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

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

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?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

Don't Let the Wall Street Journal Scare You

Beware of sheep in wolve's clothing. Today we pick on the Wall Street Journal. Someone at the Wall Street Journal wrote a piece over the weekend that tries to scare you into believing another bank collapse will occur any day now, or in particular, that WFC and JPM are going under before Christmas.

This is such old news, it's sad the WSJ can't find anything better to do than recycle the story with little substance other than innuendo.

For the third straight month, option adjustable-rate mortgages are generating proportionally more delinquencies and foreclosures than subprime mortgages, the scourge of the housing crisis.

...could mean higher-than-expected losses for Wells Fargo & Co. (WFC) and JPMorgan Chase & Co. (JPM), as well as the Federal Deposit Insurance Corp.'s own insurance fund.

R-i-i-i-g-h-t! You can say that about any company any day, can't you? Why do you think the SEC requires the phrase "involve risks and uncertainties and are forward looking" in press releases?

So the obvious question is, does the delinquency proportion change because subprime delinquency and foreclosures have declined so much? We don't know, we haven't been told. The second point obviously presumes these Option ARMs aren't already discounted or had reserves set aside. Is there any data to support that, or is this another type of "If an asteroid strikes the earth..." existential reality?

"The realization of the issues related to option ARMs is just beginning," says Chris Marinac.

Why, because he's fixated on the asteroid belt and sees nothing but trouble? Who the heck is Marinac, anyway? The implication of "realization of the issues ... just beginning" is that nobody saw this coming. How absurd. This is common knowledge in the industry and the internet. There's a famous Credit Suisse mortgage reset calendar floating around the internet for years, originated from the chart on page 47, Exhibit 42 "Adjustable Rate Mortgage Reset Schedule" from the exhaustive report "Mortgage Liquidity du Jour: Underestimated No More" which came out in March 2007, and even updated back in May. Maybe Mr. Marinac hasn't known this for the last two years, but we're highly confident most professionals have.

Now we do have a fact or two in that whole article. Three relevant ones to be exact.

• As of April, 36.9% of [Pick-a-pay] loans were at least 60 days past due, while 19% were in foreclosure
• 33.9% of subprime loans were delinquent as of April, while 14.5% were in foreclosure.
• Wells Fargo holds ... $115 billion of the loans
• [WFC] assigns the loans a value of $93.2 billion

Some facts are just plain wrong. The following relates to some unspecified population that has no indication of it's relevance to the nation as a whole, or the purported facts of this story in particular. Specifically,

"33.9% of subprime loans were delinquent as of April, while 14.5% were in foreclosure."

Actually, according to the official Credit Conditions in the United States:

Only 12.6% were in foreclosure in April (column 26)
Only 28.9% are delinquent (sum of columns 23, 24, 25)
(Source: Subprime Excel Data)

Notice in that excel data: The percentages in the second set of three columns plus the "% current" don't add up to 100% because they don't include loans in foreclosure.

Mathematically, then, we have the following:

• 93.2 / 115 x 100% = 81%
• 100% - 81% = 19% (WFC expected losses)
• 14.5% < 19%

Since we only have Wells Fargo reserve numbers, and we don't have WFC's portfolio data, we really don't know a thing about whether WFC has enough reserves or not. Look again at those delinquency columns (create a sum of columns 23-25 for each row, sort by the summations). A total of 32 states have delinquency rates below the national average. The three lowest delinquencies are in Hawaii, North and South Dakota at about 23%. How is WFC's portfolio distributed around the country? We do know not all delinquencies end in foreclosure, and WFC has discounted their portfolio to practically expect that they will.

WFC discounts their portfolio as if the entire portfolio will be foreclosed at the present rate of Pick-a-pay loans (19%) and that all foreclosures result in 0% recovery. Put another way, you can buy WFC mortgage portfolio for 81 cents on the dollar. That sounds like a bargain! Worse yet, we have nothing at all about JP Morgan's reserves or portfolio allocation. The article says it got some data from a filing. After all that work Eckblad did reading government filings, he can't present any meaningful data from JPM to support the headline and article innuendo. Either he wasn't competent enough to know what to look for, or the data he found didn't support the editorial opinion woven between the lines, so he left it out. Either way, you can't trust this author's expose. He comes out barking, but beneath the covers there's nothing but sheepishness.

"We're just beginning to enter the cycle of resets" on option-ARM loans, says Matt Stadler.

That's perfect, then, isn't it? Interest rates are ripe for refinancing right now. Libor (upon which many ARMs are indexed) has been falling. Resetting them now for another 3 or 5 years is just what we need to buy us time for the economy to turn around. Of course, if the United States of America in 2010 is going to become like the United Soviet Socialist Republic, then indeed, we have a problem. Don't count on it.

You can see that will a little effort, it doesn't take long to show Eckblad's main premise is lacking substance to give it more credibility than a weather report from a quick glance out the window. We hope you aren't paying for that kind of advise, and worse, basing your investment decisions on such shallow insight.

Fed Funds Hits the Upper Limit

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!