Let the Trade Wars Begin

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

"...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!

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?

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

“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

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

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

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.

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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

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

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

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

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

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

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

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

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

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

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

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.

"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

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

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

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?

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

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

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

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

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

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

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?

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.