income securities in its analysis."

The problem we see all too often in the internet world of truth is few people bother to actually take the time to understand the basis for these long-standing fundamental or technical indicators, nor take the next step to actually vet the information to see if in fact the data is in conformance with the statistical presumptions, requirements, a priori, and other critical factors.

We think one can take solace in knowing the low-quality data monitors who perpetually cry "the sky is falling" can be ignored more often than not. Notice Bespoke confirms the 2008 instance of the Omen, while Zero Hedge gets it wrong when they say the last Omen occurred during 2009. Not only is it statistically wrong, you can see from a chart if it had occurred it would have undermined it's reliability.

Our conclusion is that Bespoke is right and that Zero Hedge isn't filtering out fixed incomes, and therefore wrongly attributes an instance of the Omen to a point at which it never actually occurred. This is a good thing as it suggests the Hindenburg Omen is still a reliable indicator, if one can first learns how to read data and understand the meaning and abstractions of the words that make up the theory.

How's That Risk Curve Doing?

2010-07-31T14:27:00.000-07:00

As our friends at Bespoke Investment Group point out, the market suggests we are not yet ready for higher-risk equity investments.

Compare that present influence with Pimco's Bill Gross discussion on market risks, namely how demand shifts toward the inner circle of safety during a crisis, then slowly back out the risk curve over time.

Note there are many risk vehicles not in Pimco's analysis; not because they don't exist or aren't relevant, but because there are so many layers and instruments. The key point is that bonds are less risky than equities, and preferred stock less risky than common stock.

The real rally is still taking place in risk circles inside of common equities, and the sell-off at earnings suggests we aren't yet ready to see a strong rally in equity.

There's No Place to Invest Capital

2010-07-25T22:25:00.000-07:00

“If you look at financial markets, say, look at how much the Treasury is paying to borrow today, there is a lot of confidence, not just of Americans but investors around the world, that we’re going to find the political way to do it,” Geithner said. “There’s no alternative for us. We’ll be able to do that.”

So that's the optimistic spin on the U.S. Federal deficits and stagnating economy. Bloomberg spins the facts by beginning their title with "Deficits Don't Matter...".

From our point of view, the historical low yield on U.S. Treasury debt in the face of record high deficits indicates the investment world is saying the global economy is so bad there's no place to invest capital with any hope of getting a good yield -- might as well bury it in the back yard until some opportunity presents itself.

If you're unemployed, you better start thinking about how you can start your own business, because Corporate America obviously isn't going to do it for you.

The Whipsaw Song, by The Trading Tribe

2010-07-02T18:16:00.000-07:00

Can't pass this up -- five old fogey stock traders get down and dirty with some Kentucky blue grass written especially for market-a-holics.

Happy Fourth of July!

You can find out more about The Trading Tribe at their web site.

Banks Are Not Intended to be Safe Place To Keep Money

2010-06-25T08:28:00.000-07:00

We've been seeing rules like this lately with the phrase "prohibits branches of banks … from operating primarily for the purpose of deposit production."

Let that sink in for a minute --- if you want to run a bank, you can do X, Y, and Z, and many other things, but if you have a primary purpose of attracting deposits, it's a no-no -- slap you on the wrist, bad boy!!

Now put on your consumer hat. Why do you put your money in a bank? Isn't the primary purpose to ensure your wealth is in a safe place so you don't have to stash a bunch of money in a steel, tamper-proof, fire-proof, locked-down safe, and then carry wads of cash around where thieves can separate you from your wealth when you go buy something? From your point of view, a bank's primary purpose is to be a safe place to keep your money.

But the bank is prohibited from primarily attracting your interest in their safekeeping services.

We can't speak for you, but that explains a lot.

Declining GDP Can Be Good

2010-05-29T13:16:00.000-07:00

The following is an open letter to John Mauldin in response to Thoughts from the Frontline Weekly Newsletter, Six Impossible Things. It ties in with another story at telegraph.co.uk about the rapid decline in money supply.

--------------------------------------

Good essay, as usual, Mr. Mauldin. Hey, ask a trusted scientist about dimensional analysis. Your delta force equation is slightly incorrect; it should be multiplicative, not additive. Conceptually it's right, but the formula is formed wrong and the implications may be very different when you use the correct dimensions and mathematical operations. You might characterize this with the label "Busy Boys ... Better Boys", from the 3-cent stamp I discuss at the end, where I reveal another time in American history that produced sustainable healthy economic output. In short, declining GDP might not be bad if we think about it a little deeper than our illustrious leaders who seem to be acting out of habit, not knowledge.

First Fixing the Formula
For your delta force equation the definition of productivity has to be "dollars per person", since "population" is clearly "sum of persons". Therefore, the plus sign is wrong; it must be "multiplied by". Think about it this way in dimensional analysis: if you get 10 miles per gallon and have 20 gallons of gas, how many miles can you travel? The formula is "M traveled = 20G x 10 MPG". Take away the numbers and just use dimensions: M = G x MPG.

The "per" in math means"divided by", and so the Gs cancel each other out:
G x (M / G) [in our case, 20G x 10M / G)]

Canceling out the Gs...
20 x 10M = 200M

You can't do that with addition: 20G + 10MPG = M is an invalid formula.

So look again at your delta formula. What you're saying is correct, but addition is the wrong operation and the implications are different when you properly put them into the correct mathematical dimension.

In dimensions, your delta force would be "Dollars" = "People" x "dollars per person" [D = P x D/P]. But there is still something missing. Some dollars per person are zero. My 5 year old productivity is zero because he isn't working. Likewise for the unemployed. Those have to be clarified as "working people" x "average dollar per working person".

Implications
It is not enough to "grow one's population", one must grow the population of people "that contribute to monetary productive efforts". If population grows, but the output of the new people are smaller than existing labor, it may not produce a rising GDP. To the extent new population produces less per person than existing population, GDP may decline if workers leaving the work force were more productive.

The corporation I work for is making this mistake. In the latest economic downturn, they got rid of highly-skilled labor because their wages and benefits were high, resting on imported immigrants with lower wages. The consequence now is that what they produce requires much higher labor input, because the inexperienced immigrants repeat many of the old mistakes the experienced laborers learned how to avoid. I'm not against immigrant labor, I'm just pointing out that low-wage immigrant labor may do more harm than good, even though low wage costs can increase productivity metrics. Wage-based productivity metrics can't tell you how much output was sacrificed.

There is a component of output, momentum, that doesn't manifest itself instantly with the replacement of high wages with low wages. Decay exists in everything. Poorly maintained plant and equipment break down more often. Poorly engineered products don't last as long. Poor quality of service and product diminishes customer willingness to return for more or refer others when needs arise.

If our economic stimulus programs don't produce another artificial credit-induced wave of consumer spending to make up for the diminishing sales of the old customers, the diminished momentum from displaced experienced labor is going to become evident when the consequences of the inexperienced low wage worker is reflected in declining output, increasing costs, or declining sales.

Busy Boys ... Better Boys
I think this single-minded focus on dollar metrics by economists, business managers, and policy planners is insufficient for solving the real problems facing the global economy. I have a 3-cent US postage stamp I found in my Mom's estate. It has no date on it, but others appear to be from the 1950s. This little 3-cent stamp speaks volumes about the decline in American culture, and it's impact on GDP when we consider the abstractions evident in the Delta Force equation.

It's a picture of newspaper boy on the left walking through a neighborhood. A bag rests over his shoulder with the motto, "Busy Boys ... Better Boys". On the right is a hand holding a torch with the motto, "Free Enterprise". Between them is a statement, "In recognition of the important service rendered their communities and their nation by America's newspaper boys."

We used to call that "work ethic"; it used to be a virtue. I don't recall seeing any government program honoring and extolling the virtues of work ethic like that 1950s postage stamp. Instead the focus is on entitlement, equality, and rights. It's evident, too, when you shop for products and services. Finding anyone with a work ethic that values one's contribution to others is rare, especially in the young. The predominant theme is one's right to income, or making a sale (getting one's money) at the cost of integrity and future product loyalty.

It isn't enough to just get more people earning wages, or keeping wages high to prop up tax revenues. The culture needs to re-discover the value of contributing to the success of others, which is the essence of the old work ethic. The idea that one's existence earns them a fair wage without consideration of their contribution is the essence of the decline in American industry and economic health.

Bad Can Be Good
Declining GDP or contraction of money supply are not problems in and of themselves. They are symptoms of something more fundamental. Whether they are good or bad depends on the essence of the underlying fundamental. A family that lives within it's means is a financially healthy family. If that family had a growing GDP (lots of economic activity based on new debt) they would be creating new money (increasing money supply) as they take on new debt and buy more products and services.

If they change their wayward ways, stop incurring new debt, reduce spending to conform to current income, they will flatten their contribution to GDP and contribute to a reduction in money supply. This is good for the family and the community, because there comes a point when economic activity shifts from debt service payment to new product and service output, but at sustainable levels. This was what characterized the decades following the great depression, an age where people understood the good things of life come from hard work, not easy credit.

If the old GDP reflected this old over-spending habit of the community at large (an addiction to "more stuff" now!), a declining GDP may be indicative of a more sustainable and healthy future. Furthermore, to the extent business learns to evaluate their output based on making product more desirable to the consumer, not only on price, it means a higher satisfaction (standard of living) and a more sustainable business model for business.

PIIGS - Propped Up By Hope

2010-05-21T06:07:00.000-07:00

Maybe Governor Daniel K. Tarullo's testimony to Congress helped the stock market sell off yesterday. There's nothing better than a federal official making an official proclamation that "Europe is still in trouble, and it can mess up the U.S.,too. We don't expect another U.S. bank crisis, but ya never know!" That, of course, was a paraphrase. Actually, the direct quote was

...holding out hope that further financial disruptions can be averted

There ya go, Europe is propped up by hope!

Too bad the fed can't just get involved in more swap markets. Their excess profits are returned back to the US Treasury, and the last crisis not only earned $5.8 billion in interest on forex swaps alone, but cut the cost of federal funding from the flight to dollars.

It's good business being a central bank.

Over the life of the previous temporary swap program (from December 2007 to February 2010), all swaps were repaid in full, and the Federal Reserve earned $5.8 billion in interest. Finally, the Federal Reserve bears no market pricing risk in these drawings.

Analyzing Non-Borrowed Reserve Trends

2010-05-08T13:11:00.000-07:00

Now this is interesting.

(click for full size)

Latest Observations from the chart. (full data series available from The Fed):
2009-12 968.670
2010-01 966.727
2010-02 1113.265
2010-03 1094.656
2010-04 1036.615

We see a drop from Dec. to Jan., but then a spike from Jan to Feb. It might not be coincidental the stock market was dropping after Jan. Money that flees equity risk may have been parked into the safety of bank deposits for a period of time, faster than banks were making loans. But Feb. to Mar. to Apr. we see either money has been flowing out of banks, or banks are lending more reserves into new loans.

It will be interesting to see in June what happens in May as this early May market turmoil reveals itself in the national metrics of bank balances. If the previous paragraph correctly identified cash flows, we would expect May's non-borrowed reserves to be up, based on the theory that retail investors sweep their proceeds into bank accounts and professionals sweep their proceeds into Treasuries.

Program Trading In A Falling Market

2010-05-06T15:10:00.000-07:00

Look at SPY on March 3rd & 4th, 2010

The high on the 3rd was 112.80
The low on the 4th was 113.10.

That gap wasn’t filled before today.

Look at today’s one-minute intraday chart gradual falling off up until 14:21 EST.

The low was around 112.97 at which point it tried to bounce up but couldn’t hold. The steep sell off got really bad just about the time that false rally crossed back below 112.97 and took out the gap.

It appears there just happened to be a lot of mathematical models around that price point, whether because of the gap or something else. Volume started picking up at 14:00 EST, and then at 14:35 when the support was broken volume really took off in a free fall to the day’s bottom.

There’s no particular spike in volume, just this surge of selling and then buying over the last two hours of the trading day. A lot of stop losses were filled today which probably precipitated the free fall.

Forget the silly rumors of an order error. It's just someone making a joke that a bunch of simple minds believe and repeat until everyone believes it. Today's market action was driven by algorithmic trading and people with day jobs having their risk management strategies triggered by the machines.

Bank Lending Has Finally Resumed

2010-04-19T18:10:00.000-07:00

Looks like the great deflation has finally hit bottom. Today the Federal Reserve reported Total Commercial and Industrial Loans rose for the 2nd week in a row after 16 months of weekly declines. Since Oct 22nd there have been only 11 weekly increases in total loans out of 77 weekly reports.

To be sure, this was a doozey, bottoming out at a year-over-year decline of 20%, the largest decline on record since this data was collected in the mid-70s.

Incontinent Spending

2010-04-10T22:06:00.000-07:00

Kudos to Donald J. Boudreaux who used the phrase Incontinent Spending over at our friends' site Cafe Hayek to describe the fiscal policies of the Obama administration.

We've seen or heard some with less self control call that administration full of ... well, you know what, but we try to be family friendly here. Nevertheless, we find this to be one of the best word pictures of the week. We leave it as an exercise for the reader to find the other puns, double entendres, and innuendos in this angle.

Bank Reserves Continued Improvement

2010-04-10T11:26:00.000-07:00

Finally, non-borrowed reserve growth took a small drop. Two key interesting points about this: 1) the fed was still slowly creating money as new reserves in March and didn't actually stop agency debt purchases until the 31st. 2) The drop means bank borrowing of free reserves grew faster than the fed was creating money.

Meanwhile, total borrowings from the central bank continues the steady decline. This means banks are unwinding some of the facility loans and using more of their own capital as backdrop against troubled loans.

We still believe fed funds will remain low for an extended period, but we continue to watch these reserve metrics for evidence that a turn of events is around the corner.

Fed Funds Rate History

2010-04-07T07:56:00.000-07:00

During the last interest rate stimulated stock market recovery after the dot-com bubble popped, the federal reserve raised it's fed funds rate in July of 2004 (click the 'all' label above the chart). At that time, the market was just a bit over 1 year from it's bull market starting point in the late winter of early 2003. Just before the rate rose, the market had stalled and moved sideways a bit before making it's long run to the 2007 top.

Currently we are about at the same time frame from this markets launch point in the late winter of early 2009. With fed funds still sloshing around at the bottom of the barrel, and unborrowed reserves at astronomical levels, there's no reason to expect the funds rate to rise any time soon. The fed would have to sell everything they have into the repo-market to pull the excess reserves out of the system and get the funds rate to budge even a little.

So if they do want to raise rates, they're going to have to start some serious operations of a different kind to influence this market. Given Bernanke's propensity to come up with creative facilities for implementing policy, there's no telling how or when we will get some insight into their approach. Nevertheless, we are at a juncture where one would expect some kind of policy shift soon, or at least a stock market that takes a breather.

Another reason to anticipate something soon is the closed-door meeting of the board of governors that happened on Monday the 5th. On the weekend that link had the announcement of the unscheduled meeting under special rules of privacy. As we write, it's been removed. Nothing special came out in yesterdays March 16 meeting notes, so we presume the consequences from that meeting won't be known now until the actions are ready to implement.

Long End of the Treasury Curve May Stall

2010-03-31T06:51:00.000-07:00

The yield curve appears to be hitting a ceiling.

For the rate to spread to narrow with long bonds rising, the short end would have to move fast and furious. With piles of excess reserves, it's unlikely short end is going to rise quickly in less than half a year.

Money Multiplier and Velocity

2010-03-27T16:31:00.000-07:00

Can you have GDP growth without debt growth? Is debt contraction (monetary deflation) a sure sign of economic contraction? Apparently the common perception is no and yes: without debt expansion we are doomed. While we believe at SBC that these events can exist for a period of time, we don't believe they are forgone conclusions of some necessity borne out of some fundamental economic equation.

John Mauldin has produced for us some excellent analysis on this topic. We don't like predicting the future, but we conclude from his recent work that GDP growth does not have to be negative nor small.

First let's look at some conclusions from The Multiplication of Money. We believe it's a mistake to conclude a nation can't have economic growth without credit growth. If we understand the money multiplier correctly, it measures growth of debt; how much M0 money (reserves) gets converted into M1 money (via loan origination). It doesn't measure how many times the dollar from wages and income changes hands. In fact, if we pay cash for something and the business we trade with pays cash, and that business pays cash, and their business, and on and on down the line, all kinds of GDP is being created without any debt growth, either in M1 or M2. Economic activity without debt growth is very possible. It's how the world operated before fractional reserve banking was invented.

What we've described there is money velocity. Mauldin has another excellent description of that in the recent weekly newsletter titled The Implications of Velocity. In it he presents an example of one kind of GDP growth.

"Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP rises to $14,000,000."

Wait, how did they get their hands on the money to conduct trade? If mom and dad gave them the money, mom and dad had to give up spending it themselves. If the bank loaned them the money from fractional reserves, the velocity doesn't have to change for everyone to stay at the same level of income, since everyone still has all their money to spend and the new kid on the block has newly created money from fractional reserves. For sure, this is how economies have grown in modern times, giving someone future money to spend today.

So let's take a look at the velocity equation. Notice P=MV does not have debt as part of the equation, except to the extent debt is a component of M. Since GDP transactions are conducted in real physical cash or checking deposits, the monetary metric to use is M1. The astute reader will notice immediately that one can conduct transactions with credit cards and bank loans. True, but since we are presuming an economy where debt is not growing, those don't count. They either get offset by someone paying down loans, or by the person paying off the loan (credit card) at the end of the month with cash or M1 money.

Furthermore, for those who spend cash on debt repayment (pay down car loans, mortgages, etc) we need to realize those payments are M1 asset transfers from debtor to creditor. They don't affect the M in the velocity equation, either.

In fact, Mauldin shows M2 is not growing as M1 has recently. Since M2 is not directly spendable money, it appears the nation is churning the money in demand deposits and cash (GDP is not zero) instead of loading it into savings vehicles (M2 is not growing with M1). Unwinding debt would do this. As pointed out above, debt pay-down is nothing more than an M1 asset transfer from debtor to creditor. If the creditor then uses it to pay down their own debt, it too is another asset transfer of M1 from debtor to creditor. This creditor to debtor pay-down cycle can go on for some time. It can happen any number of times, all the while reducing "total debt". Does that alter velocity or GDP? Not necessarily.

At some point a creditor is payed and decides not to reduce debt, either because they don't have any in the first place or they are comfortable with the debt they have. If they save it, the money appears as M2 growth. If they spend it, it appears as a contribution to velocity and GDP.

It seems apparent, then, that if M1 is growing and M2 is not, and GDP is not contracting, that M1 money is being used to buy things with cash or pay down debt (or bury the bills in a can in the back yard.) There really aren't any other things one can do with money but to spend it, save it, or pay off debt.

People don't spend M2. It might be a funding source for spending, as people cash in the CD or transfer money out of a money market. It may also form the basis of confidence for spending, since one can buy on credit and pay it off when the CD matures or when they chose to redeem Money Market funds. But M2 itself is not directly spendable. It only represents the confidence of spending what is available in M1 or new debt. One can think of it as a source of "respending". If one writes a check today and something else comes along to entice the person later, one always has that M2 savings to use for the purchase. Nevertheless, all commerce takes place with M1 money.

We conclude that it is not a forgone conclusion that we must have economic stagnation if we have debt contraction. It's not even certain that we will have weak economic growth. Whether we do or not really depends on the velocity of money. If those with money have confidence to spend it, and if they relearn how to live within their means, we could have very healthy GDP. The problem we have with the common public data is that they predominantly provide statistics representative of the Losers; those who've botched it; those who are financially illiterate. While we have no hard data to prove it, we believe those people make up the minority of the American public.

Isn't it interesting how many advocate that people live within their means and that the nation would be stronger if we didn't rely on debt for economic well being? Has anyone even provided a picture of what that transition would look like? We don't want to sound too proud or arrogant, but maybe we just did.

Now what fiscal policy can do to this aspect is another matter. We'll have to look for evidence to that effect somewhere else.

Before you scoff at our conclusion, take another clue from chaos theory. Mauldin points out a very useful lesson from the book Ubiquity: Why Catastrophes Happen. The conclusion is that stress points are built into the fabric of human existence. The implication is that it almost doesn't matter how one responds to a crisis. The long term consequence is that complacency and comfort will set in, preparing the way for the next build up of critical mass to produce another crisis. Now if you can't tell when you are there at the precipice, how can you tell what the fundamental change is that is setting up the next generation for a fall? If you knew when the fundamental change was taking place, one presumably could prepare a plan for the consequences of the complacency that follows. But in fact these things are never clear until they become hindsight.

The Fed's Report Card, by The Fed

2010-03-26T06:09:00.000-07:00

The federal reserve put out their assessment of Ben Bernanke's helicopter ride in a report titled Large-Scale Asset Purchases by the Federal Reserve: Did They Work?

Presumably it isn't surprising they conclude what one expects when demand rushes in like a flood:

We present evidence that the purchases led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than lower expectations of future short-term interest rates.

Well of course! When demand for security jumps, so does the price. For a bond, rates fall when prices fall. And given the money to fund the purchase was created out of thin air, there was no decrease in demand for competitive instruments. The money that may have purchased those bonds was free to purchase others.

The reductions reflected lower risk premiums because it was made perfectly clear that there is no limit to the money available (since it doesn't come from finite pre-existing money) and hence no reason to expect lack of funding. It didn't reflect lower expectations of future short-term interest rates because it was also made clear it would end and the dilution effect was sure to increase the inflation premium in future markets.

One wonders if the authors actually expected any other conclusion. Imagine a rocket scientist being surprised that propelling an object at 200 MPH in an upward vector would make the object fly, but eventually fall to the earth as the applied acceleration source was stopped.

In spite of the humorous angle, it's a good piece of writing for one who wants to get a good look at how open market operations function.

Investing on The Edge of a Precipice

2010-03-26T00:14:00.000-07:00

Today we highly recommend the March 8th weekly comment by John Hussman, The Rubber Hits the Road. Hussman makes some good points about history, comparing post-war economies with financial-crisis economies, relates that to this present period we face, and describes the human psychological factors that come to bear on security prices. The discussion of pending mortgage resets and how that may play out is particularly relevant.

It is interesting to see someone actually point out how and when we may rely on the irrational exuberance of speculators to make informed decisions of our own:

As we move through the coming months, resolving the "two data sets" issue will help us to determine which set of historical precedents is relevant. If the current economic environment produces fresh credit strains similar to previous periods of credit difficulty in the U.S., Japan and elsewhere, valuations and margin of safety will remain the most important consideration in determining investment positions. If the economic situation reveals itself to be more like typical post-war cycles, valuations will still be an important consideration, but we'll be better able to assume that speculation (provided sufficient evidence from market internals) will be reliable even in the absence of clear fundamental support from valuations.

If you are a Graham-Dodd fan, you'll particularly like how Hussman builds upon their foundation in presenting the expectations of investors in the current environment. Our conclusions is that with the infatuation Americans have with entertainment and personal emotions and opinions over facts and substance, we are unlikely to see any sound behavior by the general public with regard to investments.

The one thing he didn't mention in March 8th were the fundamental factors pointed out in a previous weekly comment, which contribute a third influence on the confluence of forces affecting the markets: the Fed quantitative easing policy coming coming to an end, just about the time we may begin to receive some clarity on his "two data sets". Add to that the potential for more debt issues out of Europe in the next few months, and the security markets may very well be resting on a weak precipice.

Now YOU Can Have Bank Reserves, Too.

2010-03-25T07:20:00.000-07:00

"As an additional means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers."
(Source: Ben Bernanke's exit strategy testimony)

We have to hand it to this guy, he is one of the most creative bankers in history. In just two sigmas the American people can sink their claws into Federal Reserve excess reserves. Now all we need are 15 million savers willing to lock up their full FDIC insurance allocation in these new instruments, which will probably pay diddly-squat interest.

Of course money market accounts will have direct access, too, so the consumer angle is actually not that important, provided consumers feel compelled to put their money into money markets paying diddly-squat instead.

The real problem with bank reserves is that they don't provide a rate of return. The only way to entice the free market to park their money in reverse repos is to make them more attractive to alternative investments. So this plan can only work if interest rates rise (to attract capital into these instruments) or velocity of money remains low (velocity being the basis for high reserve balances as a threat). If velocity picks up, price inflation will also, and rates will naturally rise. The trillion dollar question is how quickly can rates stifle inflation forces, or will the lag between price increases and rate increases be a kind of self-accelerant of velocity. The feed-back loop could be phenomenal.

But that's all just speculation, isn't it? No doubt the creative genius of Bernanke will devise a plan for that at the right time. Of course Greenspan didn't stop the dot-com bubble, and Bernanke didn't stop the real estate bubble, so it's pretty hard to imagine what will provide Bernanke with the incredible insight and forethought to recognize how to prevent the next bubble. One thing is for sure, it ought to be interesting.

In July of last year we had similar comments on the exit strategy. One might want to compare notes, both ours and Ben's, to see how things have changed.

Sector Analysis and Business Cycles

2010-03-24T05:47:00.000-07:00

Faheem Gill has a nice analysis of the business cycle and equity sectors that do well in each. He focuses on energy, but the charts would be good for one to copy and mark with one's own preferred investments at each stage.

The only thing lacking is a note to shift out of equities into bonds at the peak of the interest rate cycle.

Treasurys No Longer Risk Free

2010-03-23T07:18:00.000-07:00

It looks like this generation may be the one to see a new definition for "risk free interest rate".

From Bloomberg yesterday:

The bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama.

Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity ... Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.

Wikipedia also has a good article on the importance of this to investment models.

Metals and Mining

2010-03-22T06:26:00.000-07:00

Today we discovered Wildebeests, a web site devoted (in their own words) to the four M's: Minerals, Metals, the 'Merican economy, and Mathematica. They have some very good research and writing skills on the subject matter dear to our hearts, hard assets, and as such have earned a place in our investor links.

For some dialog between us, see the topic "Investing in Copper — What You Need to Know"

How Can Stock Market Asset Prices Fall?

2010-03-14T23:20:00.000-07:00

For the stock market to drop in value, something else has to be in greater demand. In the realm of paper assets, the only competition for equity is debt or debt-money, and the non-paper competition is commodities and real-estate. Let's look at each one, except real-estate, which should be clear without saying in the spring of 2010 is a non-starter.

It's been clear for about three years now that money does not flee to hard assets when paper assets are in jeopardy. Those hard assets experience a sell off, too, as money flees in a crisis for the stability of U.S. dollars. This should be expected for some of the reasons we pointed out in November. So if the stock market has a significant sell off, don’t expect a commodity price spike. Whether one thinks it should or shouldn't is irrelevant. That fact is it hasn't done so for the last three years. If you think it should, then take the sell-off as a chance to take a position at steep discounts. We address the fallacy of the counter-argument for deflation at the end.

We are then left with the realm of paper-assets: debt-money (currency) or debt instruments. Debt instruments can get very complicated because there are many types with a variety of risk and valuation models. However, we can simplify that into a few commonalities: short term and long term, corporate and government. There is another debt instrument that doesn't quite fit that simplification: debt derivatives. Of the collateralized debt types, they essential represent the same fundamentals as bonds, except risks are slightly lower as default risk is diversified among autonomous entities. The other common derivatives can be grouped as options, futures, or credit default swaps. Virtually all of those by definition are relativity short-term bets.

If one is worried about equity valuations (the theme of this writing) corporate bonds would be of interest to some as bonds receive the first-fruits of cash flows and stand ahead of stock in bankruptcy (government usurpation notwithstanding). But if equity prices are at risk, corporate default risks rise, too, so prudent investors won't flee to corporate bonds in a crisis. We find ourselves left with short and long government debt, or debt derivatives, competing with equity for capital investment.

Let's take debt derivatives now, particularly the CDS type. The only intelligent reason to sell equity for CDS is a credit crisis. This is in fact exactly what we saw in February. As the credit crisis that precipitated the change subsides, money flows back out of short term CDS instruments and back into longer term assets. While we don't have access to CDS price charts, we can certainly see the equity markets didn't stay low for long, which is consistent in fact and in theory with crisis of the past. So CDS competition is necessarily sudden or short lived, especially as CDS contracts are temporal by nature.

The next type of debt instruments we look at are short term parking places: short-term government bonds, and short-term derivatives other than CDS. All are havens for capital in times of uncertainly. All are temporary parking places where one then reallocates into something of greater risk with more reward potential as the precipitating event subsides. The certainty of that movement is assured by monetary low-interest rate policies of central banks. No serious money manager can sit on ROI assets below 2% for long unless in fact the world experiences price deflation of all asset classes across the board. The Austrian theory of inflation arising as a consequence of money creation suggests in this season of 2010 that is an absurd expectation. The arguments to the contrary are addressed below.

Like real-estate, it should go without saying that holding long term government bonds in an era of Keynesian expansion with extremely low interest rates as one of the most high risk (to asset price) low-yield investments of capital. Just as rolling short term bond holdings into short term bond holdings for an extended period is only sensible in an era of broad-based systemic price deflation, holding fixed rate long bonds when currencies are threatened by increasing debt, and interest rates have no where to go but up, is asking for capital loss.

Finally, the last paper asset vying for attention of investor and speculator capital is currency. In a crisis, even after all the liquidity measures and deficit spending in the U.S., the U.S. dollar is still the target of those fleeing for safety. Again, we aren't concerned about whether that is a long term good bet, but simply recognize it as the status quo. If indeed one believes such moves are unwise in the long run, take it as an opportunity to buy more reliable dollar based assets at a discount if it should transpire. But keep in mind, when this flight to safety takes place, money that isn't secured in currency derivatives will be parked in government bonds of the currency of choice, and we’ve demonstrated those arguments only have temporary extremely short value propositions. So the fundamentals of holding "cash" (pseudonym for currency), is really just another name for a bond position, and hence currency moves will follow the fundamentals of bond investments. Since bonds of all substantive nations are basically in the same boat, we don’t expect significant changes in currency price ratios as much as we’ll see in equity positions, and of course foreigners’ demands for equities ultimately translates into foreigners’ bias for currency price ratios. We covered that topic to some degree in our September piece titled "Where is the Next Bubble?"

Given the choices money managers have in allocating capital, there appears to be only one reason to expect any kind of significant decline in equity prices in the near term, and that's a flight to safety. Just as the financial crisis of the past faded into history, there's every reason to believe this one will play out the same. We pointed out some of those reasons in November under the title "Contagion: Been There, Done That"

In that piece we also point out how the latter sub-crisis had less effect than the instigating crisis. We've seen this take place recently with Greece's crisis, where there was some quick and noticeable reaction to flee to dollars and push down equities and commodities, but it was short lived and of little significance. Many have tried to build the case that "this time it's different" and pull some data out of a hat that appears different. Typically what we find is that they simply were unaware of similar data that did appear last time, or they miss the similarity of essence and difference only in nomenclature of the old and new data.

So we are left with the only variable that could explain a protracted equity bear market - positive or negative inflation. Positive inflation usually gets improperly discounted by the established world view in one of two ways -- they pick a measure of money that hasn't grown well and then conclude we'll see tame inflation or deflation, or they pick a secondary influencing factor (velocity is popular these days) and argue that it will overcome the creation of money. We've provided some links on the velocity argument back in July '09 and revealed how money supply and velocity can take some interesting forms. It is our belief that the contradictions between the Austrian school theory that inflation is a monetary phenomena, and the new school that it is a velocity issue, is simply missing the point that the Austrian school theory carries with it an inferred premise that the time between the money hitting the street and the prices showing up at retail are delayed by several months to a few years. In order for monetary inflation to not eventually show up in price inflation (either consumer or capital asset price increases), one has to permanently and systemically keep the velocity low. For nations whose people have consumer goods in abundance, inflation most likely appears in financial asset prices. For nations whose people have a higher portion of earnings going toward basic goods and services, inflation most likely appears in consumer goods.

One could achieve low monetary velocity with an economic collapse, but no substantial and influential market participant in the global economy is working toward that goal. Every policy choice and operation is designed to get people to dump their cash for something that will provide a return. All policies are designed (intentionally or accidentally) to make holding cash a losing proposition. It's the essence of both kinds of capitalism; traditional theoretical capitalism and corrupted modern capitalism. The former objective is to use one's financial capital to produce value in goods and services to reap a return on investment. The latter objective is to use one's financial capital to make other people's money work for you. The latter is the fundamental basis of the debt-money system used by every nation on earth: leverage. With every segment of every population save a few fringe radical thinkers working toward the same objective (i.e. maximum return on investment) something global and earth shaking will have to occur to put everyone off their agenda. We aren't suggesting that can't happen, just that the most likely expectation is that it won't happen until this next round of business cycle expansion pops sometime in the teens of the 21st century.

For the stock market to drop in value, something else has to be in greater demand. At this juncture in 2010 it goes without saying that real-estate and long bonds are non-starters. Other hard assets have proven themselves unattractive as replacements (albeit good co-equals) for equities. Being left with nothing other than short-term non-performing parking places and short term quick gains made attractive by temporary sudden shocks, there simply isn’t any real long-term asset class competition to distract the global investment community from demanding more equity positions. The prudent scholar, historian, and investor should be prepared for another cyclical equity bull market in the coming few years.

Insider's view of the business cycle

2010-03-10T08:16:00.000-08:00

What does the business cycle look like after a bust when you're the one on the inside looking out at the investment horizon? According to Bloomberg, it looks like half a trillion dollars.

"Buyout funds sitting on half a trillion dollars committed by investors may need more than a decade to put the money to work if mergers and acquisitions continue at the current pace."
(source: Bloomberg)

As readers should be well aware, nothing stays the same. The rate of M&A spending of the last year or so won't be the rate of spending in the future. As the business recovery solidifies the evidence of a "good buy" will change for the better and this money will start flowing. But notice this key point from the same article:

"“Investors only give the fund a particular investment period, typically three to six years, to invest the capital,” said Michael Harrell, co-chair of Debevoise & Plimpton LLC’s private-equity funds group in New York. “If you don’t use it, you lose it.”"

So there are two strong human factors at play there. First, those entrusted with the money don't want their clients to take it back. They will find a way to put that to work, and they have only two or three years to do so. What a coincidence this lull in M&A just happens to coincide with the first signs of recovery. (NOT!)

Second, if they don't put that capital to work, the clients who take the money back are going to have a lot of pent up demand as they seek out someone who will put the money to work for them.

No matter how you slice it, the business cycle is alive and well with capital left over from the recession looking for something to buy. 'Buy' is the operative word there. The only unanswered question is what will be in demand, and you can be sure it won't be cash and cash equivalents. After all, we're not talking about a world of Warren Buffett money managers. These are sharks looking for a kill.

But lest one gets too excited, temper the emotions with an interesting chart from the Bespoke Group. Looking at that 2009 March low, which was the bottom of that bust of the last business cycle, one should expect the 68% number will stick. Not only is the potential from here much less than the potential from 'there', but we still have a wave of news about to arrive regarding the mortgage reset wave of 2010.

We don't personally expect the news to crash the market or the economy, and don't expect a double-dip recession, but we do expect a wobbly stock market too jittery to make a firm run in either direction, albeit with a bias trend upward as happens with any business cycle boom phase.

As an aside, the astute reader should be careful to differentiate a boom from a bubble. Bubble talk won't be appropriate until about two or three years from now.

American Justice on Trial

2010-03-01T22:53:00.000-08:00

Uggh, this is certainly off topic, but the significance of the mockery of the American Justice system is too important to ignore. We won't comment any more on this, but readers should take the full 10 minutes to watch this whole video.

The first eight minutes are the setup that describes why Americans should cherish their legal system, built upon the foundation that the accused is guilty until proven innocent.

...if that man is tried in an American court under the American system of justice, then there can only be one verdict rendered, and that verdict is, not guilty“
- William Whittle

Don't miss the legal basis for that conclusion.

First Sign of Reserve Improvements

2010-02-19T21:21:00.000-08:00

Great news. Bank reserves have shown the first sign of change for the better.

For January, non-borrowed reserves have finally revealed a down tick. Sure, it's no big change, but it is the first sign. They've been steadily rising as the fed "adds reserves" (aka prints money) to buy agency debt. Note that this down-tick occurred in January while the fed was still adding reserves. That means banks are starting to lend again.

It's no surprise then that the TAF and discount rates were revised this week back toward pre-crisis conditions. No doubt the fed has better data than this nearly month-old update.

Get Paid To Move Your Positions

2010-02-19T07:05:00.000-08:00

Normally if you want to transfer your securities from one account to another you have to pay a broker to do that for you. This is certainly a preferred method in taxable accounts, since selling in one and buying in another would trigger a tax consequence and possibly incur significant costs from commissions if you have a lot of positions to move. If your securities are in a tax sheltered account though, you can use options to move those securities and generate income rather than an expense.

Options sell at a premium. If the underlying price is $70.00 and you buy a put option with a strike price of $75, you can expect to pay more than $5.00 for the privileged of selling the position at a higher price than it is at the moment. You can use that to your advantage in this position moving scenario by selling the option in the account where you want the position to be at the same time you sell the underlying in the account you no longer want it.

Here's the dollars and cents of it:

Account A:
Sell 1000 XYZ for $70.00.
Income: $70,000

Account B:
Sell 10 XYZ front month in the money $75 puts for $5.30
Income: $5,300

At Expiration:
Assign $75 put.
Expense: $75,000

Net: $70,000 + $5,300 - $75,000 = $300.

Assuming you aren't doing business with Lame Broker's LLC, the $300 net gain should be well above the cost of commissions.

The key point is you need to make this move when the markets are stable and reasonably predictable so the underlying doesn't shoot up so much in price that your option does not get assigned (unless it is also desired that you be out of the position at the strike price anyway). The days immediately after earnings is a good time to do this as you will get a good idea of price direction, and most market moving surprises about the fundamentals of a company come out at that time.

The Fed Did Not Raise Rates

2010-02-18T19:05:00.000-08:00

Did the Federal Reserve just come out and surprise the world with a "rate hike"? Technically, yes. It all depends on what "is" is. Read the official press release.

Notice this isn't really changing the fundamentals. What really happened was they removed some of the recent "emergency" measures.

On August 17, 2007, the Federal Reserve reduced the spread of the primary credit rate over the FOMC's target for the federal funds rate to 1/2 percentage point, from 1 percentage point, and lengthened the typical maximum maturity from overnight to 30 days.

As we pointed out in "Credit Spreads Expected to Narrow", the business cycle is alive and well. The Federal Reserve basically just sent out a press release to that effect. They've restored the spread and duration to pre-crash conditions. Yea, the spread is still not quite there, but hopefully you get the picture.

This is a change at the discount window and TAF, not fed funds. Bernanke is pushing up that rate to force banks to suck up the fed funds and entice other bond holders to find repurchase funding in the commercial paper markets. We predict it won’t have any impact on lending costs just as they say (since fed funds are still over-supplied), but to the extent the public believes this is something big, there’s some good shorting opportunities for the next day or two.

This is more to do with normalizing the old methodologies than a real rate policy change. The daily Fed Funds market shows no signs whatsoever of "improving conditions" as far as market interest rates in ring-zero financing is concerned.

All through the policy changes leading up to market collapse the Fed Funds data revealed policy changes in the days leading up the public announcements. Expect to see something move there, too, before any real rate increases happens in monetary policy. As it stands the current news is just getting a few markets back to pre-crash normality.

Credit Spreads Expected to Narrow

2010-02-11T18:30:00.000-08:00

This Time Is Not Different

The business cycle is alive and well. If you read the blogs and mainstream media you'll see a lot of bearish sentiment about the destruction of the American economy. Certain things won't be exactly like they were, but the interesting thing we see often is those bearish pessimists keep trying to discredit the optimists by pointing out the fallacy of "this time it's different", meaning this bubble isn't going to thrive any more than the last one.

Well, they're right on one count. The bubble won't thrive better than the last. But the one guilty of clinging to a fallacy are the bears. The "this time it's different" fallacy really points back at them. See, the bears are trying to sell us on the idea that "this time" the business cycle isn't going to happen. No sir, this time we've really shot ourselves and the stock market is just going to go right back down until the entire economic system of the world resets.

Well, maybe we exaggerate their point of view a little, but the essence is there. We contend the business cycle is alive and well and the prudent person will plan accordingly.

So how then do we interpret the budget deficits in light of the business cycle? For background on the business cycle of boom and bust one should go dig around at some of our favorite economic sites:

The Mises Institute
The Foundation for Economic Education
Cafe Hayek

Budget Deficits For Fun and Profit

Budget deficits necessitate a rise in interest rates. To attract money to Treasuries, the price has to fall since people will be competing for better returns in riskier assets. A lower price for Treasuries will attract that money to that instrument along some continuum of risk/reward which differs from one person to another. Meanwhile, the supply of Treasuries is going to be growing. To attract buyers then, the market has to push down the price of Treasuries.

On the off chance (slim as it is) that the government can’t attract buyers from the open market, the central bank will have to monetize the debt to prevent failed auctions. Hence, gold would be a good buy against U.S. dollar dilution by the central bank. This is not only true because of the recent past liquidity measures, but even more so for potential future liquidity efforts, if they arise.

Nevertheless, even if there are no more waves of quantitative easing, the last stimulus will be enough to create a wave of price inflation in the next five years. The recent sell-off in gold was simply profit taking and flight to cash on fears of Euro defaults, accentuated by program trading on the momentum and short term hysteria. Now that has subsided, we can get a wave of movement back toward long-term fundamental expectations based on centuries-old historical expectations of the boom-bust business cycle.

The beauty of this setup is that it implies higher risk in Treasuries than historical norms. Higher risk between Treasuries and corporate bonds means the spread between Treasury and corporate will narrow to the extent that businesses still know how to run a sound business. This translates to basic business-cycle fundamentals acting in opposite directions on the two sides of the spread.

Even though Keynes may not have had the big picture well understood when it comes to long term health of the economy, he was not wrong that government deficit spending stimulates demand for goods and services in the marketplace. Demand for goods and services in the marketplace is good for “business”, which translates into improving business credit default risk as cash flows improve for them.

Given then improving business credit default risks with degrading government credit default risk, we have a nice scenario that translates into narrowing credit spreads between so called "risk free" Treasuries and business risk corporates.

We're not trying to sell the value of the business cycle, or suggest it's a good thing. We simply want to point out it is alive and well. The fundamental factors that create it in the first place aren't gone. Names change and leaders switch places, but the same system that brought us all the other booms and bubbles is going to give you another one. We happen to think the global Q/E policies of every modern nation on the planet is going to make this next one a doozie. The good news is you have plenty of time to prepare for the pop and chaos that ensues from the bust.

For a more entertaining perspective, check out the viral video "Fear the Boom and Bust".

Can demand for credit derivatives really lead to economic decline?

2010-02-05T11:34:00.000-08:00

If we read the attempted implications of "Bond Market Vigilantes Sink Stocks" right, Mr. Mirhaydari claims the surge in the CDS market is threatening to raise interest rates on sovereign debt, which will force governments to cut spending and raise taxes to counter the cost of debt, which leads to a double dip recession, which leads to a falling stock market.

It makes perfect sense except for the part about politicians giving any hoot at all about the cost of their debt. Europe certainly has rules about limited deficit spending, but does anyone else that matters to global growth have such constraints?

Still, if the rush for CDS instruments is really the impetus behind recent market movements, that money flow will eventually unwind as the speculators take their profits and look for another ride to get excited about. Maybe the only real connection that makes sense is that institutions that have the clout to speculate with CDS, bonds, equities, and commodities all over the world have found a nice little emotional roller coaster to take out for a spin, after which they’ll whipsaw the markets and ride something else up to hysterical levels when they are ready to take profit out of the CDS markets.

If Mirhaydari is correct we'll see people talking about S&P 500 at 600 within a few months. If our secondary supposition is correct, we should see a strong rebound in stocks and commodities before summer. According to Jim Jubak's analysis of leading and lagging indicators, the latter appears more plausible.

SPX Created Five Gaps Since 11/6 - The Chaos Indicator.

2009-12-03T13:18:00.000-08:00

Count the gap-open on the S&P500 recently since November 6th. Notice how the chart (OHLC bar style) looks like a very unstable thinly-traded security. We count five gap-opens since the close on November 6th. If we fill that gap (which hasn't happened yet) it would put the SPX very close to the lower bound of the Bollinger-band.

Is there a technical formula that measures "chaos"? That's what the chart looks like since early November. If the chaos factor were high, would it be a bearish or bullish indicator? Intuition suggests bearish since it indicates indecisiveness, and selling and holding cash when you aren't sure what to do is easier than buying and holding risk when you have no firm conviction.

The Fear Factor

2009-11-21T10:45:00.000-08:00

The following isn't technically a technical indicator discussion, but looking at the pattern of the current five month bull market from Bespoke Investment Group, we get the sense that both bulls and bears fear factor of being wrong and missing out on the big move is getting stronger.

We couldn't help but notice the length of the candles getting longer and more regular. Notice especially the first test of 1100 and the ensuing test of the 50 day SMA.

The run-ups are for the most part slow and steady (until the most recent one) and the pullbacks fast and furious. But notice the pullbacks almost always have strong up days trying to fight them.

Conclusion 1: the old adage that it's easier for the market to fall than rise is clearly seen. This is because pulling money out is easier than taking the risk of committing money and having it decline. Cash never declines in value (please, don't even think of starting a tangential diatribe about the dollar. We're talking about a two variable, and only two variable, equation: dollar priced SPX vs dollars, period.)

Conclusion 2: The 50-day and 1100 support and resistance points have become "sticky", both of them. In the last three areas where the price has approached either point the market did not want to move away from that point in either direction. There is very strong sentiment in both directions.

Monday will be interesting. We're expecting some volatile sideways movement as the moving average rises to the 1100 mark. Besides the technical aspects of that, the price range of indecision during the last three tests is awfully close to the range of price between support and resistance.

The ideal scenario would be sideways motion from now to end of year with SMA(50) rising up to 1100 without a strong breakout. That would give us some very nice income on our bi-directional short put strategy and top off our year with close to 20% gain so we can go flat around the new year and catch our breath, waiting out the market's indecisiveness and getting some sense of economic effects on corporate America during January earnings season.

While we're not one of those who subscribe to belief in the end of the financial world as we know it, the 10-year chart on SPX suggests this push off the bottom has come faster, straighter, and longer than the 2003 recovery. It is also clear the sell off was equally more straight. So one would expect a fast straight reversion to some equilibrium point. Because of that, our sentiment for the next few months is sideways/down for a few months as opposed to our current sideways/up sentiment. However, during 2006 we were bearish on the premise that the market can't just go straight up for a year without any correction, and was clearly proven wrong. We'll never say never again. [roll theme song]

My name's Bond ... Jade Bond.

Profit Taking Rules the Day

2009-11-17T06:46:00.000-08:00

It appears the last two days saw big moves upward in all of the following:

10 and 30 year U.S. Treasurys
GLD
DBB
FXE
SPY
DIA
QQQQ

Stocks, bonds, commodities, everything on a roll at the same time. This can't be a sentiment shift (since Treasurys typically move the inverse of equities.) Our guess is derivative profit taking is pushing up underlying securities.

Where did all this money come from?

2009-11-13T18:19:00.000-08:00

Has anyone else been watching this and have a specific explanation other than "the banks aren't lending". Seriously, where did 400 billion dollars come from in the last two months?

Non-borrowed reserves in the last two months have jumped from around 400 billion to around 800 billion.

Who's pumping money into the banking system?

Oh, and did you notice the shaded recession period is in the past. Somehow we missed that announcement, but we did observe something similar on November 10th.

Contagion: Been There, Done That

2009-11-10T06:20:00.000-08:00

If you haven't seen Commanding Heights, we highly recommend it. It goes best with a strong thinking cap so you can read between the lines and find the subtle nuances of cause and effect in global finance.

I part three in particular, they covered the Asian Financial Crisis that started from a small little economy, that through currency controls created the exact same financial situation we had last year (don't miss the entire city built from the ground up on debt financing to which no one ever moved in to populate!), and as the piper came calling and financiers decided they were no longer going to sing that tune, it spread to all the healthy nations in the region as electronic funds transfers sucked all the money out of the region, one nation after another.

The funny thing is, that time the money needed a place to park, so it fled to another emerging nation -- Russia. They didn't go into details on the underlying reasons for Russia's default on debt, but ultimately it lead to Long Term Capital's implosion.

And then Brazil was hard on its heals with another collapse in this game of financial dominoes, but was averted by a quick influx of bail out money as the signs of stress were about to crack.

In every case: bail out after bail out after bail out.

The difference in 2008 was apparently "they" (those with all the money under control) learned how not to make the same mistake. When credit stopped in 2008, the money this time went straight to U.S. Dollars. No messing around this time with some new emerging entity that offered hope and promise of the perfect utopia. Instead, get out, park the money in the one nation and one security most likely to not have a political revolution over the hub-bub, and wait it out.

So in spite of all the uproar over Federal Reserve emergency lending and government bail out of banks in 2008, it really was not unprecedented. It was exactly what was done the last time. The only difference being this time it was an internal massive bailout instead of foreign nation massive bailouts. We contend the labels on the entities in question are irrelevant. It's the same thing every time (remember the third-world financial bail outs in the 80s?) Apparently it's a necessary evil every decade.

There is nothing new under the sun. Watch it, learn to read the signs, and get ready for a repeat since the fundamental foundations, the global monetary systems, haven't changed one bit. The hard part is learning how to discount and ignore the incessant monthly claims that "it's going to happen again!! Sell now and protect yourself!!!"

Meanwhile, like last time, it appears the contagion has stopped spreading. See our other post today, The Financial Crisis of 2008 is Officially Over.

We left out one interesting link on those references though. Just as Brazil's contagion was contained by preemptive quick response, The Fed has preempted the Commercial Real Estate issues that are falling on the heals of this most recent global financial crisis. Like Brazil's non-issue of the 90s, we predict the present CRE "crisis" will also become a little known financial issue of 2010.

In a nutshell, banks can restructure the loans and won't be "criticized" for what otherwise would have been bad lending practices. It's now OK to carry bad debt on the books.

Just like Japan? Well, not exactly. Turns out we can learn another important fact from Commanding Heights. In the 90s, when Japan's banks were stuck with all those bad loans, one bold man stood up and suggested if they want to get out of the crisis they need to loosen up the over-bearing burdensome regulatory structure that was constraining the banks. He was quickly fired from his cabinet post, they refused to "fix" the systemic problem, and the lost decade ensued.

If Benny and Timmy had nationalized the banks in the U.S. to "solve" our crisis and put massive layers of regulation on them (as if you can implement "Soviet Union Economics" and create vital capital formation) then we would have been destined for a lost decade in the U.S. as well. Instead, we have a much better chance of getting back to normal, which is setting ourselves up for another crisis in the teens of the 21st century just like the previous three decades.

The Financial Crisis of 2008 is Officially Over

2009-11-10T05:39:00.000-08:00

On Friday of last week:

The Federal Reserve Board announced Friday that a temporary exemption to the limitations in section 23A of the Federal Reserve Act, instituted as part of the response to the financial crisis, will expire as scheduled on October 30, 2009
(source: 2009 Banking and Consumer Regulatory Policy)

Then today:

9 of the 10 Bank Holding Companies (BHCs) that were determined in the Supervisory Capital Assessment Program (SCAP) earlier this year to need to raise capital or improve the quality of their capital to withstand a worse-than-expected economic scenario now have increased their capital sufficiently to meet or exceed their required capital buffers. The one exception, GMAC, is expected to meet its remaining buffer need by accessing the TARP Automotive Industry Financing Program, and is in discussions with the U.S. Treasury on the structure of its investment
(source: 2009 Banking and Consumer Regulatory Policy)

Update 11/18/2009

In light of the continued improvement in financial market conditions, the Federal Reserve Board on Tuesday announced that it approved a reduction in the maximum maturity of primary credit loans...
Prior to August 2007, the maximum available term of primary credit was generally overnight. The Federal Reserve lengthened the maximum maturity first to 30 days on August 17, 2007 and then to 90 days on March 16, 2008...
(source: Federal Reserve Press Release)

Who cares about Latvia, anyway?

2009-10-08T08:28:00.000-07:00

Apparently the financial markets consider it a minnow in an ocean of liquidity. Stocks and bonds are all doing just fine today, thank you, while Latvia is having serious currency problems that threaten Sweden's banks, while the other Euro nations are strained themselves.

"Latvia's latest crisis unfolded as new data confirmed economic fragility across Europe, where nine countries -- including Germany and Italy -- drew warnings Wednesday from the European Commission for widening budget deficits."
(source: WSJ)

An analyst from Brown Brothers provides more detail of some of the austerity programs -- limiting liability of homeowners. Apparently no big deal to the West, since credit default swaps are down today.

It might very well be a perfect setup, as Jansen at Across the curve points out:

"Maybe all this means that we are setting up for a giant duration grab which will leave the curve far flatter than anyone though possible. Investors will delude themselves into thinking that there is no risk in a 10 year Treasury or a 30 year bond.

When everyone is in the pool someone will saunter by and throw a plugged in toaster into the deep end. It will surely end very ugly."
(Source: Across the curve)

To which someone created a fanciful depiction of the toaster in response. One can only wonder if the founders of Thinkorswim had this type of metaphor in mind when they got started. It certainly seems appropriate.

We believe the thinkers can use today's experience to gain a better understanding why it's prudent to discount the U.S. economy bashers, as it is clear that economic troubles in the U.S. are matched by the Eurozone troubles. There just isn't all that many places to flee to if you want to stay out of financial trouble.

So it's no wonder that even in the face of massive deficits in the U.S. all the way out to the visible horizon US Treasury prices hold their own. Even if it's true that the U.S. is a sinking boat, all the other boats have big holes in the hull, too. The U.S., being the biggest boat in the pool, will most likely be one of the last to soak it's passengers.

Where Is The Next Bubble?

2009-09-30T06:54:00.000-07:00

Look out for the next round of "emerging markets".

In the late 90's the easy money policy coincided with the advent and new-found stability and strength of the Internet, pumping huge amounts of speculative money into dot-com ventures. In the early 00's, the easy money policy coincided with the advent of the new-found stability and strength of credit derivatives. Readers might recall Enron set the stage for a new way to look at derivatives, after which the same geniuses of mind that invented them for energy and bandwidth extrapolated the concept into credit markets like never before. The question for us today is what financial model has the same characteristics that make for speculative exploitation?

First, it must be global in nature -- accessible and understandable to every language, culture, and nation. The last two bubbles occurred everywhere. In fact, there isn't a single nation big enough to absorb all the money in the world by itself. We need a band-wagon big enough for the entire human race.

Second, it has to be relatively new, as in "iteration 3". It has to be a bit of a novelty for the commoner and limitless. Bubbles don't grow where there are walls or boundaries. The Internet iteration 1 was limited to academia nerds, with commoners intrigued by the mystery of the new concept. Iteration 2 of the Internet found some bold adventurists dabbling in newly invented business models that only a very few understood well enough to make sense of. By iteration 3, the commoners began to understand this new business from having been exposed to it as consumers in iteration 2. The Internet had no bounds. So when the easy money politics of Alan Greenspan kicked in, it was a no brainier for high-finance to use that cheap easy money to take extraordinary risk on new ventures into this emerging new opportunity called "The Internet".

In the case of credit markets, collateralized debt began with mortgage backed securities, invented and implemented first in the federal lending agencies created in the 1930s and later. In the 70s, securitization of those mortgages was invented. (source: "Introduction to Commercial Mortgage Backed Securities (CMBS)"). For years they mostly sat their as a tool for the nerds of finance. With the advent and spread of computers, the agency bonds became a common investment playground of everyday finance. By the time Greenspan stepped in to rescue the markets from the dot-com bust with round two of ridiculously low interest rates, the collateralized debt instrument was so well established and proven it was now ready to exploit that cheap easy credit through the carry trade, in which even Japanese housewives were speculating.

Now that Ben Bernanke is fully entrenched with round three of subsidized and ridiculously low interest rates, where will that money go? It might very well be the Asian and South American emerging markets. In the '90s, a wave of free market economics swept the globe. The managed economy fell into disrepute. Small and large nations alike abandoned their commanding heights and implemented market reforms. In this iteration 1 of emerging markets, only the nerds of economics understood what was going on. No common investor in their right mind would gamble on such a large experiment in finance as to invest in a former dictatorship. By the time the collateralized debt machine was in place, these nations had established themselves as more than just a wild experiment. Their reforms actually appeared to be working. Business ventures in these nations seemed to be sticking. Policy official spoke the same language as industrial nations. Global trade and open markets were working. During the 2000's, the term "Emerging Market" and BRIC became reputable areas of interest for normal investment firms. Average investors were leery, but interested, and willing to dabble with 10% exposure to this "industry" as the bulk of their portfolio focused on Real Estate and domestic equities. Most importantly, they were learning the lingo of international investments and cursory knowledge of foreign economics.

Enter iteration 3 of emerging markets. The fuel for such an explosion could very well be the U.S. carry trade. If Bernanke can keep interest rates unnaturally low "for an extended period" like he has said, it just might fuel a new round of exploitation in those growing non-US markets, which would lock up huge amounts of US Dollar assets in foreign debt at absurdly low rates, and drive the price inflation we should have seen in the US into those other markets instead. The confirmation of this new bubble will be normal asset allocations in the high double digits in emerging markets by Western investors. The peak will come when taxi drivers and hair dressers share tips about the nations they are exploiting.

If Carry Trade Wave 2 is funded with dollars, we would not see significant price inflation in the US. Instead, price inflation will be "exported" to emerging markets as an ample supply of funds flows to them. Just as "credit risk" became a thing of the past in the last bubble, "foreign investment risk" would be a thing of the past in this bubble, as their GDPs explode in what would be sold as the new age of international trade. That would be the ultimate confirmation, when broker pitches include the assurance that foreign investment is nothing to fear as emerging nations support each other without the 'need' for the U.S. economy to sustain them.

Don't Ask, Don't Tell

2009-09-24T20:16:00.000-07:00

Putting a new twist the common vernacular ...

Subtitle: "Why we need to keep our operations hush-hush secret", by Scott G. Alvarez, General Counsel, United States Federal Reserve Bank, in testimony before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C, September 25, 2009.

If you don't believe me, you can read the full text of the prepared speech for yourself as we've linked to it above. Or you can just believe me when I say the basic message is, "Trust me, we do all this for your own good. These aren't the drones you're looking for. You can go about your business."

Don't ask why we're on a Star Wars kick this week. It just seems to be working out that way. May the force be with you.

Embrace Your Feelings

2009-09-23T08:45:00.000-07:00

That’s the wisdom from “Old Ben” of Star Wars fame as he tried to take down the Evil Empire's death star. Looks like the nation of France is embracing The Force after all these years as they try to take down the Evil Empire's death star “players”.

I'm sure it's just a coincidence the author of "France to count happiness in GDP" at the Financial Times is Ben Hall.

The Economic Policy Journal blog has a free summary of the news.

Money Supply Blog

2009-09-23T08:35:00.000-07:00

The Financial Times has a blog on Money Supply around the world. We haven't yet formed an opinion about it yet, but the graphic (logo?) is slightly innacurate in our estimation. That scafolding and framing holding up the nations should be a house of cards, not steel. Steel is SO-O-O 19th century!

Bond Fundamental Shift on the Horizon

2009-09-22T16:56:00.000-07:00

Not sure if this horizon is near or far, but it will be an interesting experience when we get there.

Sources say the Fed is in secretive talks with bond
dealers to restart "reverse repurchase agreements" in an effort to siphon
some of the $1T-or-so it's pumped into the economy. Unused since last December, reverse repos take cash out of circulation when the Fed sells securities to its 18 primary dealers for a set duration.
(source: SeekingAlpha).

So if the Fed is delivering inventory into the system, and the Federal Government is issuing new inventory into the system, how exactly are interest rates supposed to stay low for an extended period if this horizon is not equally far away?

Why Everyone Is So Bullish on Gold

2009-09-21T07:20:00.000-07:00

Cliff Wachtel at Seeking Alpha asked the question today, why are "speculators" buying so much gold while "professionals" are shorting?

It appears to us he fails to realize (or he's obfuscating his real understandings for some journalistic reason) the broader fundamental nature of where prices and value come from. By that we mean the fundamental nature as described by Ludwig von Mises' in Human Action.

In the fall of 2008, the Federal Reserve made it abundantly clear that they would stop at nothing to ensure they could control all financial markets and keep dollars flowing. Finally, after the success at keeping security markets open, they found themselves with functional markets but little or no demand for debt. As money piled up in accounts of all kinds, they then had to worry about the collapse of money velocity.

There is absolutely only one way to make money moving -- punish anyone who doesn't trade it (spend it) in exchange for non-money. Since they have no legislative power, the only tool is debasement and negative interest rates (charging savers for storing money instead of rewarding them with interest payments).

Debasement was easy -- in Dec '08 and Jan '09 they announced unprecedented (in the U.S.) money creation schemes in the purchase of agency debt and U.S. Treasurys. Negative interest rates seemed to manifest themselves by the nature of the credit crisis.

So we now find ourselves in an environment where holding cash carries a risk that has to be weighed against the risks of buying bonds, stocks, commodities, or anything else. Furthermore, add to the equation the necessity of businesses of all kinds to produce a ROI above single digits, and the natural inclination is to buy something that has potential for price appreciation or income. It's no surprise to us in this light, that equities and bonds are showing price strength in spite of so many macro-economic weaknesses and the fragility of all those green shoots.

Enjoy for now the fact that institutions are doing the buying of equities, bonds, and commodities. When the higher costs of the latter start squeezing business profits, they will either have to raise producer and consumer prices or suffer systemic business losses.

In the former case, PPI and CPI go up, which means the risk of "holding cash" now hits consumers with inflation -- they will start spending their cash before it's purchasing power disappears, empowering producers to raise prices (the ultimate feedback loop). In the case of the latter, shrinking profit margins will be bad for equities, which religiously motivates another round of policy changes to "stimulate" the economy, further devaluing (diluting) cash (i.e. dollars).

Very few choices today will provide price support for purchases in either scenario of inflation or economic stimulation (i.e. more currency debasement). One of them is precious metals and their centuries-old reliability as a store of value. It's not a coincidence that some sovereign nations are thinking of gold again as they did before the prevalence of fiat currencies and floating exchange rates. The only major institutions who seem to be bucking that trend are the biggest institutions in traditional western industrial regions who pin all their hopes on fiat currencies. They are the bankers and commercial traders Cliff refers to in his post.

Update Sept 22:
ColdCore now reports at SeekingAlpha some details about those other sovereign nations and their interest in acquiring the "real money" that the west shuns.

Corporate Bonds Priced to Perfection

2009-09-11T12:21:00.000-07:00

Just posting this to record the event for future reference. This example of today's bond market pricing is a set up that makes us uncomfortable about bond prices. They've rallied so much that spreads don't allow much in the way of price appreciation on Corporates unless Treasury rates across the curve all come down.

It would be an unusual situation indeed for the U.S. economy to recover and have Treasury yields drop from where they are now. Some examples of price movement lately:

Colgate deal which priced several weeks ago at T+ 67. The deal was a six year maturity. That issue is now traded 14 basis points rich to the 7 year Treasury.
Walmart 5 year paper issued in May at T+ 125 basis points. That paper trades 40 basis points over the 5 year Treasury.
MSFT 5 year paper is freely available at T+ 25

Source: Across the Curve

------
Update 10/15/2009
J.D. Steinhilber, over at Seeking Alpha, provides some current bond information and more detail on the bond investor's dilemma.

Carry Trade, Funded by the U.S.

2009-09-11T10:54:00.000-07:00

There's an interesting piece out of Across the Curve today from a USD/JPY analysis. If it's a fluke of nature and prices revert to the recent normal relationships, it will be easier to predict the outcome of US fiscal policy. If this is the start of a protracted trend, the global dynamics of money flow will be very different.

Namely, all this excess liquidity piling up from US and global quantitative easing would not produce the normal expected price inflation in the U.S. if dollars are borrowed by the Carry Trade crowd to fund their currency speculations outside of U. S. borders.

3mth USD LIBOR is now LOWER 3mth JPY LIBOR. This spread turned negative about three weeks ago, and in the same timeframe, Usd/Jpy has also fallen 2.9% (see chart attached).
Bottom line, the USD is soon becoming the new global funding currency...
(Source: Across the Curve)

We're not going to jump on a bandwagon touting that last sentence just yet, but if it comes to fruition it would sure change the dynamics of Bernanke's unwinding process. It might be the mechanism that gives the U.S. another stab at exporting the fiscal consequences of policies to the developing world. In other words, more of what has just happened in the last 10 years.

The S&P 500 According to the U.S. Treasury

2009-08-27T06:02:00.002-07:00

Let's do a little common sense extrapolation. From the minutes of the August 4th Treasury Borrowing Advisory Committee meeting, we have this little factoid about American corporate income taxes.

Director Ramanathan discussed the components of federal revenues in the current fiscal year versus last year, noting that corporate income taxes (which generally account for about 10% of total receipts) were lower by over 50% year to date...
(source: Treasury Borrowing Advisory Committee)

Ok, so if tax revenues are down by 50% and there are no significant changes in tax rates, one can extrapolate that corporate profits are down 50% from a year ago.

A stock price is claim on long-term future cash flows from the company. Therefore, equity prices should be about half of what they were last year all things being equal.

But all things are not equal. Credit is different, money is different, business prospects are different, and perceptions of risks are different. Credit will not be as readily extended, the currencies across the globe are being diluted as fast as possible, businesses don't know when or where growth will come from, and everyone is on edge about credit defaults.

The SPY 52-week high is roughly 130 and today's trading is around 102. Valuations on stocks a year ago were at historic norms according to much of the research at Hussman Funds.

It sure seems to us that S&P 500 prices today are not at sustainable levels unless one presumes valuations last year were reasonable (i.e. the current year profits are a glitch on a much longer time frame) or currency debasement has been so deep current equity prices are normal when adjusted for real purchasing power. Neither of those seem to make sense, though, unless somehow the world is at a stage to repeat the growth of the 90s. How that might happen given the financial system's recent changes is a mystery.

The Bond Market Speaks

2009-08-26T07:31:00.000-07:00

John Jansen's blog at Across the Curve gives us intraday bond market readings. One of today's posts on intraday spreads seems to us to indicate big money is preparing for economic weakness.

Today he points out, which has been repeated now for some time, that "TIPS spreads continue to narrow." Early this morning we found out overseas markets had no direction across the curve except in the 30-year bond. This might be anticipation of Federal Reserve interventions, except the long end of the curve has been particularly strong lately, which indicates subdued inflation expectations.

We think all this combined is telling us inflation is not presently feared, and that can only be based on a presumption that the economic environment is going to be soft.

If you you have a lot of long equity at this point, be careful. This same perspective came to us last weekend as we summarized last week's Barrons.

Meanwhile, over at Barrons, Michael Kahn provides technical analysis in "Fear Creeps Back into Bonds" suggesting bond market readings point to risk-aversion in the market place. The stock market is rallying on the new home sales report this morning as we write. Time will tell if equity markets are aware of this risk aversion or not.

What Does Soros Think?

2009-08-26T06:47:00.000-07:00

Market Folly published a nice summary today of George Soros' hedge fund holdings.

This review by C. Kurdas on Soros' book The Alchemy of Finance will save you the trouble of reading the book. The book simply describes basic well known market psychology theory including a round-about way of describing the prevalence of existential belief in the minds of market participants. We like to summarize that with the catch-phrase, "You don't know Jack!"

If you want to be a successful, adaptable, 'reflexive' trader or investor, we recommend instead two books more directly addressing the issue of psychology listed below. As Mark Douglas pointed out in his book (the first one below) to a bond day trader whom he was advising, don't presume the other poor schmuck making a trade has better insights into the future than you. Stick to your strategy!

For adaptation to information as the market delivers it, we recommend reading John Hussman every week. Hussman is not a teacher, but his weekly commentaries to clients help you learn how professionals absorb data and apply it to reality, rather than trying to impose one's feeble world view onto the market.

Top Recommendations:
The Disciplined Trader: Developing Winning Attitudes
Trading for a Living: Psychology, Trading Tactics, Money Management

Take aways from Barrons, August 22nd, 2009

2009-08-22T10:56:00.000-07:00

Stocks: Where's the demand-driven commerce? So far everything has been driven by government spending.

Look before you Leap

Gummy Bears

Banking and Finance: Commercial and Residential mortgages are worsening in some respects, in spite of all the green shoots. Some numbers and quotes from the Federal Reserve, and announcement that TALF will be extened.
Weekly Review

Technology: So where is the so-called PC Refresh cycle going to come from? Intel painted a rosy picture of the future, but three other tech companies have now joined the crowd of those who simply don't see any particular good news in the making.
View From the Top: No Rebound in Sight

Dividend Investing: Another piece on why reinvestment of dividends makes a good long term strategy. Read it if you haven't heard about that angle before. Skim for tickers if you have and like the idea. We think it makes sense to have some long term holdings in this phase of the business cycle in large cap companies with strong dividend histories. We'll leave it to the reader to judge whether Greek history provides any value to the theory.
Marathon Investing

Bonds: The best may be over for the bond market unless we get a sell off in corporates and munies and a rally in Treasuries for another buying opportunity. You can look for bond yields at your favorite quote provider, but there's also a good story on the municiple market. Suffice to say spreads between Treasury and corporates have narrowed in the last few months making it harder to find corporate bonds with a good chance of covering potential drop in purchasing power from quantitative easing. We might as well stick with the safety of Treasurys.
Seeking Yields on Munis That Aren't Puny

Speculative Plays:
Long MELA: "Taking Aim at Skin Cancer"
Short SHLD: "Washed Out"

Strategic Thinking:
Stocks are overpriced unless utopia breaks out real soon now. Commodity prices are priced right as long as China keeps buying what it doesn't presently need and India keeps it's capitalism in tact. Western economies are most likely going to see muted growth while Asia continues it's expansion of the middle-class demand for goods and services. The mindset "follow the money" suggests being invested directly in Asia and Brazil if not indirectly through domestic companies that get a high volume of revenues from them.

The off-the-cuff allocation at this point is long blue-chip dividend paying companies, short US indexes, and long commodity based companies or funds that pay dividends (or short their puts for dividends and purchases on pull-backs).

Caveat: While we are bullish on commodities in the one year time frame, we don't want to hide the fact that this week Barron's has a story that this might be a dangerous outlook. See "Base Metals on Borrowed Time"

Best of the Week
BRIC - forget Russia -- go where the commerce is. The interview with Christopher Wood contains some good insight into the macro-economics of the global economy, and why Brazil, India, and China have some specific characteristics about each of them that makes a focused investment in the right places a good idea. We highly recommend paying particular attention to his analysis of decoupling (in economics as well as the stock market) and what signs to look for that indicate decoupling of Asia equities.

What's our take on his expose?
Look for falling interest rates in Brazil. If FOREX fundamentals are right, Brazil bonds might be choice instruments there for income and long-term capital gains. One might also use the yields to buy something that is a domestic currency hedge in case your FOREX eats away at the gains.

India has the best of the equity markets of the three. See the interview for why that is. Our take then would be to look for small cap companies that supply goods and services to businesses.

In China, the strength is in state-owned companies, as they get the best of command economic privelidges. Thier financial services are especially inviting as corruption and greed that ruined Western finance is dealt with in China via execution. You may not share our opinion on the death penatly, but we think it provides a strong incentive for bank managers in China to be careful of thier actions.

When Premiums Make Sense

2009-08-19T09:17:00.000-07:00

In the car industry there are rare events where certain cars sell at a premiums to MSRP when the product is rare and not likely to ever be available again.

While it's useful to know fact from fiction, especially in something that's easy to mathematically quantify, it's also good to know free market prices that are out of line with traditional pricing models don't necessarily indicate irrational behavior. Context is always the most important thing. While "bubble" is one of the most popular words in the investment community today, not everything you see that you don't value highly is a bubble. Context is everything.

When context lines up with analysis, you have strong forces at play. Such was the case in the dot.com bubble and the more recent real-estate bubble. On the other side of such crisis, when context no longer lines up with analysis, you have to put aside computer models and add human insight. In the case of PHK, the context is a rare bond market dynamic unavailable to retail investors. So it's not irrational for buyers to pay a premium to get a piece of something that won't be available shortly, specifically because it has very, very strong fundamental market forces behind the assets, and many of those assets are still priced to account for the end of the American economy within thier lifetime.

If $1.3 trillion of newly created money weren't chasing the bond market; if the Federal Reserve wasn't the primary market maker in commercial paper; if MBS and CDO bonds were trading in a free market; then PHK would probably be the worst product on earth. But this is not a free market. The dynamics of a deep pocket buyer chasing what no one else wants is unlikely to ever occur in my lifetime. Owning anything that has that kind of demand behind it can't be evaluated by traditional methods.

When the Delorean sold over MSRP, it wasn't foolish for those who paid the premium to get it while they could, because those who knew the auto market knew the prices would never be that cheap again, and the opportunity was limited. Now in hindsight we can see Delorean motors collapsed. So if you think the bond market and Federal Reserve buying program is going to collapse, you should not be participating in these bonds. But if you think the market is normalizing like it did in the other crisis, then a little investigation of fundamental forces is in order.

For months I would read John Mualdin describe the valuation of collateralized debt and the out of proportion pricing relative to real risk during the worst of the credit crisis. Every time I would salivate over the chance to buy those out-of-favor bonds as the irrational fear that the world as we know it was going to end tomorrow drove prices of even well-structured bonds into the ground. Not having a Bloomberg terminal or a bond trader's account, there was a fundamental opportunity of a lifetime that I had no way on earth to participate in. Then I discovered PIMCO was chasing that market for the same reason and in the same way I wanted, and had a vehicle available for me to jump on.

I paid a premium to get a piece of it because a) there was no other way for a common citizen to sell junk to the Federal Government at top dollar, and b) there were no option contracts I could buy to lock in the inevitable rise in price for this class of bonds, and c) Ben Bernanke's actions made it undeniably clear there was nothing on earth in the financial market that he wasn't willing to buy - nothing, not even the worst junk imaginable.

Like an option, there's no guarantee the market moves in your favor. One has to know the deeper fundamentals behind the cash flows and demands for the assets of the entity in question. You can't just look at the balance sheet values of the Real Estate assets of Sears Holdings Corporation (SHLD) and know what it's really worth. You have to know the actual location of that real estate and whether the real estate market itself will sustain, threaten, or increase that value. If the market for those R/E assets is drying up, SHLD may be overpriced. If they have a large government revitalization program behind them, SHLD may be under-priced. The issue boils down to whether the retail market has realized those values yet, or not. Price to book value may grow far more quickly than book value, primarily because book value is constrained while human intellect is not, even if abstractions and market forces not quantifiable by GAAP make it clear where future book values are most likely to move.

If we revisit this CEF when the credit crisis of 2008 is a distant memory, after bond spreads have normalized, and it still trades at a high premium, then I will join the short-seller's camp. Until then, Uncle Ben and Tim are ensuring the bonds I own through PHK have a strong, liquid, demand-driven market. I don't know any other product on earth that has an avid open buyer standing in the wings with an unlimited supply of blank checks to buy product.

When that buyer departs, things will change. But at this point their interest is strong and reliable.

The Business Cycle Continues

2009-07-31T07:59:00.000-07:00

The last 12 months have seen unprecedented political, financial, and legal change in America and the world. Anyone who thinks they can make a 5-year expensive financial commitment today and go golfing is fooling themselves. Everything needs to be hedged and watched closely with a highly critical eye, with a strategy to get out and reverse course quickly.

The deleveraging angle so often touted as the required outcome from our recent past excesses is moot. There are two ways it can happen and the Fed has predictably chosen the unnatural path. The first way (the natural way) is credit contraction. Not just your favorite metric, but the entire scope across the globe. One thing the recent generation gets out of the new free-trade global economy is spreading of the costs of managed economies. No longer can one central bank destroy a nation through lousy policy as happened in the 90s. Now the consequences of lousy policies are dispersed globally.

The second way, the artificial way, is the course all industrial and developing nations are doing today: debasing the currency. This method works by keeping current-dollar credit values constant from artificial central-bank stimulated demand (see monetarism), but reducing the purchasing power of those dollars by dilution of the currency.

That's precisely why the U.S. economy is stabilizing, and that in turn stabilizes bonds across the spectrum. Oh yea, we will pay for it, but the piper isn't going to come calling in the next 12 months. He's lining up his resources to come charging in sometime in the next 3 or 4 years. The details of the intervention are different this time, but the pattern of replacing wealth destruction with new money (whether by fractional reserve credit expansion from absurdly low rates or direct injections of new reserves when rate intervention is insufficient) has been used over and over with the same outcome every time: economic boom followed by economic bust.

The boom is just starting. The really horrible bust that everyone is ranting about today won't hit us until about 3 or 4 years. You can see that pattern in any of your favorite long-term macro-economic charts.

Corporate Bond Rally May Stall Now

2009-07-31T06:32:00.000-07:00

Today high-rated corporate bonds are trading just barely above government guaranteed bonds.

Yesterday we got a glimpse through Seeking Alpha just how far we've come in the last year.

At least at the top end of the rating scale, there's hardly room for any more contraction in spreads. The long term prospects for high-rated corporate bonds doesn't look good unless in fact Bernanke can actually overcome the forces of monetarism and keep real inflation at historical lows.

The best bet in bonds is the lower grade issues at this point. If high-grade rates remain low on a recovering economy from central bank purchase demands, those lower rated investment grade bonds will see continued contraction in spreads as default risk subsides. If high-grade rates rise while the economy recovers, lower rated investment grade bonds may not see declining yields, but contraction in spreads can still produce stable prices and above-inflation yields.

There are two primary risks, one of which is almost ignorable. The first is demise of the global economy, which is most unlikely but theoretically possible. For that scenario you better have backup food supplies, loads of currency (legal and barter) tucked under your mattress, and a plan for wilderness survival. The second is inflation rates rising to the point where low grade bonds fall in value with or without contracting yield spreads. This is much more likely than the former, and highly probably if Governments around the world don't back off their stimulus programs in rapid fashion.

The good news on the inflation story is monetarism reveals this kind of inflation takes 12 to 24 months to find it's way into consumer prices. At that point one will have to switch to inflation investing.

Until then, high yields, contracting spreads, and green shoots are the fundamentals one should be keeping their eyes on, and high yield investment grade bonds provide a tempting opportunity not often available with fundamental support like we have today.

How Ben Bernanke Saved the World

2009-07-21T05:41:00.000-07:00

Subtitle: "How I Learned to Land a Helicopter", by Ben Bernanke

The title is past-tense for posterity's sake. This link needs to be remembered in the future when reality testifies on Ben's behalf. Fortunately for Ben we can never know what might have been -- we only know what he claims would have been if not for his policy, and must believe reality is better no matter how bad it is in fact, when the facts are in.

This, though, is his expose on how he plans to keep the world from hyperinflation after the biggest creation of fresh dollars the world has ever seen. Download a copy for posterity before the Wall Street Journal archivists cut off the link.

This isn't very reassuring: "we can raise the rate paid on reserve balances as we increase our target for the federal funds rate."

It's reassuring if all one cares about is ensuring that interest rates rise. We'd really like to know how the next upward move in fed funds isn't going to create a financial shock like all the others in this present generation. Granted, inflation is under control as measured by CPI and a few other choice tools, but 9+% unemployment is approaching historic levels, so this last fed funds move failed on the employment objectives. And apparently wiping out American investors' wealth is an acceptable outcome (as happened in the dot-com bust and now the real-estate bust) since it isn't a policy mandate to target preservation of American 401(k) accounts.

Furthermore, it doesn't address the bank's fiduciary duty to shareholders. How are banks going to justify tiny ROI when fed-funds level of yields are earned on an ever growing pile of reserves? This is going to pressure banks to use reserves for higher-yielding assets. To keep bank stockholders from rebelling, the rate on reserves is going to have to be higher than fed funds. This program will create a ceiling for fed funds, not a floor. Small banks without large in-house investment departments like Goldman and Morgan (recently converted to banks) are going to demand yields that match ROI garnered from their securities market operations. Equity investors will not stand for ROI in single digits. If banks can't make loans to business, they will seek out returns in other markets like securities.

As taxpayers, we're not very reassured. It is certain this board of governors won’t make the same mistakes as their predecessors, but equally certain the mistakes they do make will be costly. One can always offer the blind assurance that it would be worse with any other option. But of course you can’t prove what might have been. You can only have faith. When it comes to faith in the central bank policies, our only faith is that they will create a boom-bust cycle just like they have for generations. As for us, we’ll prepare for the inevitable disaster in what ever form it comes in the next business cycle bust, including the potential of having to pay 80% tax rates on inflation-induced capital gains for the "rich" (where rich is defined as anyone not a ward of government social programs) to pay for the next Keynesian stimulus devised for the consequential bust of present-day quantitative easing.

TALF Fails Its Objectives

2009-07-16T22:46:00.000-07:00

That title might be misleading. It fails the stated objectives, but some might wonder if the real objective is to ensure a steady stream of large transactional revenue for primary dealers.

According to the federal reserve:

The Federal Reserve created the Term Asset-Backed Securities Loan Facility (TALF), to help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities...
Source: NY Fed

Notice on the July 16th facility, a full $0.6 billion in loans were requested. However, they weren't new loans. These were legacy securities. That means someone is putting up some old commercial real estate loans as collateral for cash, so they can do something better with them. It also reveals while they want to "support the issuance" of new securities, those working face to face with them aren't interested. There's too much junk in bonds they need to get rid of first.

One might argue, the proceeds from this loan might be used to fund new loans. While that's possible, its also possible they might be using the proceeds to fund payroll, pay bills, or who knows what.

But you see why the larger banks are in the money these days?

...Eligible borrowers must use a primary dealer...

The fee for the Fed alone is 20 basis points, or $1.3 million for this one operation on one day. No telling what kind of haircut the borrowers of the securities have to take with the primary dealers.

That also means one or more of the 17 dealers get piece of this action, even if they don't lend consumers a penny. One way to keep the banks solvent is to simply lend money back and forth between them; and you wonder if GDP is going to take off?

Maybe, maybe not. But one thing is for sure: those Goldman employees are going to be buying some pretty nice cars, clothes, jewelry, and other luxuries with their $386,395 annual salaries. Goldman is one of the primary dealers, and is no doubt making a boatload of money churning these legacy assets through all the facilities, not to mention the new bonds being issued by corporations, and the Federal Reserves direct purchase of securities.

As a matter of fact, Goldman is doing so well they confidently plan to issue around a billion dollars in unsecured bonds so they can leverage this new world of global liquidity. We don't yet what asset class is going to get that billion dollar stimulus injection, but something bubble somewhere is being pumped up.

Velocity of Money

2009-07-16T09:40:00.000-07:00

We're going to have to do some serious research on the Velocity of Money. This topic keeps coming up, but there doesn't appear to be a good discussion of the fact that Velocity can't be measured; it can only be calculated.

Furthermore, the fact that it exists (though some think it doesn't) doesn't mean it is the cause of inflation. Most posts appear to interpret it that we.

We at SBC believe velocity is a consequence of the psychology driven by theories expounded on by monetarism and Austrian economics. Until we get the in-depth analysis, we'll have to suffice for a few comments on the web.

See today's note on Seeking Alpha.
And another on Across the Curve.
And what appears to be one of the first arguments discussing Velocity and Monetarism. Mauldin has good analysis, but we don't think it discredits the view of V as a symptom rather than cause. Rather, it simply explains why there is a 12 to 18 month delay between monetary expansion and price expansion.

If you have more background and commentary, please put them into the comments so we can consider them in our analysis.

Gold analysis at Seeking Alpha

2009-07-14T10:52:00.000-07:00

Jake Towne has done an excellent job analyzing gold prices in Unlocking the Money Matrix: Gold Price Suppression. This deserves a careful review, especially by gold owners.

A first pass over this essay impressed us as the author uses many references to government and official documents. If we understand this correctly, the gold price is "managed" by central banks today, Paul Volker made a big mistake not to do likewise, and they won't make the same mistake this time until such time as their holdings preclude them from success. This premise is strengthened by a reference to a central bank research paper advocating just such a policy decades ago.

Someone pointed out months ago we don't have to worry about gold confiscation in the 21st century since it isn't the basis for money any more. This article suggests that even though that's true, the price of gold is the basis for psychology and fear in the populace, and that is something "they" certainly do need to control -- all nations, not just the U.S.

So it's interesting to consider how long they can succeed at controlling the price of gold, and what will they do when they no longer can?

There was also an interesting reference to replacing the many foreign currencies with just a few. This reminds us of the speech at the Council on Foreign Relations we pointed out last month advocating for fewer international currencies.

We don't believe in conspiracy theories (i.e. specific global planned and orchestrated events), but we do believe in a finite and very small universe of ideas. With billions of people and hundreds of thousands of leaders in government and business, it's not surprising for ideologies (like those at the CFR speeches) to hold sway over many powerful people who either intentionally or coincidentally align their actions to support the premises behind the conspiracies. Much like blogs and analysis hold sway over investor actions and move stocks, bonds, and currency prices in particular directions.

Mr. Towne has done an excellent job of research. What we now need is equally excellent peer review of the hard data. Please post your analysis as it comes in.

Oil Speculation

2009-07-10T06:26:00.000-07:00

This topic is rich today! Other titles come to mind:

1973 all over again
Political Stupidity Trumps Hard Facts
What to Oil and Onions Have in Common

At least a year ago, while oil prices were still threatening global economic development, the Commodity Futures Trading Commission (CFTC) was embarking on another round at attempting market manipulation through government regulation to ensure price stability of this precious and vital commodity. Congress even started at least nine bills, presumably in case the CFTC didn’t do their bidding. Luckily for consumers, rationality and reason prevailed that time. Hopefully the history of onions helped the first debate.

Rinse and repeat
Not to be dissuaded by circumstances, they’re at it again. Like every bad idea bureaucrats sink their teeth into, giving up and letting go is not an option. The Financial Times summarizes the present reality of another move to "fix" the "volatility" in oil prices yet again.

The fact that the so called "mess" they are complaining about happens to be perfectly in line with what any clear-headed thinker should have expected is beside the point (to them). As Craig Pirrong at Seeking Alpha put it:

...the past two years have been among the most volatile in the memory of most living people–you have to go back to the 1930s to find anything remotely similar. In 2007-FH2008, Chinese (and Asian growth generally) greatly spurred demand for commodities. Note that in addition to commodity prices, shipping charter prices skyrocketed, even though the price of something perishable like transportation on a ship can hardly be distorted by speculative buying, because it has to be consumed and hence is impossible to hoard. That was followed by a financial collapse and economic recession of severities unseen since aforementioned 1930s. Look at every measure of uncertainty, notably such things as the VIX volatility index. These things have been at dizzying heights since last August (and had begun their rise even earlier, in 2007). What would be weird is if oil prices (and commodity prices generally) HADN’T been volatile during this period.

He goes on to provide yet another round of reason and fact-finding to refute the notions spewing from the halls of Congress.

Mr Pirrong also provides us with a nice graphical representation of trading data. Notice that plunge in oil prices from 2008 to 2009, and speculative long futures contracts during that time, directly contradict precisely the claims of the fools in Congress and the CFTC. Not that you should expect bureaucrats to see the light when you shine it in their face. In spite of the clear evidence to refute the idea, we can at least hope the CFTC pursues this because of congressional pressures to please the lemmings in the general population who don't know any better but to demand someone look into it.

Last time the world financial system nearly collapsed, OPEC used it as the impetus to band together in a more concerted effort to ensure their revenues were not ruined by American policy.

Independently, the OPEC members agreed to use their leverage over the world price-setting mechanism for oil to stabilize their real incomes by raising world oil prices. This action followed several years of steep income declines after the end of Bretton Woods, as well as the recent failure of negotiations with the "Seven Sisters" earlier in the month.
(Source wikipedia)

It’s unlikely the price controls on oil in the U.S. helped matters. Some say the world won't experience inflation like we did in the 70s, but the global quantitative easing is ruining the value basis for currencies everywhere like massive new stock issues dilute the values of equities. Between the potential for CFTC regulation of futures markets, and the potential for ruinous monetary and fiscal U.S. dollar policies, America once again appears to be setting up for another round of high oil and gas prices.

At least you now know you can confidently brush off whatever nonsense someone tries to feed you when they use open interest in oil futures to tell you where the price is going next. Like any investment, you actually have to know something about the fundamentals of the market to make a rational informed decision.

While the last few weeks have seen some profit taking and softness in crude spot and futures prices, we’re still bullish on the intermediate and long term price potential of oil. If Congress and the CFTC does nothing, human nature and normal supply and demand will provide price support. If regulation ensues, we might learn something from the onion (depending on what actions are taken) and have more opportunity to profit from this essential commodity.

Security Analysis

2009-07-09T09:42:00.000-07:00

Are all equity investments created equal? Is a common stock, CEF, and ETF all fundamentally the same because they are bought and sold on the stock market exchanges? How about securities in the same class? Is it reasonable and necessary to presume all types should match their peers' fundamental metrics?

Today PHK went ex-dividend for the month and in typical fashion took a beating in price. This time it was compounded with a recent set of negative reviews at Seeking Alpha.

PIMCO High Income Fund: Substantially Overvalued?
CEF Funds Review: Worst to First

In the first, we've commented on the analyst's perspective asking some of these questions. If you have some insights to add, we hope you'll speak up and add your analysis to the mix, either here at SBC or at Seeking Alpha.

Round 2: Smart Securitization

2009-07-08T12:07:00.000-07:00

Here we go again, boys and girls. Let the music begin. Last one without a chair is out!

Thanks to the wonders of modern finance, we can now spread out the risks of debt defaults by repackaing instruments into ladders of risk. Sound familiar? Well, you're wrong. No sir, this is the new era of smart securitization. Unlike the last time this system collapsed, this time the wizards of finance are going to do it right. So says Geoff Smailes, managing director of global credit solutions at BarCap.

These new mechanisms are in some respects similar to discredited structured products such as collateralised loan obligations, which were widely blamed for fuelling the financial crisis. But the schemes' backers argue there are two significant differences. First, they involve the securitisation of banks' existing assets, rather than of new lending. Second, bankers argue that the new products do not disguise the transfer of risk.

"This is the world of smart securitisation… not securitisation for leverage and arbitrage"
(Source: Financial Times)

Darn, we sure wish we had contacts with their buyers. We've got a great idea to lease the Brooklyn Bridge. No, we're not talking about selling the Brooklyn Bridge. That's obviously an old con job. No sir, we just plan to lease it. That makes all the difference in the world.

The New World Order in Stable Global Currency

2009-07-07T11:10:00.000-07:00

Across the Curve recently pointed out some interesting developments in China's response to the financial crisis and their bloated dollar reserves. It should be a forgone conclusion Manhattan R/E prices will fall. No news there. But China now allows settlement in Yuan. Now that’s interesting.

However, this argument for the value of stable exchange rates was the basis for Bretton Woods, which didn’t turn out so well.

The architects of Bretton Woods had conceived of a system wherein exchange rate stability was a prime goal. Yet, in an era of more activist economic policy, governments did not seriously consider permanently fixed rates on the model of the classical gold standard of the nineteenth century. (source: Wikipedia)

Go ahead, blame the collapse on the U.S., but the core fact is fixed exchange rates are really price controls on foreign exchange, with some enforcement mechanism to dictate what sovereign nations can and can’t do with fiscal and monetary policy. Notice a key phrase above, which is as true today as ever in the U.S. and every other nation: "…an era of more activist economic policy…” (read that as “managed economy”).

History is clear, price controls inevitably lead to misallocation of scares resources and poor financial decisions, then to gray and black-markets, which in the case of forex and national policy translates into cheaters who’s self-interests trump the desires of their partners. In the case of Bretton Woods, the strain of national interests working against the rules of fixed exchange finally blew up in ’72. But notice one of the preceding problems (emphasis added):

…The United States was running huge balance of trade surpluses, and the U.S. reserves were immense and growing… (source: Wikipedia).

So how would a new forced stable exchange rate (i.e. if China somehow convinced the world their managed currency exchange rate to ensure vibrant exports was a better reserve system than floating U.S. dollar exchange rates) fare better in the 21st century than it did in the 20th, especially in light of the balance of trade surplus problem in the 20th century and China’s balance of trade surplus today?

Don’t get us wrong, we're not bashing China for their response to present problems. It's natural, normal, and expected for every nation to try and keep it's citizens productive, useful, and well fed. But swapping one fiat currency for another new one doesn’t seem like it will do our children any good.

Side Note: Turns out you can celebrate Bretton Woods 65th Anniversary this month, in case you don’t already have vacation plans. We hear New England is pretty in the summer, but the guest speakers look like the type to extol the virtues of Bretton Woods without much serious criticism of its failures or alternatives. Too bad Ron Paul, Mark Skousen, or just about anyone from the University of Chicago won’t be there to speak as an alternative voice.

Follow up on Fed Funds

2009-07-06T16:55:00.000-07:00

Late in June we pointed out the Fed Funds market rates were rising, and had actually hit the upper limit of the target range. It appears to have been a normal month end, if not quarter-end, phenomena. Since then, fed funds have fallen back to the teens.

We can see from the Term Securities Lending Facility Options Program (TOP) that collateral pressures are expected at quarter-end dates (emphasis added).

The program is intended to enhance the effectiveness of TSLF (Term Securities Lending Facility) by offering added liquidity over periods of heightened collateral market pressures, such as quarter-end dates.

However, we can see also from the historical data that the TOPS program started out heavily over-subscribed, but has in the last two offerings been under subscribed. This is consistent with our June 16th observation that credit conditions have significantly improved.

We don't mean to imply the world economy is robust and healthy, but as Hussman often points out, we will take the facts as they come and adjust our opinions accordingly.

Collapse of the Dollar? I Don't Think So

2009-07-06T06:24:00.000-07:00

There's a very good chance that dollar will decline in value relative to many currencies in the next few years. But to call it a collapse is hyperbole. Even if it collapses like the stock market did the previous two years, it would still be less than a 50% correction other than a very short-term steep trough at the zenith. As we pointed out in June, Robert Prechter is the only reputable analyst declaring equity investments dead.

Nevertheless, the hottest topic these days seems to be the collapse of the dollar because of America's horrendous debt load, the Fed's quantitative easing, loss of world reserve status, and who knows what else. We here at SBC would be inclined to bet you could find someone blame the dollar's demise on global warming, even.

Well, lets see if we can compare the British pound history to the same argument about reserve status. In the 18th century, the pound was the most equivalent asset to today's reserve currency, if you leave gold out of the discussion. At that time, it traded in the 20-cent range (relative to the U.S. dollar). The question of value is one of the most clearly subjective questions one can think of. Lucky for us someone has created a web site, Measuring Worth, that tries to provide "price" data for very long periods of time.

We can now compare the old reserve currency to the modern reserve currency and see what one should expect of the dollar exchange rate if in fact someone (like the IMF?) comes up with a replacement currency. We can see the dollar to pound exchange rate for more than 200 years was mostly stable in the low 20s during it's reserve period. Shortly after the first Bretton Woods agreement it started falling, and was again relatively stable for around 17 years (1950 - 1967). From that point on it enjoyed the roller-coaster thrill of the new world order of completely free exchange rates, apparently initiated by what Wikipedia called the "Floating" Bretton Woods. But in spite of that, the 2007 price was hardly different than 1967.

In the end, after 200 years of currency history, the British pound lost it's reserve status and sits about about 1/2 it's value from the reserve days. The only clear currency-based investment choice we can see from the advantage of hindsight from 1949 to the present is converting pounds to gold rather than converting pounds into the new global currency reserve emerging in that day (the dollar). Our friends at Kitco have some nice gold charting tools where one can compare the performance of gold relative to the dollar, and with a little work, convert that price chart to gold in British pounds.

We leave it as an exercise for the reader to analyze the choice between reserve currencies and stocks and bonds. But to argue that losing it's reserve status will ensure the "collapse" of the dollar is an exaggeration in light of reserve currency history. The real movers are more than just reserve status. When the data catches up with us, we'll look at foreign net purchase of U.S. debt in the early summer of 2009 and see how that theory is holding up.

Quote: C.S. Lewis

2009-07-01T07:29:00.000-07:00

It is a common saying, one who does not learn from history is prone to repeat it. The ever-analytical C. S. Lewis explains why in his essay titled "Learning in War-Time" from the book The Weight of Glory:

... the scholar has lived in many times and is therefor(sic) in some degree immune from the great cataract of nonsense that pours from the press and the microphone of his own age.

Fed Funds Hits the Upper Limit

2009-06-20T13:36:00.000-07:00

On Tuesday June 16th we pointed out the banks don't think they need bailing out any more as no one asked for any money through the CMBS TALF operations. On Thursday, "Effective Fed Funds" hit the upper limit set by current monetary policy of 0.25%. The Federal Reserve provides daily Fed Funds Data. For many weeks now the high of the day has been 1/8 point above the effective rate (a type of average), with the effective rate steadily rising. On Thursday that affective rate "hit the limit." So what?

To the extent that people believe Fed Funds are important, and to the extent computer models make decisions based on interest rates, monetary policy, and the fed funds rate in particular, it's very important to the direction of your stocks, bonds, and currencies.

Prognosticators and speculators have been suspecting the Fed would raise the fed funds rate.

Traders’ expectations of a Fed rate increase in November surged to more than 70 percent on June 5, according to federal-funds futures contracts traded on the Chicago Board of Trade. Expectations have since fallen to show a 32 percent probability of an increase. (Source: Bloomberg, June 17)

Now you know why. The bank's reserve requirements are dictating that it should, and futures traders know what that means to interest rates, just as bond market king Bill Gross pointed out in his November 2008 Investment Outlook "So CQish". Furthermore, if the fed funds rate rises, it indicates diminishing excess reserves. In a nutshell, that means either bank lending or loan loss write offs have returned. In absence of news about the latter, we conclude it must be the former. The natural expectation then is that GDP, interest rates, inflation, and bond market prices will soon be returning to normal, and by normal we mean 10 and 20 year time frames, not 2006.

But you don't have to speculate on what the Fed will do. Their hands are tied by the market place as far as Fed Funds go. John P. Hussman, Ph.D., President, Hussman Investment Trust, pointed out years ago that market prices of federal funds force the hand of policy planners. While we can't find the exact article, we were able to find a compelling discussion of the market mechanics from 2006 titled "Superstition and the Fed":

I should note at the outset that yes, as long as investors believe the Fed matters, it is important to consider the Fed. The real issue, however, is whether the Fed actually has any impact, and my argument is that it does not. It's an argument that goes against what we're conditioned to take for granted (and even what I once used to teach my own economics students). Nonetheless, the evidence against an effective Fed, when you scrutinize the data, is fairly compelling.

We encourage you to read the full article carefully and apply it to a market moving in the opposite direction. Most notably, the federal reserve has been building its inventory of bonds like never before. We all know it's part of the Quantitative Easing policy to stimulate the economy and provide liquidity to refinance the comatose mortgage markets. The side effect is that it provides more assets to help them become more effective. Unfortunately, Congress is working against that benefit by creating a huge mountain of new debt.

Now you understand what Bernanke means when he tells Congress their deficit spending puts stress on the economy and monetary policy. Just when he has a chance to get a leg up on controlling the marketplace with a larger SOMA inventory, Congress provides Bernanke's market competition with a massive new influx of inventory of their own. One of the points Hussman made is that the size of foreign bondholders inventory outweighs The Fed's inventory 3-to-1. That was yeas ago. Only time will tell which way that ratio changes in the coming months.

If we are right and the fed funds rate continues rising, the fed will raise their target this year. The only other possibility in light of rising fed funds rates would be an announcement of yet another 'facility'. With the RMBS market still under pressure from a high level of mortgage resets on the horizon, Bernanke can't afford to let rates rise this year. Our bet is on a new facility or policy announcement that doesn't involve a target rate increase giving them some additional influence on fed funds that they desperately need.

For more on the Federal Reserve's ineffectiveness to control the marketplace, read Hussman's special study on the topic from their Investment Research and Insight, "Why the Federal Reserve is Irrelevant". First published in 2001, he provides in depth discussion of the history of American policy and the effects on the influence of The Fed on the marketplace. It may be even more important than ever as the size of other market forces grow larger. China's Treasury inventory is the most obvious, and the huge inflow of new reserves provided by quantitative easing, but those are topics for another day.

It is a common saying, one who does not learn from history is prone to repeat it. The ever-analytical C. S. Lewis explains why in his essay titled Learning in War-Time:

... the scholar has lived in many times and is therefor in some degree immune from the great cataract of nonsense that pours from the press and the microphone of his own age.

Don't be duped by the cataract of nonsense. Check back with us often, learn how to see below the nonsense that pours from the press, and post your insights and data sources here at Stocks, Bonds, and Currencies, Oh My!

FED Funds Rising

2009-06-18T05:56:00.000-07:00

Recently Fed Funds futures have been predicting a rise in the target rate by the Federal Reserve. Many pundits talk about how unlikely that is, (especially our friends at Across the Curve).

However, few bloggers or news services point you to the actual fed funds market. The Federal Reserve doesn't control fed funds directly, they can only "help it along" with the purchase and sale of bonds (it used to be Treasurys only, but to legitimize the "full faith and credit" implied support of agency bonds they now buy those, too).

If you've been watching that market, you'll know the rate has actually been moving up toward the higher end of the range. If you are interested in the bond market, you should bookmark the Federal Funds Data.

Like the CBOE e-mail we pointed out today, you can also sign up for free e-mail alerts on Fed Funds. We always recommend you get your data direct from the horses mouth, rather than rely on some editor to tell you what it says. You might think they are experts and know how to interpret it better than you, but read this blog daily and you won't need them to think for you.

CBOE Answers Your Questions

2009-06-18T05:34:00.000-07:00

The Chicago Board Option Exchange is a great place for both option market data as well as education. Today's Ask The Institute question was a common question many people ask (even some of those who know the option market well), namely, what happens to my puts if the company goes bankrupt? Can I still exercise the option if the stock stops trading?

Check out the answer at Ask The Institute. It might surprise you.

If you want to learn the basics of options, you can also get some nice video tutorials on basic option strategies at the CBOE Online Media Center. Click the "Strategy and Education" link under the Channel Guide on your left.

Finally, if you want to get the same e-mail alerts and news that brought this to our attention, go to the CBOE login page. The "benefits" promo links to the sign up screen to create your own personalized CBOE home page.

The End of National Currency

2009-06-17T06:50:00.000-07:00

If the Council on Foreign Relations wasn't so full of influential powerful traditional men and women from around the world, I'd write this off as ranting from some deluded conspiracy theorist. But it's no joke -- these people really think like this and carry weight with people that matter.

In "THE RISE OF MONETARY NATIONALISM", Benn Steil, Director of International Economics, argues that national currencies create nothing but trouble for the global economy. The premise is that the troubles we've seen are created by the inability to manage economic activity because of a lack of an organized over-arching system of "good" currencies so those dumb little "emerging" nations don't mess people up with their uninformed and inexperienced economic planning.

I like the implications of the first part -- if we just had a lot fewer currencies, maybe one global one in fact, then we could regulate and manage a perfect economic world. Those darn national currency speculators are just nothing but trouble for everyone, wrecking all our lives. What we need are professionals to plan the global economy. He even goes so far as to say, "The economics profession has failed to offer anything resembling a coherent and compelling response to currency crises." Poor Benn, he appears to have been isolationg himself.

George Reisman offers a much better answer to the many global crisis in his essay, "Our Financial House of Cards". Lo and behold, he's part of the economic profession, too! The reason you won't find this in prestigious [cough] institutions like the Council of Foreign Relations is it doesn't provide men and women with the power they want over other people's lives.

It never ceases to amaze me how those who are afraid of the Moral Majority and "Right Wing Radical Religious Zealots" have no problem putting some other group in control over their private free-will behaviors. Oh no, we don't want religious slavery, but economic slavery, that's fine. How 'bout we just liberate ourselves from slavery, period?

If you plan to be an investor for 30 years you might want to read these two points of view and consider how you'll protect yourselves when "they" sell the idea of one global currency. It shouldn't be too hard. Imagine how your little lone nation has messed up your finances, then imagine what it would be like if they do it on a global scale and remove your ability to allocate your assets in some safe harbor. I suspect it won't be a very obscure idea in the next 5 years when all the global money printing press operators have had their fill and we start reaping the consequences of our new love for Quantitative Easing.

And all this time I thought it was the unregulated credit futures and derivative speculators that got us into trouble this time. Ha, so glad I now know better who the real villains are. Do you?

Banks Don't Need a Bail Out Any More

2009-06-16T19:38:00.000-07:00

Ok, I admit, the title is a bit of a stretch. The Federal Reserve press release came out with the title "No loan requests were submitted through June 16 CMBS TALF operation".

Still, it's significant that no one needs any Asset Backed Security loans from the central bank today. Why not? How are they managing the debt? Aren't the banks supposed to still be on the verge of collapse? After all, Robert Prechter is still touting the demise of the U.S. AAA credit rating.

Well, some might say the banks are simply back to the same old tactics of denial and self-deception. I say half a trillion dollars of quantitative easing can't go unnoticed. Well, we might not see it, but the invisible hand of the market knows full well there is a lot of money sitting around that needs a home. There just aren't many places to put it other than stocks, bonds, and currencies, and the banking system has quite a hand in that middle tier.

Barclay's Capital Keeps SOMA Assets in thier indexes

2009-06-13T18:48:00.000-07:00

The headline from Barclay's reads, "Barclays Capital Announces Decisions Regarding its Benchmark Fixed Income Index Family".

This should shore up the bond market, since many use the indices as benchmarks, and the Feds purchases will provide support (since they won’t be selling those bonds any time soon). Other pending changes include excluding certain types of asset backed securities.

I can’t find the list of directly affected index tickers.