Search This Blog

Wednesday, December 31, 2008

Hussman Article

Below is an exerpt from John P. Hussman's article "The Dollar Crisis Begins." I have been sharing this view for some time. Either the dollar will fall or the yield on the long-bond will rise. The retail way to play this is through TBT and UDN. I am currently working on an options strategy to best play this theme. Hopefully I will post shortly with my findings.

"On Tuesday, the Federal Reserve took the somewhat expected but extreme step "to establish a target range for the federal funds rate of 0 to 1/4 percent." Included in its policy statement was an additional bit – “The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.”

Think about that for a second. We've got 10-year Treasury bonds yielding only about 2%, and the Federal Reserve is “evaluating the potential benefits” of purchasing them? While that statement may have been intended to encourage a further easing in long-term interest rates (to which mortgage rates are tied), the prospect of suppressed interest rates at every maturity sent the U.S. dollar index into a free-fall. If the Fed ends up buying long-term Treasuries, it will almost certainly be a bad trade, but it may be required in order to absorb the supply from foreign holders set on dumping them.

And for good reason. The panic in the financial markets in recent months has driven Treasury bond prices to speculative extremes. Unfortunately, unlike the stock market, where hopes and dreams about future cash flows can often sustain speculative markets for years, it is very difficult to sustain speculative runs in bond prices. The stream of payments for bonds is fixed and known in advance. For foreign investors holding boatloads of U.S. Treasuries, the recent rally in the U.S. dollar, coupled with astoundingly low yields to maturity, have created a perfect time to get out.

In the next several months, we're likely to observe one of two things. If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it.

As I noted earlier this year, a continued flight to safety in Treasury bonds, coupled with a continued massive current account deficit, “ places the U.S. in the difficult position of having to finance an enormous volume of capital needs from foreigners, particularly for Treasury debt, yet without being able to offer competitive yields or strong prospects for additional capital gains. My impression is that the markets will respond to this difficulty with what MIT economist Rudiger Dornbusch referred to in 1976 as “exchange rate overshooting.” In the present context, that means a dollar crisis. Specifically, if there is a weak prospect that foreign lenders will achieve a total return on U.S. Treasuries competitive with what they can earn in their own country, and every prospect that short-term interest rates in the U.S. will remain depressed or fall even further, the only way to attract capital is to immediately drive the value of the U.S. dollar to such a sharply depressed level that it will be expected to appreciate over time.”

I don't expect that the likely depreciation of the U.S. dollar will compound the current recession as much as it will simply reflect it. Recessions are essentially periods where a mismatch arises between the mix of goods and services demanded in the economy, and the mix that was previously produced. In recent years, the huge trade imbalances we've observed have not reflected a sustainable mix, so dislocations have been inevitable. Nevertheless, the introduction of additional sources of volatility from bond price and currency adjustments will probably extend the likely trading range we experience before sustainable market gains are likely."


Sunday, December 14, 2008


We are now at a very interesting point in time. This upcoming week should provide some fantastic data. Not only do we have some interesting earnings being reported (GS, MS, NKE, FDX, etc.) but we also get to see the FOMC decision and the CPI data. Plus who knows what news will come out of Washington with regards to the auto bail out or any other stimulus plans. This week will likely set the tone until inauguration. I read an interesting stat lately that I felt was worth sharing, in the past 12 months the Fed’s assets grew by 146% the ECB by 58%, the Swiss National Bank’s by 74%, and the BoE by 158%. I find it somewhat funny that we are solving the problem of excessive leverage by leveraging. One can’t help but wonder when long-term rates will raise and inflation will once again be a fear (I guess it is just a function of how talented the Fed has become at putting its collective feet on and off of the accelerator).

Goldman Sachs recently came out with their top trades of 2009. I have pasted a brief overview below, enjoy.

TRADE #1: Long Chinese A-shares at 2,079, target 2,600 Despite the uncertainties in the global equity picture, the scope for a sharp increase in China’s A-share market this year, which is down 70% from its peaks in October 2007, is quite real. While the Chinese economy is heading towards its worst slowdown in many years, the policy response, both on the fiscal and monetary fronts, is also set to be aggressive. Broader quantitative easing and the kind of renewed USD weakness that our FX forecasts show would probably also help this Dollar-linked market.

TRADE #2: Long/Short EM FX Differentiation Basket at 100, target 106 in spot (plus carry) This basket, with 20% long EUR/PLN, 30% long EUR/CZK, 15% long EUR/TRY, 20% short US$/MXN, 15% short US$/BRL, seeks to take advantage of valuation differentials in EM currencies as well as different degrees of vulnerability to further deleveraging. At this stage, we view Eastern European currencies as most vulnerable. LATAM currencies, on the other hand, have seen disproportionate depreciation moves lately and the economies seem less exposed to ongoing tensions in the credit markets based on various metrics of leverage and banking system health.

TRADE #3: Short Dec-11 crude oil futures at US$67.97 target US$ 60 The global recession has put sharp pressure on oil prices, which will likely extend to long-dated oil contracts, as typically occurs during cyclical downturns. With long-dated oil at very significant premiums to front-month crude, there is substantial positive carry and plenty of evidence that this dynamic has not yet fully taken hold. One consequence is that integrated energy stocks (and the broad energy sector) may see renewed relative and absolute pressure.

TRADE #4: Long US 30-yr current coupon Fannie-Mae MBS, target 4.0% As ‘unconventional’ monetary policy measures in the US, and perhaps elsewhere, begin to kick into gear, the mortgage borrowing rate is likely to become a more explicit focus of any new policy measures. With this in mind, we recommend buying current coupon Fannie Mae 30-yr MBS. The 5% coupon trades at a yield of 4.7% on current pre-payment speed assumptions. This corresponds to a spread of over 300bp over the 5-yr Treasury yield (roughly comparable duration on current prepayment assumptions). Our target is 4%. An alternative is to enter Dollar ’Rolls’ at an implied repo of 2%.

TRADE #5: Sell credit protection on Sweden through 5-yr CDS at 148bp, target 60bp
As investors have become more concerned about Sweden’s banking sector’s exposure to the Baltic countries, and Eastern Europe more broadly, the 5-yr Swedish sovereign CDS has gone from 13bp (or flat to Germany’s) at the end of September to 148bp currently
(Or 100bp over). Even accounting for the sharp slowdown in economic activity and our banking team’s estimates that banking losses from exposure to Eastern Europe could reach 3.0% of GDP over the next few years, Sweden’s credit fundamentals are solid. The government is expected to run close to a balanced budget position, after a string of surpluses; gross public debt is a meager 30% of GDP, less than half the Eurozone average. The current account position is a healthy surplus (in excess of 7% of GDP) and external liabilities are tiny.

TRADE #6: Long the Wavefront housing basket at 58.97 for a target of 70
Our Housing basket is a relative trade, pitting homebuilders and other housing related areas of the US equity market (appliances, furnishings, house wares, autos, electronics) against a broader set of cyclical areas of the market. We expect to see residential investment growth bottom in Q4 2008, and, with the Fed focused on quantitative easing in the mortgage and agency space, we think stabilization and sequential improvement in the data (even if not outright strength) will prove supportive for this relative equity trade, even if the broad cyclical picture remains weak.

TRADE #7: Long Cable (For those wondering Cable is the exchange rate between the U.S. dollar and the British pound sterling. The origins of this term are attributed to the fact that in the 1800s, the dollar/pound sterling exchange rate was transmitted via transatlantic cable.), at 1.48, for an initial target of 1.65 a large part of recent Dollar strength has been the result of forced deleveraging flows. As these flows abate, the Dollar should weaken on the back of continued large current account deficits. And if the US administration continues towards more aggressive quantitative easing policies and succeeds in raising inflation expectations, that too could be Dollar-weakening. Alongside this, we are of the view that much of the weakness of the UK economy and banking system is now priced. Moreover, the exceptional easing of financial conditions due to fast
BoE rate cuts and unprecedented trade-weighted Sterling weakness create upside risks to the UK economy.

I am particularly inclined to believe in trade #7 as I think the dollar is grossly overvalued purely due to the fear in the market place. Once people realize the world is all equally hurt and it is not ending, they will trade out of the dollar (and dollar debt) until yields rise to an appropriate rate commensurate to the risks associated with the US Government and economy.

One interesting stock that I think could make an intriguing trade should it fall from its current levels is De La Rue plc. They are a UK based printer of banknotes. I believe this is one of the more interesting equity based ways to profit off of all the balance-sheet growth currently occurring in the world. De La Rue, traces its roots back to 1813 and was originally listed on the LSE in 1947. De La Rue specializes in the supply of cash-related printing and systems services to both central and commercial banks. The Security Printing & Paper division prints currencies, passports and other documents requiring security features. It has 50% of the outsourced banknote printing market (10-20%). It is also the largest independent producer of banknote paper (30% market share). The cash systems division supplies cash counting, sorting and dispensing equipment for the banking industry. It has a 27% stake in Camelot, which has the license to run the National Lottery until February 2009. So this company should benefit from a few trends: global balance sheet expansion, lottery participation (which increases in tough times), and the need for consistent and increased global ID protection/management services. Over the past five years the company has extensively restructured. It has returned more than $1+Bn to shareholders. They even sold a commercial cash systems business to The Carlyle Group for about $600m. Analysts currently expect the company to earn around $100m of net profit for 2009 which equates to a forward P/E of around 11x (this by the way is well below its historical average in the high 20s). On an underlying basis (excluding legacy central costs not disposed with Cash Systems), De La Rue trades on around 10x EV/EBIT and 13x PE for Mar 09E. Unfortunately the stock has held up fairly well YTD, should this name come down substantially from its current 850 pence price I suggest investors take a serious look.

Sunday, December 7, 2008

Quick posting

Looking back at my previous recommendations the one thing that I have gotten wrong more often than not is my unfortunate bullishness on emerging markets. I thought now if ever was a good time to revisit this position.
Thus far various EM economies have taken quite varied approaches towards the crisis. Historically, emerging markets have reacted to crises by jacking up short-term interest rates, tightening fiscal budgets, and either rigidly trying to defend their exchange rates or, when that proves impossible, permitting large devaluations. However, during the current episode, as Friday’s surprise 100bp cut in Thailand illustrates, most EMs have opted to lower interest rates. Moreover, many are easing fiscal policy, and have taken the middle ground with respect to exchange rate management by letting their currencies depreciate gradually. In other words, EMs are trying to react to the global economic slowdown in the same way that most developed economies are reacting. But will the new medicine work any better than the old?
The reality is that countercyclical fiscal and monetary policy is a luxury that not every EM can afford, not every EM economy has the resilience associated with more developed economies. The good news for EMs is that, as a group, they have become a lot more resilient over the past decade. Total EM external debt to exports has declined from 152% in 1998 to 66% in 2008. Meanwhile, the overall EM current account balance has moved from a deficit a decade ago to a surplus of about 2.6% of GDP in 2008. The bad news is that in an environment in which advanced economies are likely to experience a nasty recession –GDP in advanced economies are expected to contract 1% in 2009 – the traditional reliance of many EMs on export demand will prove to be a handicap. Furthermore, the resilience to economic shocks varies significantly across EMs. For example, between 2000 and 2008, the ratio of external debt to GDP declined from 36.7% to 20.4% in Latin America, and from 28.2% to 16.5% in Emerging Asia, but increased from 45.3% to 50.5% in Central and Eastern Europe. Thus, we need to differentiate between countries such as China that are really part of the solution, in terms of their capacity to ease both fiscal and monetary policy, and countries where the fundamentals are shakier. This latter group of countries is at risk of experiencing significant balance of payments pressures if the global financial crisis were to worsen.
Russia looks vulnerable. Interest rates are negative in real terms, credit growth – at least until recently – has been very high, and the country has a weak inflation track record, marked by periodic bouts of extremely high inflation. Furthermore, the sharp deterioration in Russia’s terms of trade since the summer has left it with a currency that is overvalued. While debt payments (both private and public) due in 2009 are a manageable 9% of external reserves and 10% of exports and foreign income receipts, there is concern that a move by Russians to shift their deposits from Rubles to Dollars and Euros could put a strain on reserves, which have already fallen by $150 billion (25%) since August. The CBR has reacted by allowing the Ruble to weaken by 1% on three successive occasions over the past three weeks. These glacial moves stand in stark contrast to the forwards, which are now pricing a 27% depreciation against the Dollar over the next 12 months. As such, a large one-time devaluation would be appropriate, as it would help the CBR conserve reserves and give a competitive boost to the Russian export sector. On the fiscal side, Russia is expected to run a small fiscal surplus in 2009 and government debt to remain low at 8% of GDP, the high CDS spread on Russia’s sovereign obligations suggests that investors have become more concerned about solvency risk.
In Latin America, CDS spreads are pricing in significant default risk in Argentina and Venezuela. Sovereign spreads are moderate in Colombia, Brazil and Mexico, and relatively low in Chile. Real rates are quite high in Brazil and Mexico, and there is scope for both countries to ease monetary policy as inflation concerns begin to subside. However, while Brazil’s fundamentals have improved markedly over the past 5 years to the point that it has become one of the most resilient EMs, given the country’s history of hyperinflation, as well as its large negative net foreign asset position (43% of GDP) and somewhat overvalued currency, policymakers will need to stay vigilant in the event that the global financial crisis worsens and capital outflows intensify. Likewise, in Mexico, while the Peso is undervalued on a trade-weighted basis, a high ratio of scheduled debt service in 2009 (36% of reserves) may complicate the conduct of monetary policy.
Among the major EM regions, emerging Asia seems the most resilient, although even here, the Philippines and Indonesia look quite vulnerable. China in particular appears very resilient. While the Renminbi is now about 8% overvalued on a trade-weighted basis, total debt service in 2009 is projected to be only 1% of exports and foreign income receipts, and 1% of external reserves, while net foreign assets stand at a healthy 31% of GDP. Real interest rates are also positive (real deposit rates are about 3%), which gives the PBoC further scope to lower deposit and lending rates. Moreover, the country has no recent history of hyperinflation, and hence has more monetary credibility than many other EMs. The fiscal position is also strong. While the government balance is expected to shift to a deficit of 1.8% next year, government debt is low (18% of GDP), and CDS spreads indicate that the market is not overly concerned about solvency risk. China also has the fastest long-term growth rate of any EM, with an estimated GDP growth rate of 10.1% between 2010 and 2025.
In thinking about the market implications of this analysis, it is important to juxtapose the risks described above with how the market is pricing them. In a number of EMs, the market is pricing in significant tightening of monetary policy. Brazil is one market that comes to mind where this is obviously already priced in. I am still bullish on the long-term stories of select EMs, I would just be careful in selection. I will reiterate what I have been saying for some time, now is the time to be writing OTM puts on select securities that you would be interested in otherwise purchasing. It is just like putting in a limit order and getting paid to wait. With implied volatility near all time highs and the VIX at the highest 3 month realized levels since the Great Depression the premiums on some names are absolutely fantastic. For example, last week I wrote some Dec 35 GS Puts and received $1.60 up front! Those are fantastic annualized returns. The key to this strategy is you have to want to take delivery on the underlying security should it fall to your level.
While it is tempting to believe that a New Year will bring an entirely different set of market prospects – a new slate – the reality is often different. The start of 2009 is unlikely to bring a change in the dynamic of growth and the unlocking of credit that is required for risky assets to re-rate. While I do expect an inflection point in economic activity and the pricing of equities and credit markets sometime in 2009 it is likely to be from lower levels and later in the year. From a trading perspective (aka I am going off my gut, there is no real deep research backing me up) I would expect the current rally to continue (although at a more moderated tone) through the beginning of next year. After our new president is inaugurated and we start to see some ugly Q4 data, people will bid the markets further down. I would expect a bottom sometime in Mid-summer when I hope we might begin to anticipate the affects of Obama’s plan to save the American consumer. Fears of debt deflation are probably overdone – the mistakes of the 1930s, and Japan in the 1990s, are unlikely to be repeated as government action becomes increasingly aggressive, coordinated and unorthodox. But we live in an age where the unexpected happens – regularly. Investors are assuming the worst before they are proved wrong. Governments are likely to be seen as guilty until proven innocent, and so deflation, while unlikely, is likely priced as a growing probability in the near term. It is still too early in the process of growth deterioration and falls in profits for the market to start pricing in the next recovery. The credit markets need to right themselves before I can put any faith in this recent bear rally.

With all these speak of need for further government intervention I am amazed at how little structure the government plan has thus far. Apart from the still uncertain size of the stimulus package, there is even greater uncertainty regarding its composition. Infrastructure has been the top theme in the debate, but there appears to be limit to how much infrastructure spending can be carried out in the two-year timeframe lawmakers are considering and especially in 2009. Other options include state fiscal assistance, which is more or less limited to the amount of state fiscal shortfalls, and tax provisions. Ultimately, the first two options appear likely to have a higher multiplier than the last, but the last is by far the easiest to implement in large amounts and also has quicker effects. Near term projects do exist, but there is a limit. The Congressional Budget Office estimates that $18 billion in transportation related
projects are “shovel ready” and could begin within 120 days. The American Association of State Highway and Transportation Officials (AASHTO) puts this number at $32 billion. Meanwhile, the National Governor’s Association (NGA) has estimated that $136 billion in infrastructure projects – including not only transportation projects but other areas as well—are planned and ready to be started within the next year. It will be interesting to see where the final dollars go. My hope is that it will be spent useful i.e. not building bridges to nowhere in Alaska.

Going forward I think this market will turn into a truly fantastic time for hard core value stock pickers. One recent move that I hope everyone was smart enough to participate in was when Berkshire Hathaway fell below $80,000 (those are the A shares for those of us who are less fortunate I recommend investing in the B shares which are usually 1/30th the price). Berkshire fell due to fears of derivative contracts that expire in 10+ years. For more on this read the Barron’s article written two weeks ago or just look under Yahoo! Finance, I am sure there is a story on it. The CDS for a short period shot up on Berkshire to 5%, I would have loved to traded in those. The key to winning in volatile times likes these is being ever vigilante to take advantage of those sweet opportunities. I know I am watching both the equities, options, and convertibles market like a hawk for the once in a decade opportunity. If any readers see anything or would like to discuss some please feel free to post a question which we can discuss in greater detail. Thanks.

Sunday, November 23, 2008

How President Bush can save Christmas (or other Winter upcoming holidays)

My how far have we come, in less than six months, a market that was firmly focused on inflation risk has swung sharply as growth has crumbled. Deflation is now more and more openly discussed and with the Fed funds rate approaching zero, talk of liquidity traps, unconventional measures and quantitative easing are all firmly on the agenda. With all this volatility and uncertainty one can’t help but ask, what happens next? The most obvious near-term steps involve both sizable fiscal stimulus and pre-commitments to keep rates at lower levels. Beyond that, more active plans to target longer-term securities are also likely to come into focus. But further action is also likely to be needed to try to reduce the spread of risky debt to risk-free securities. In the current episode, more than in 2002-03, it is less clear that influencing the Treasury curve alone would be enough to bring borrowing rates down sharply or deliver the easing in financial conditions that has so far been missing. For that reason, other measures including Fed purchases of risky assets could also be important. While these options are further away outside the US (and Japan), because there is still relatively more room for policy rates to fall, in principle many of the same options exist for policymakers in the other major economies too. In terms of the markets, these policy shifts have important implications. They make it highly unlikely that the market’s pricing of higher US rates next year will prove correct. Longer-term yields may also fall further, particularly if they become a target of policy, while mortgage spreads could compress from current levels as policy shifts more explicitly towards reducing the spread between risky borrowing and risk-free rates. For FX, the implications are less clear, but the risks are towards USD strength in the near term, but weakness further out. The good news – particularly with a Bernanke Fed – is that policymakers have a heightened awareness of the unusual risks posed by deflation and liquidity traps, and have plenty of tools left in the arsenal. But the biggest problem is likely to be that these policies will look radical and may require significant political capital to find support. Whether talking about the size of fiscal stimulus that could be needed or ‘unconventional’ monetary policy, we are moving towards territory where orthodox responses may not be enough. The key risk now is a lack of boldness on the policy front in the face of extraordinary pressures. Hence the title of this piece, we need radical action by the government before Obama is inaugurated on Jan 20, 2009, simply put, we need President Bush to save Christmas (or other similar winter holidays)!

With riskless short-term interest rates now close to zero, conventional monetary policy is becoming ineffective. So what other measures do US policymakers have up their sleeves? There are three options with a relatively high likelihood of near-term implementation: (1) a large-scale fiscal stimulus program, (2) more proactive use of Fannie Mae and Freddie Mac for purchasing and securitizing mortgages, and (3) a pre-commitment by Fed officials to keep the federal funds rate low for a considerable period (probably following a final 50- basis-point cut at the December 16 FOMC meeting). Options (1) and (2) are likely to be quite effective, while (3) would probably provide a more modest boost. If these policies fail to result in an economic pickup, Fed and Treasury officials would likely reach deeper into the unconventional policy toolkit. In particular, Fed officials might (4) purchase long-term Treasury and Agency securities in a more aggressive bid to lower rates further out on the yield curve, perhaps in order to finance another round of fiscal easing. Finally, the Treasury might (5) decide to purchase risky assets outright, and this could again be financed by Fed money creation. Both of these policies would probably be quite effective, although they are more radical and not imminent.

While it would be nice if the government would take such bold actions, risking any capital on that assumption is sheer lunacy. Now is the time to focus purely on individual securities experiencing aberrational price movements, one fantastic example of this is Citigroup. Over the past week we have seen Citigroup’s market value fall by more than half. This is the largest bank in the U.S. on a deposit basis. Currently the NPV for the investment bank is so negative that it is dragging down the value of the relatively good commercial bank. Although I think Citigroup will raise additional capital, further diluting shareholders, I would be surprised to see it fall any further. The following programs backstop Citigroup’s liabilities: a) its deposits are FDIC insured; b) the company is working out a program to insure some of its debt with the FDIC; c) the Federal Reserve discount window is always open to the company; d) it can sell commercial paper to the Fed; e) it can use the primary dealer debt facility; f) its deposits, which equal $780 billion, are primarily sourced overseas (64%) giving the bank greater diversity in capturing funds; g) it has access to bank protection programs in multiple countries around the world; h) it has $393 billion in long-term debt; i) it has net free cash flows; j) it has paid down $94 billion in long-term debt this year and $42 billion in short-term debt; and k) it is reducing the size of its balance sheet faster than any other company in the banking industry. The company’s estimated Tier One ratio by year end is 10.45%. This is very high relative to the past. Its stockholder equity is estimated to be $150 billion assuming the TARP contribution. Although I don’t technically have a hard line valuation number on the stock, I think its value is well above $4 which it closed under on Friday. At $4 they are valued at .4x tangible book value which is quite ridiculous. Although my investing career is not as long as others I think .4x tangible book value represents an interesting risk/reward trade-off. That being said this is a rather speculative wager, as we have seen in this market fundamentals matter far less than sentiment. I will keep you posted on Citigroup as I research this situation more.

Sunday, November 16, 2008

Quick thoughts:

With the US election now behind us, markets are back to the more mundane task of focusing on the economic landscape (aka “bad news”). As should be quite obvious at this point world growth has lost momentum over the past few months and many leading indicators suggest a further slowing in growth in the coming months. I have seen no data that suggests a turning point in the economic cycle, the environment for riskier assets is likely to remain challenging in the near term. Given all this negativity I am inclined to believe we are more likely to face a severe overshoot to the downside which would result in a more V-shaped recession, I think this will actually be good as it will allow us to reach a true bottom and not stay in purgatory like the Japanese markets have for the past 20 years. The bottom line is that the signs of weakness in the US have spread.

The key issue now for markets is whether global policymakers will be successful in stopping the economic rot. Alongside further monetary easing, the re-emergence in policy deliberations of (expansionary) fiscal policy as an instrument of macroeconomic policy is a very encouraging development. Signs of a trough in the global IP cycle would be an important sign that policymakers are winning the tug-of war and in turn would be catalyst in changing some recent near-term trends, both in the world economy and risky markets. The weakness in the industrial growth cycle, particularly outside the US, has been an important contributor to recent market concerns about the growth outlook. Better signs here would normally be consistent both with firmness in global equity markets and some underperformance in bonds. It is personally my opinion that the US will have to offer substantially higher rates on the longer-term bonds that need to be offered to fund current budget deficits; this will inevitably further benefit those who are smart enough to be engaged in bullish steepeners. Steepeners are used to bet that the yield curve will be steepening (hence the name). Simply put, I believe the yield curve will steepen as the government will pursue numerous expansionary policies further driving our country into debt which will force the government to offer higher yields as in the long-run (i.e. many years from now) our currency will surely drop to a level that is more commensurate with the inherent risk associated with a deeply indebted country.

This actually brings me to one of the points I wanted to make today. On an absolute basis, both equities and credit look inexpensive. P/E ratios are at their lowest levels since the early 1980s and credit spreads are at historical wides. While current valuations have been driven by a bleak fundamental outlook, including the potential for declining earnings and rising defaults, risk aversion and liquidity have also played a major role. Both credit and equity look good relative to government bonds (this goes back to my steepener thesis). Limited liquidity has been an important driver of cash credit spreads, due to mark-to-market losses, lack of available funding, tighter risk budgets, and redemptions. Other asset classes, also affected by severe liquidity problems, also appear to offer very attractive valuations. While equities have also been challenged in this respect, liquidity problems have been less severe, however there are special situations, i.e. stocks with mass hedge fund concentration. Credit spreads may move even wider as default rates rise. Similarly, equities are unlikely to stage a sustainable rally until closer to an inflection point in economic activity. Moreover, as credit markets have been at the center of the financial turmoil, it is unlikely that equities can stage a meaningful recovery before credit markets, which in turn requires liquidity conditions to improve. Equities have de-rated against bonds. European equities are down close to 50% since their peak, erasing most of the gains since 2003 (or 1997, for that matter). Equities have not only performed badly in absolute terms, they have also underperformed bonds for most of the last 15 years. Equities usually lag the credit markets and as the credit markets have yet to improve I would be surprised if equity could improve. I would therefore recommend that investors seriously look at investing some capital in high quality credit and the reserve a portion to play in the equities market this way they could benefit from both turns.

Now I would like to take a moment to speak about that cowboy market that is energy. Oil prices and returns continued to decline sharply in October as negative macro sentiment accelerated and as the severe slowdown in economic activity resulting from the credit crisis – evidenced by plummeting manufacturing surveys around the world – has substantially weakened physical oil fundamentals and prices. In particular, substantial weakness in the Asian petrochemicals sector has prompted a collapse in petrochemical margins, which has weighed on refining margins, likely motivating a reduction in refinery utilization in Asia.

This weakness in petrochemical demand is also occurring in Europe, exacerbating downward pressure on the Atlantic Basin gasoline market as naphtha (a colorless distillation product) that is not being consumed to make plastics is being re-directed into the gasoline pool. On net, the recent weakness in petrochemical activity is further weighing on the US gasoline market, which is already plagued by a combination of weakening motor gasoline demand and increasing ethanol production. This gasoline weakness is hindering the recovery of US refinery runs after the hurricane season, further reducing the demand for crude oil. Going forward, expect low demand for crude oil by refineries will likely continue to exert downward pressure on crude oil prices. While the announced 1.5 million barrels OPEC cut could counter weak refinery runs providing support to prices, the full implementation of the cut is not likely within the next couple of months, underscoring the downside risk to crude oil prices in the very near term. That being said I think the long-term price of oil will settle at the marginal cost of production which last time I checked is in the $60s now and is expected to go to around $75 by 2010. The reason for this increase is all the easy wells are already drilled. This forces E&Ps to move to more difficult locales, like tar sands or deep offshore drilling, these are expensive places to drill land as such require oil prices to be higher. Although oil is a waning resource it will be kept in check by developments in alternative fuels (which last time I checked are realistically 20+ years away from mass implementation). It should be noted that I am not recommending buying E&Ps but I think there are some real values in the pipeline MLPs which can be found to yield in the high single to low double digit dividends and have locked in business for years to come. This is where I would be focusing my attention.

In summary I recommend people take a look at steepener swaps (or other comparable ways to play a steepening yield curve), and be ready to pounce on values in both credit and equity markets, paying particular attention to MLPs with locked in business. On an aside, I want to apologize for the brief post, work has been quite all encompassing as of late and I have barely had time to go grocery shopping let alone craft a veritable in-depth investment thesis worthy of posting for public consumption, hopefully over the upcoming Thanksgiving holiday I will be able to devote some more time to this.

Sunday, November 9, 2008

Interesting economics analysis

I wanted to write a post about how I thought the Fed was running out of options and we were most likely headed for a longer recession than the government would like, but then I found this paper which quite frankly is much better than anything I could have written, so please read and enjoy....

Economics Getting to the End of the Rate Cut Road Hatzius 2008-10-31[1]
Get your own at Scribd or explore others:

Saturday, November 1, 2008

Emerging Thoughts

Before getting into this week’s post I just want to comment on this past week. Last week I spoke about the temporarily insane valuation of VW and how it was easy money to short it at 90 like it was temporarily during the past week. Well have I got good news for you, on Tuesday Volkswagen surpassed ExxonMobil to become the world's biggest company by market cap after Porsche announced plans to raise its stake in the German carmaker to 75% from 42.6%, triggering a short squeeze. As of Oct. 23, almost 13% of Volkswagen's shares were on loan, mostly to short sellers who were forced to swallow massive losses and exit their positions. The ADR traded as high as 225 on Tuesday which is a full 400% from last Friday’s (10/24) close of 53. They traded down the rest of the week to end at 122. Let me preface this by saying shorting is very risky and by nature has an unfavorable risk/return slope. That being said if you are a fundamental value investor, it is not very hard to see that the current price on VW is absolutely insane. Anyone who knows there financial history can see that this is a modern day corner and that fundamentals have been thrown out the window. For those with a strong stomach join SAC and Greenlight and try to ride VW back down to where it should be in the 30s.

In other economic news real GDP fell -0.3% in Q3, better than economists' -0.5% consensus, according to advanced estimates. Last quarter it grew 2.8%. The largest contributors to the downturn were lower prices for nondurable goods and a deceleration in exports. While the GDP shrinkage was more modest than expected, things will likely get worse before they get better. The key to this is GDP is a lagging indicator and the recent GDP number does not represent the pain seen in October or the pain we will see in November and December. I am not saying the markets will fall, I am saying spending will fall on a YOY basis. Although this may be painful for retailers and the economy in the near term I can think of nothing better than U.S. consumers tightening their purse strings and hopefully reducing some of that outstanding debt, not to mention I would love to get our savings rate up there, remember counting on social security to support you in your golden years is a fool hardy proposition.

One thing that is becoming starkly obvious is the stimulus package has not succeeded as many had hoped. It is slowly becoming more evident that another stimulus could possibly be needed. Another large stimulus in the range of $200bn + will be needed to offset the sharp drop in spending relative to income by US households and businesses (i.e., the increase in the private sector financial balance) that is now underway due to the tightening of financial conditions. If left unchecked, this retrenchment raises the risk of yet more adverse feedback effects between the real economy and the financial sector.

Aggressive government responses could limit the impact of the adjustment (in other words no action is clearly the wrong action) both directly via the fiscal boost and indirectly by stabilizing expectations and financial conditions. What is technically worrying about this is that the US budget deficit is already quite large and any further leveraging might damage the system (i.e. our old nemesis inflation might rear its ugly head). But taken in perspective this objection is misguided because it ignores the greater cost of letting the downturn continue unchecked. Net-net I think we will see our federal deficit continue to climb until we see substantial government action. Remember the Federal Deficit equals the sum of private sector surplus and net-foreign capital inflow. Although it is just an accounting identity, this equation has the following, very powerful implication: An increase in the private sector balance must raise the government deficit by the same dollar amount, unless it is offset by a reduction in the current account deficit. Historically higher private sector balances have been a bad thing. In principle, it would be nice to see a package that offsets the entire negative impulse to economic activity since further increases in unemployment – from a level that is already well above what’s needed to control inflation are – a pure social “bad”. In theory, one might argue that this requires an increase in government spending on domestic goods and services of 4% of GDP or a tax cut – which inevitably involves some “leakage” into increased imports – of 6% of GDP. In dollar terms, this would imply a massive $600-$900bn stimulus. Either way I would bet the next administration does something within their first month of office (that’s if something doesn’t get done sooner).

The recent weakness in emerging markets has raised concerns in developed markets about the overall impact on profits as well as the specific risks to companies with high revenue and net income exposure to EM. In general, until very recently, the highly exposed companies have outperformed the broader market and their more domestically exposed counterparts. However, the sharp reversal of performance in these stocks being seen currently reflects the growing concern about further EM activity weakness (For an illustrative example see IBM or YUM). While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.

Earlier in the year emerging markets were seen to as a pillar of stability since the credit crunch started to emerge in the summer of 2007. Three key factors were at play. Firstly, emerging market banks were seen to be relatively unaffected by the deepening crisis in the US mortgage market, secondly emerging markets were continuing to weather a slowdown in export growth as domestic demand remained robust, and thirdly most of emerging markets benefited from higher commodity prices as they were commodity producers. With the fall in commodity prices and the worsening of the global credit markets EM indexes and stocks have fallen sharply. Emerging countries typically have had limited access to USD funding in proportion to their IMF quota. The Fed, however, on October 30, 2008 announced that it is extending dollar swap lines to the central banks of Brazil, Mexico, Korea and Singapore so as to boost USD liquidity in those emerging markets. The swap lines amount to US$30 billion for each central bank. These swap arrangements allow central banks in the major countries to provide liquidity to their local banks without having to deplete reserves or tap the normal FX market. However, if central banks in the other parts of the emerging world want to provide their banks with USD without impacting the normal FX market, they have to use either their reserves, turn to the IMF or look at less orthodox measures such as capital controls. These fears have made it more difficult to roll over existing liabilities in global capital markets and even harder to issue more debt, putting pressure on countries that do not have enough liquid assets to offset the shortage in foreign liquidity. Asian countries are less exposed to this risk relative to Eastern European countries, Latin America and Asian economies that have recently come under pressure (like Indonesia and Korea) rank somewhere in the middle in terms of exposure. The growing focus on the vulnerability of Central and Eastern European economies has been reflected in weakening currencies in the region, prompting several EM central banks to tighten liquidity either by intervening in the FX markets (and reducing reserves) or through higher overnight rates (for example the National Bank of Hungary raised rates by 300 bps, while overnight rates in Romania reached a peak of 500% last week). Weakening currencies have two major impacts. First, Eastern European countries have borrowed in foreign currencies and will face higher repayments when their national currency weakens. Second, for foreign companies exposed to this region, they will have lower profits when they translate them in their reporting currency. Growth expectations for the region have come down aggressively. While Russian GDP growth accelerated to 8% in 2007-2008H1, the pace of activity had already slowed before the banking crisis hit. The slowdown started on the back of a rapidly tightening labor market and widespread price pressures. The banking crisis has significantly added to the problems. Despite significant injections of liquidity into the banking system by the Central Bank of Russia and Finance Ministry, inter-bank lending has ground to a virtual halt over recent weeks with significant negative impacts on banks funding. Working capital constraints have emerged and anecdotal evidence suggests this is causing stoppages at a number of manufacturing facilities; this will ultimately result in starkly lower productivity. On top of the risks to growth, several countries in the region have needed to turn to the IMF for financial support. While Iceland and the Ukraine have already negotiated broad packages with the IMF, Hungary reached an agreement with the IMF for a package amounting to US$25.1 billion (including €6.5 billion from the EU and €1 billion from the World Bank). Interestingly, in contrast to what we saw in the Asian crisis, the programs have less conditionality than in the past. These are likely to be supported by at least some extension of liquidity support from central banks in advanced economies through the expanded use of swap lines and similar instruments. Together these should boost investor confidence and trigger a return of capital inflows. However, the sheer size of the external funding requirements in these countries means that some may still have to experience a sharp contraction in import demand.

While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, high EM-exposed banks and telecoms have only recently started to underperform the broader market and their own sectors. In both cases, however, the recent falls seem to have overshot their peers in emerging markets. Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Amongst this group basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.
The real question in my mind is when the developed markets calm are the EMs going to be the first to “pop” back up? As the world is painfully learning, the problem with leverage is that it is much easier to create than to reign in. Banks can, in effect, create leverage out of thin air. For example, when a bank makes a loan, it creates both an asset for the borrower (the proceeds from the loan) and a liability (the obligation to repay the loan). However, if the bank wants to reduce its leverage, things are not so easy. The bank can either wait until the loan is repaid (which can take a long time) or sell the loan to a third party. And even if there is a secondary market for such a loan – and recently such markets have become increasingly illiquid – selling the loan does nothing to reduce overall leverage in the financial system. This is because of the iron law of finance: for every buyer there has to be a seller. The liquidity that the bank gets from selling the loan is offset by the liquidity lost by the party that purchases the loan. But this creates an obvious problem. If most institutions are trying to delever at the same time, then asset prices must decline until enough investors with sufficient liquidity are lured back into the market. Needless to say, this dynamic has the potential to be particularly damaging to emerging markets (as we have seen over the past few weeks). On balance, the question of whether we see another full-blown EM crisis (i.e. worse than it is today) will hinge on the speed and vigor of the policy response. Thus far, the response from policymakers has been encouraging, which suggests to us that a baseline scenario in which all but the most levered EMs face a soft-landing is still the most likely outcome. That being said I think it might be time to look into the best positioned EM. I personally am most fond of Brazil as I think they have the cleanest balance sheet and should benefit from either their strong natural resources or/and their buoyant domestic economy.

Hopefully next week I hope to present a stock idea, I know I have been saying this for some time, problem is I am finding a lot of flaws in numerous ideas so I have yet to find one that I am comfortable presenting. Rest assured I will find one, so keep reading.

Sunday, October 26, 2008

The second mouse gets the cheese....

All week I have been inundated with various people (whether colleagues or market pundits) calling for market bottoms. I have not made up my mind yet on where the bottom will be, I think the US presidential election in November will be a real catalyst but expect any real political stimulus to come in 2009. Lawmakers will make a push to enact stimulus in a post-election “lame duck” session of Congress. This is likely to mean that a proposal takes shape, at least in draft form, by the week of November 10, and comes to the floor the week of November 17. Debate would probably last the full week, and could possibly run into early December. However, there is a possibility that stimulus could be delayed until late January or February. The legislative calendar is short, and it is entirely possible that lawmakers could fail to agree on a package. It is also possible that President Bush could veto a fiscal stimulus bill. It is also possible that if Democrats make significant gains on Election Day, they will aim to pass a first round of stimulus in November, and a second round focusing on Democratic priorities early next year. It should be noted that the stock market and economy rarely (read never) bottom at the same time, so at this juncture it might be prudent to start accumulating a little here and a little there. Remember while the early gets the worm it is the second mouse that gets the cheese. One strategy that is looking increasingly profitable is to sell out of the money short term puts, this acts similarly to a limit order with the key difference being the purchase risk and premiums received associated with the puts. With the VIX at such a high level you can find some substantial yields on such a strategy.

That being said let’s take see where we stand.

For several reasons, corporate liquidity is becoming a very valuable resource. First, the primary market is likely to remain slow, as investors are still recovering from recent losses. Moreover, expect banks to continue to act conservatively when underwriting new business, despite the windfall of new capital. Second, the bleak economic outlook is likely to cut into corporate cash flow - profit expectations are already falling fast. Third, the recent injection of bank capital and debt guarantees, along with other tools, are designed to help the credit markets defrost, but the toolkit offers little direct help to non-financials. In summary, corporations could get a hit on both the earnings and the liability side.
Slowing profit growth and the negative outlook for funding are causing firms to tap their existing credit lines. According to the Wall Street Journal 18 companies have drawn down on bank lines following the Lehman default. This is partly to replace funding across the malfunctioning credit markets. For many companies, credit lines are the best option, since the long-term primary market remains fairly inaccessible because of weak investor demand. The recent large defaults will have a long lasting impact on investor’s risk aversion. The terms of the facility commitments from agreements signed in the recent boom years are likely a cheaper source of credit compared to the current market rates on bond and loan funding.

One instructive example is Goodyear Tire’s announcement on September 25th, that they were drawing $600 mm from their revolving credit line. Goodyear explained the credit line was tapped because they had $360 mm frozen in a money market fund with redemption problems. Following the news, Goodyear’s CDS spread widened 300 basis points.

Dislocations continue to cross historical highs in virtually every segment of the credit market. The current disruption of funding markets and the subsequent poor market liquidity are the main drivers of this situation. Therefore, the improvement of short-term funding conditions is a necessary condition for normalization going forward.

Defaults. This recession will be deeper and longer than we expected just a month ago (let’s just hope is a long flat U as opposed to the dreaded L). While the money market will gradually improve as systemic fears begin to relax, stabilization will be slow. The slow normalization of the money market will cause bank lending terms to crunch tighter, perhaps sharply; GDP and profit growth will slow accordingly.
Spreads. While spreads on banks and other financial institutions have substantially tightened on the back of the recent policy measures, the macro uncertainty is still high. This should start to weigh on consumer, retail and cyclical names, expect them to underperform.

The sharp underperformance of EM equities relative to developed markets, and now of EM currencies to the majors are also what you would ‘expect’ to see in a broad global slowdown. And even the dramatic dollar move is consistent with this general theme as the market has been in the process of reversing a two-year view that the US is uniquely exposed to slowing – and in unique need of easier financial conditions – and moved to price a more uniform global slowdown. The shift in pressure to emerging market FX – most recently to EMEA currencies – is also in part a reflection of the fact that the global slowdown and credit crisis has broadened to a point where even the more resilient are likely to share more pressure that until recently the market expected them to escape. The acceleration in many of these moves is consistent not just with increased funding and financial market stress but with the data.

That being said let me venture a wild guess about the future. Deleveraging is going to be a long and painful process. The economy will not likely turn until either housing stops declining or banks start lending. Sadly I think both are likely to occur at the same time. As the banking system gets more aid bankers will start lending albeit and much higher rates. These higher rates will spur a lack of consumer spending which will bring prices down. This deflationary spiral will be countered by the new president and his various “stimulus packages.” It is my opinion that the government is terrible at market timing and as such will continue their inflationary inducing policies long after the deflationary threat has faded away. This couple with massive US debt spells a long-term weakening dollar versus export driven economies. We have already seen the Yen appreciate massively against the dollar and I expect to see the Brazilian Real, Reminbi, and the Rouble (so long as the Russian government doesn’t screw things up). I think we will see hardline retailers continued to be punished by reduced consumer spending but I think softline retailers like Wal-Mart, Target, and Costco could offer an interesting entry point should the equities fall further. I think the decline in oil will likely overshoot to the downside and should offer interesting opportunities to the savvy investor. I would particularly look towards MLPs and E&Ps offering high yields with clean balance sheets. Lately I have been thinking about how the economy moves in cycles. For example, the following I would classify as periods of consumer leveraging their balance sheets (1920s, 1960s & early 1970s, 1980s, and obviously the 2000s). Each of these periods were marked by massive run ups in equities followed by severe declines. What led to the next run up is of interest to me. The Great Depression was ended by World War II so I hope we can avoid that alternative. The 1970s was turned around by a massive drop in commodities and raising rates to the point of reducing inflation (this is possible although I would be shocked to see commodities fall to that point). The bear market of 1991-1993 was ended by the mass proliferation of the computer and the internet. So this brings us to now, I can’t help but wonder what innovation our policy will lead us out of this recession. As previously stated I think we will likely see some inflationary policies put in place by the new administration and this will revive the system but not stimulate significant growth without substantially deflating the dollar. Being an eternal optimist I am hopeful that someone will crack the energy mystery (maybe the University of Utah can rediscover how they cracked cold fusion). Either way I expect this to be three to four year period of slow to no growth. That being said I urge people to consider putting their money in companies with sterling balance sheets and enormously wide economic moats. I expect to post an example of such a situation over the next week or two. If you have any suggestions or ideas of your own please feel free to post them.

Also on another side note if you I strongly suggest people to look into various special situations. For example watch Volkswagen to see if it rallies in another short squeeze if it does, short it. VW was trading in the 80s during last week which is a PE of 33 times 2009 earnings which is five times the industry level (mind you the industry is likely to decline as consumers are less likely to purchase a car over the next year). Over the past year VW’s shares are up over 100%, this is due to the concentrated ownership and massive amounts of hedge funds who were short the stock and had to cover at the same time when there was an extremely limited float (especially with the bankruptcy of Lehman who was one of the largest lenders in the stock). On a fundamental basis VW is worth around $30 (it closed on Friday at 53 which is down from 90 the week before). I expect to continue to see this company to fall as hedge funds are no longer being squeezed (at least for now) and investors realize the terrible underlying fundamentals of the auto business. It is temporary mispricing situations like these that are going to offer the majority of profits over the next couple months. Keep an eye out for these, especially in the small cap and micro cap space as this is where they are more likely to exist.

Sunday, October 19, 2008

This will have to do....

I was going to write something over the weekend, but I had to work on both Saturday and Sunday so this will have to do.

Sunday, October 12, 2008

Mr. Toad's Wild Ride

It goes without saying that this past week is not one that will be soon forgotten. In light of the recent coordinated government interventions, I would expect money markets to start behaving more normally, and ever so slowly as risk aversions start to fade we will start to see an increased interest in corporate in bank debt which should assuage the equity market’s fears and allow them to become more calmed. This is not to say I am calling a bottom, I am just pointing out that the recent high volatility (highest recorded level on the VIX, although technically the VIX would have been higher during 1987 (somewhere around 150 vs. 70 or so now, it just wasn’t around then) can be expected to dissipate at as people become more risk tolerant.

Speaking of bottoms, I just wanted to make a quick note on where and how I think we can bottom. In order for the markets to bottom, house prices will have to stop their decline. Now many people are predicting a price bottoming in the first quarter or second quarter of 2009 which is when many sub-prime resets will taper off. Although this is somewhat logical they are ignoring the wave of Option ARMSs and Alt-A which reset in 2010 and 2011. These will cause significant pain should their reset be anything like the one we went through with sub-prime resets.

Before we get into the meat of this week’s post I just want to take a minute to say, those who took my advice and went short on ZOLT, it is probably now time to close that trade, since recommending the short on Sept. 7th the stock has fallen from $17.21 (Friday Sept. 5th close) to $10.00 (Friday Oct. 10th close) which represents a nice 42% profit in the span of about a month.

The turmoil in global financial markets has recently put pressure on nearly all emerging markets (EM) assets. In part, the move has been driven by concerns for the global slowdown and its possible impact on EM. On the other hand, economies like Brazil and Malaysia appear better shielded growth-wise when looking at typical macroeconomic shocks. Over the last month, however, the forces of financial deleveraging, risk aversion and positioning liquidation have taken center stage in driving asset prices. This has raised concerns among investors about the vulnerability of different emerging markets to broader strains in the financial sector and global markets.

The good news for EM is that there is no strong evidence that they are caught overly levered in the middle of this deleveraging process. EM fundamentals have improved substantially over the last few years and are still supportive in terms of economic stability and growth, overall. In fact, the current turmoil is much different than previous episodes of distress for EM assets; it is not an EM crisis, it is financial volatility imported from a shock that originated in G10 economies. However, the recent underperformance in EM currencies with stronger fundamentals stands as a reminder that financial turbulence can affect local assets in many ways, and not necessarily in connection with the economic performance of the country. There are different notions of exposure to financial volatility. Local assets can come under pressure through various channels; a disruption in international capital flow, a reversal of capital flows accumulated in the past, a strain in the financing of short-term external liabilities or some genuine fragility of the local financial system. On average, emerging markets appear to be more resilient than major markets on most indicators (exhibiting more resilience to shorter-term capital flows disruptions, short-term financing dislocations and soundness of the banking system).

Given the recent government moves what does this all mean in the FX space? The US trade balance will likely improve further. While exports will probably slow on the back of slowing global demand, US imports may slow even more on the back of extremely tight financial conditions and expectations of a recession.

Despite the US trade balance improvement, funding inflows into the US are likely to slow as well, given the weak cyclical outlook. Moreover, the Dollar is clearly less undervalued at current levels and further appreciation would probably make life more difficult for the export sector and hence not help the weak US economy. Therefore, after a stabilization of asset markets, we are likely to see first a period of renewed moderate Dollar weakness, before the longer-term appreciation trend towards fair value kicks in.

Slowing global growth will continue to put downside pressure on currencies that display a strong link to cyclical forces, such as the AUD. However, some of these currencies have depreciated rapidly in recent weeks and this may limit the additional depreciation risks.

Moreover, lower oil prices and substantial policy stimulus mean that growth rebounds are possible in the not too distant future, led by strong structural stories, such as the BRICs and N-11. Rate differentials are also likely to play in favor of EM currencies, in particular following the rapid decline of policy rates in major markets.

So net-net, I think given the sharp pull back it might be time to purchase some EM equities or balanced ETFs. Sorry for the brief post, but I have been at work all weekend and still have another two hours plus of stuff to get done.

Sunday, October 5, 2008

Black murky waters...

In this past week the overall feeling in the market has shown a sudden and abrupt volte-face and it finally appears that the market and investing community has realized that regardless of the “bail-out” the economy is still going through tough times and is unlikely to reverse direction any time in the near future. Internally I am torn about this sudden widespread realization. On the one hand the value investor in me is in fine fettle, on the other hand the altruistic global citizen in me is nervous about our near to medium term prospects (hence the title of the post). That being said there is always a way to profit in any market so let’s try to find out how.

The passage of the TARP plan will increase our federal deficit substantially. The current fiscal year 2009 deficit (which is the current FY) is estimated to be at $565bn and this was before the passage of the TARP. If you take this plus the estimated cost of TARP plus additional maturing coupons our federal deficit could reach a staggering $1.5 trillion (with a T!). With all this additional debt you have to wonder how our dollar is strengthening versus other currencies. The key to this is it is all relative. The EU and UK were viewed as relatively strong and as such had strengthened substantially against the dollar over the past couple of years. Now that everyone realizes that they are not immune from the financial malaise, their currencies have been dropping precipitously. This in turn has been quite negative for export heavy companies. While I believe we will continue to strengthen against the EUR, GBP, NZD, AUD, and YEN, I believe we will start to weaken against EM currencies which are heavy on natural resource exportation. This is the perfect segway in to what is turning out to be my weekly update on the energy markets.

Over the past several weeks, the oil market has been whipsawed between two opposing forces: (1) strong near-term fundamentals driven by continued supply problems and extremely low inventories; and (2) rising financial and forward demand concerns which have been accompanied by significant financial de-leveraging. As the market continues to be pulled in both directions by these opposing forces, price volatility has surged. This surge in price volatility represents a significant departure from the past five years, as the one variable in the market that remained relatively stable was volatility, trading in roughly a 30-40% range. The market simply trended up or down and inventories in the United States and the rest of the OECD remained above or near the five-year average, providing a cushion to any supply or demand disruption. However, beginning this summer and accelerating this past week that trend has been clearly reversed – implied volatility reached 55% this past week as inventories continued to plummet due to hurricane-related disruptions. Volatility has not been this high, nor have stocks been this low on a seasonally adjusted basis since the Gulf War II in 2003 (see below):

US inventories dropped a massive 18 million barrels, bringing the total inventory draw since August 28, 2008 to 50 million barrels. US total hydrocarbon stocks are now at record low levels for this time of year, and US gasoline inventories are now at levels not seen since 1967 when demand was nearly half the level as it is today. Further, the situation for gasoline on the other side of the Atlantic is no better, with Europe also at low inventory levels with ARA stocks dropping to the lowest levels since 2003. Further, this week saw crude oil stock draws in Japan that took stock levels back to record lows for this time of year. What is critical is that this is the period in which stocks should be built globally to prepare for the winter months, not drawn. This puts the market into a very precarious situation as we near the winter heating season. Many observers point to the fact that demand is weak, so this observation is not as worrying as it would otherwise be. In fact, the US Department of Energy (DOE) reported exceptionally weak product demand last week. Although this demand weakness generated downward price pressure post the data release, it is again important to emphasize that you can’t consume what you don’t have. Ongoing refinery outages have left US refinery utilization at critically low levels leading to a loss so far of almost 70 million barrels of petroleum products. As a result of the outages, Colonial Pipeline – the primary artery for USGC petroleum product distribution in the southern and eastern United States – has been operating at reduced rates, generating local shortages and reports of long lines at the pump (hence the news of gasoline shortages in the south). It is important to highlight that despite this extreme tightness in gasoline supplies, traded NYMEX gasoline margins have weakened substantially in the past two weeks.

Over the past several weeks, concerns over the sustainability of Chinese oil demand have been brought into question. Driving these concerns have been real events. Two weeks ago Sinopec announced it would reduce fourth-quarter crude oil imports by 8-10 percent from previous targets as end-use inventories inside China remain high. And then last week, Unipec announced it would not import diesel for a third straight month again due to high domestic inventory levels. At the same time, expectations for 2009 Chinese growth have been revised down.

First, in terms of the base levels, these slower growth expectations do not have a large impact in terms of barrels. At most it would slow end-use oil demand growth by 70 thousand b/d and in terms of crude oil imports for the fourth quarter relative to previously announced targets, and would slow imports from 14% yoy growth to 9% yoy growth, which is still relatively strong growth from a historical perspective.

Second, the Chinese government still has two very significant policy levers at its disposal, both fiscal and monetary policy. On the fiscal side, unlike previous time periods of slower growth, the Chinese government has at its disposal 2-3% of GDP for fiscal stimulus. On the monetary side, we saw the central bank aggressively raise rates to counter inflationary pressures. Now that those inflationary pressures, particularly from agriculture, have abated, they are likely to be equally aggressive in lowering rates. The bottom line is that the government is likely to act with policy in response to the current concerns, which will likely avert a more serious slowdown. This aversion should help keep their demand high which helps add to the bullish oil argument.

In the near future I will make a specific company recommendation, so until then keep reading.

Sunday, September 28, 2008

Quick update

I don’t want to toot my own horn by my three calls last week would have paid off in spades: oil rallied 17%, Zion fell by 12% and was down in excess of 20% at one point, and WFC fell by 5% and was down 13% at one point (it should be noted that to profit from the downside on ZION and WFC you would have had to use short term puts which would have probably magnified your return due to the inherent leverage associated with options). That being said I am not faring well on my ZOLT short which has rallied 15%, that being said I still think a ttm P/E of 88.6 is a bit much for a materials company (I would mention its forward P/E is 18, which is based on, as previously mentioned, what I believe to be extremely lofty estimates). But enough about the past, let’s look towards the future.

I am sure you have all read that the bailout plan has tentatively passed. In its current form, it gives taxpayers an ownership stake and profit-making opportunities with participating companies; puts taxpayers first in line to recover assets if a participating company fails; (and) guarantees taxpayers are repaid in full -- if other protections have not actually produced a profit. The $700 billion would be available in phases. The first $250 billion will be "immediately available" to the Treasury Secretary, and $100 billion available "upon report to Congress," and $350 billion "available only upon Congressional action. While the industrial cycle looks to be slowing, in the US, the aforementioned bailout plan is likely to reduce the economic risk of a much sharper credit contraction. In addition, recently announced policy initiatives clearly go beyond the US: China and Russia have also taken steps to stabilize local markets. For example, last week, China announced a 27bp interest rate cut, as well as a reserve requirement reduction, reversing a couple of years of slow tightening measures. Globally policy makers are starting to act in concert to implement economically stimulating policies in order to avert a global economic meltdown. The real question is, will all these policies be enough to stimulate the global economy, or will it as I believe shift us from depression talk back to recession talk.

For the OECD as a whole, from a starting point of nearly 2% GDP growth in the first quarter of this year, GDP growth will flirt with the zero line in 2008Q4 and 2009Q1, but should manage to stay in positive territory. Of course, it is easy to see a technical recession in the OECD, particularly if US growth is softer than expected. But there are good reasons not to expect a deep OECD recession that could drag world growth materially lower. The world economy should continue to be cushioned by the strong demand from the commodity producing areas of the world (which have reaped the benefits of the tripling of oil prices since the beginning of 2007). If we fast-forward to the trough, what type of global recovery should we expect once the low point in the cycle has been reached? As I believe it would be prudent to expect the recovery phase in the global economy to be relatively subdued compared with the previous cycles. Indeed, the expected recovery is similar to the U-shaped upturn following the US Savings & Loans crisis in the early 1990s rather than the V-shaped upswing after the tech bubble in early 2000s. There are a number of reasons why we can expect the global recovery phase to be rather anemic, with the possibility of a longer than normal period of growth stagnation:

1. Although the bailout plan will do a lot to help stimulate the credit markets, bank lending will be tight for some time. The unprecedented policy interventions that have taken place over the past two weeks have led to a relaxation of stresses from the very extreme levels reached last week (when credit markets came to a complete halt), but conditions remain far from “normal”. As part of the deleveraging process, banks are clearly tightening credit (just look at LIBOR, on a side note a safe bet would be a further widening of the TED spread (yield difference between the interest rates on inter-bank loans and T-Bills) as I think private banks will continue to tighten which will raise LIBOR (plus LIBOR is currently understated) coupled with the fact that the FED will have trouble raising rights in light of the recent economic maladies, although it should be noted that this would be a short term bet because as we have witnessed before keeping rates too low for too long is a very bad thing). That remains the key message from the latest bank lending surveys from the Fed, the ECB and the Bank of England. Therefore, the lack of lending confidence is likely to curtail the strength of the upswing (particularly in consumption and investment).

2. Although it started out as mainly a US and UK problem the global housing correction has spread. Ireland, Spain and New Zealand are at the forefront of housing weakness. But other major economies have also seen some cooling. More recently there have been signs of housing weakness in parts of China and India. One of the key ideas to understand about housing is that it is a relatively illiquid asset (i.e. by and large people don’t buy houses to immediately flip them, the vast majority of homes are purchased to live in for longer periods of time) and as such housing corrections can have long-lasting macro consequences. For example, following the average OECD housing bust, the growth slowdown lasted four years on average (measured from the time GDP growth started to fall to the time when it bottomed), or close to two years after house prices peaked.

3. Fiscal easing has and will continue to help, but there may be constraints (for example rates are already extremely low and to lower rates further risks starting up the inflation machine). While a second fiscal stimulus package might well be implemented in the US next year, it is unlikely to provide as much bang for a buck as the first package. Nor is the Japanese fiscal stimulus package likely to give an immediate boost to the economy, given that it did not include large-scale tax cuts. The Stability and Growth Pact also makes easier fiscal policy less viable for many European governments, particularly as it might risk stoking current concerns about inflation. That being said, this constraint is less binding in EM countries, such as China, where there is substantial scope for both monetary and fiscal easing in response to a growth slowdown.

As far as portfolio positioning is concerned I still recommend loading up on EM economies that stand to benefit from high commodity prices and potential currency gains. The particularly attractive markets are those with high growth potential currently trading at low P/Es (i.e. Brazil and Russia). I think consumer stocks will continue to be punished as commodities remain high and lending remains tight, I would be shocked if these two factors coupled with a weak job market weren’t enough to incentivize the consumer to tighten up those purse strings. Interestingly, the XHB (the housing ETF) has outperformed the market by almost 20% over the last month. These companies may be unintended beneficiaries of any eventual financials/mortgage-backed-asset plan. The XHB has clearly has run ahead of the data, where only hints of optimism exists. With the recent reading of the NAHB index essentially flat, with housing permits heading lower, and with sales down, I would be shocked if the XHB went up anymore.

On the oil front, Goldman Sachs had an interesting conference call last week in which they reaffirmed their view of higher energy prices by year end. They included a snazzy chart which I have pasted below. My only warning is tread carefully because pure play E&P will swing wildly with prices of oil while refiners will swing in opposite directions (that is one reason why I like COP because it is both, plus it trades at some crazy cheap levels and has a 20% stake in Yukos).

Sorry for the short post. I just don’t think there is much to say; currently the market is in an awkward state of purgatory. Like I have emphasized before, the real action will start once Q3 earnings season begins, then we will know whether we are headed for a turnaround or a long drawn out recession.

Sunday, September 21, 2008

Financial Hodgepodge

First off, let me apologize for being MIA for a while, with all the tumult suffusing through the global markets my job has kept me quite busy. That being said let us take a moment to internally reflect on what has just happened. Ok, now lets focus on what can be done to better position us going forward.

Financial intervention to date has come in ad hoc form, first with new Fed lending facilities, then actions to facilitate the takeover of Bear Stearns, the GSE intervention, and finally last week’s decisions regarding AIG and Lehman Brothers. Without a standardized structure, the level of federal assistance, as well as the potential compensation for bearing risk, is unpredictable appears left to last-minute decision making even when it might not be. This has two consequences. First, these efforts are bound to lead to greater risk aversion among market participants. To a certain point this can be positive in reducing moral hazard, but taken to excess it can be destabilizing. This has become an increased concern over the last week—perceptions of counterparty risk have reached extreme levels and the ability of firms to attract new capital has been limited even further by concerns over potential intervention with punitive terms. Second, the lack of an agreed-upon policy makes any single intervention more difficult politically, which could constrain the Fed and Treasury in future decisions. Thus, policy may have reached a stage where a more standardized set of rules may be announced, if not legislated (hence the recent talk of RTC-esque vehicles). The need to establish the RTC is to establish a hard floor which should in essence stabilize the system (note it will stabilize it and provide a brief rally, financials will not go back to the way they were, we will still be in an extremely tight credit environment).
However, several important differences suggest that an RTC-style entity, while appropriate, is likely to be a piece of a larger solution. First, the federal government was already responsible for the costs of the S&L crisis, since it insured most S&L deposits. In contrast, the government bears little direct financial responsibility for many holders of mortgage assets in the current situation (the GSEs are the obvious exception). Without clear federal financial responsibility, the decision to establish a new agency—presumably at taxpayer risk—is more difficult. Second, the RTC was charged with consolidating assets from several hundred small banks. In the current situation, there are fewer lenders with significant assets, and they are larger. Third, in the present case, the vast majority of lenders are still going concerns rather than failed institutions which have been taken over by the government.

The RTC isn’t the only options there are at least two other viable options: Home Owner’s Loan Corporation (HLOC) or a Reconstruction Finance Corp (RFC).
The HOLC was established in 1933, under the Federal Home Loan Bank Board, to purchase and refinance mortgages. The HOLC acquired loans for two years and was wound down 18 years later. HOLC has several similarities to the refinancing program the Federal Housing Administration (FHA) is currently implementing. These programs were meant to support borrowers who could not refinance their mortgages, many of which at the time consisted of 5-year balloon loans. However, the HOLC exchanged a government-backed bond bearing 4% tax-exempt interest (less than prevailing mortgage rates) in return for mortgages, so that banks received an interest-bearing asset to replace the mortgage, albeit at a discount to the original value of the loan. By contrast, the current FHA program simply provides an outlet for borrowers to refinance into a government guaranteed loan once the previous loan has been voluntarily extinguished, also at a discount to the original value of the loan. While the risk borne by the government may be similar, the ability to purchase the loans would avoid some obstacles posed by loan-by-loan refinancing, though securitization is still likely to pose challenges.

The RFC was established in 1932 and by 1934 had purchased preferred stock from over four thousand banks. Unlike most preferred shareholders, the RFC also gained voting rights. The idea of an RFC-like approach would be to increase the level of capital in the banking sector and thereby expand the sector’s lending capacity. While most of the public discussion of remedies to the current situation has centered on how the government might purchase assets, the provision of capital to lenders may be just as important. To the extent that a program to purchase mortgage related assets is established, the sale of these assets is likely to crystallize losses and reduce regulatory capital. Some institutions would be able to absorb these losses, but others would either fall below regulatory minimums unless they are able to raise additional capital. Either way, the amount of credit these institutions would be able to extend would be diminished, with adverse consequences for growth. Providing capital would offset the significant slowing in lending now underway. From the standpoint of total credit available in the economy, providing capital that could be leveraged by ten times or so would allow the government to lend significantly more—through banks—than simply borrowing in the Treasury market and purchasing the assets directly.

Each of these three solutions presents an interesting alternative. The key in my mind is the process and structure the government uses to acquire these so-called assets. The most logical method would be to implement a reverse auction whereby the government could present a maximum bid (which should be something really low like $0.65 on the dollar) on a given type of asset, and accept bids starting with the lowest first until the predetermined capacity of the program is reached or the cap on bids is hit. I am a big believer that something needs to be done, something analogous to cutting off the leg to save the man type of thing.

Even though the pain in financials has been severe we must remember that financials are only a part of the bigger picture. The economic and market landscape has changed in some very important ways in the last few months. Much clearer signs of slowing in the non-US economies (particularly in the developed world) have turned what still looked at the start of the year like an environment where US weakness was dominant, to one with much more of the flavor of a global slowdown. The market has responded in two ways. First, it has downgraded non-US growth views relative to the US, pushing rates in many of the majors down relative to the US, fuelling a dollar rally and punishing equities with greater non-US exposure. Second, it has also for the first time traded across assets in ways traditionally consistent with a broad global slowdown, with commodities falling, equities underperforming bonds, cyclical stocks being hit hard, inflation breakevens dropping sharply, growth sensitive currencies being hit, and bonds doing well. My view has long been that what determines the resilience of non-US economies in US slowdowns has much less to do with the direct transmission of US weakness to the rest of the world and more to whether the underlying shocks that are driving weakness are local to the US or global in nature. And it is on that front that things have really changed.

In the early stages of the US housing market adjustment, the shocks hitting the global economy seemed primarily US-based – emanating from the collapse of the US housing bubble. The drag from this source has weighed on the non-US economy (the improving trade balance is a partial measure of how much the US has exported its slowdown to its trading partners). But much of the new pressure outside the rest of the world reflects the fact that over the last 12-18 months, a broader set of shocks has appeared.

In terms of housing vulnerability, the US, New Zealand, the UK and South Africa are already seeing real house price declines. Furthermore, within the Eurozone, Spain and Ireland have also seen house price depreciation. Although the price dynamics are less clear, China’s property market has also started to come under pressure after a long bull run. Parts of Eastern Europe in particular the Baltics, are showing sharp turns after having built up sizable imbalances. Much of continental Europe, Japan and many other Asian economies look less exposed.
On the terms-of-trade front, the split between commodity producers and consumers is clear. While the data does not fully account for the recent reversals in commodity prices, that conclusion over the last 12-18months is likely to hold even now. The biggest losers are most of North Asia (including China) and India, Turkey and the US. The biggest winners are Russia, Brazil, Malaysia, South Africa and the developed market commodity producers. These shifts have been dramatic in places, with a 43.6% rise in Russia’s terms of trade, and a sharp 24.1% decline in South Korea’s.

Looking at all these factors together, downside growth risk remains the most pronounced in the US, Japan and New Zealand. China and other NJA economies also face significant headwinds from a slowing global industrial cycle and negative terms-of-trade shocks, but there are important offsets from still generally healthy credit availability. For China and the Asian region as a whole, the underlying trend in Chinese domestic demand will be key, as external influences have flipped negative. On the other hand, the growth prospects look relatively better in several EM countries, including Brazil, Russia, Malaysia. Similarly, Canada, Norway and Australia may also have potential to outperform other G10 countries. The positive dynamics set off by earlier commodity rises are likely to remain supportive for growth in these markets for some time to come, even with the commodity pullback, as prices will still be generally higher than a year ago. With respect to asset prices more specifically, it is clearly important to differentiate between different asset classes. The relative growth outperformance of EM countries is likely to be most clearly reflected in FX space, where strong cyclical growth has been consistently rewarded. Local equity markets, on the other hand, and in particular those with commodity exposures, will be more influenced by spot commodity dynamics and global growth risk. This dynamic could well dominate local macro fundamentals, especially as long as we remain in a global deleveraging processing.

On the commodity front, The oil market is oversold, providing a compelling entry point, though near-term upside is now reduced Just as the market significantly overshot to the upside in the second quarter, it appears that the market has overshot to the downside and is now substantially oversold, as a combination of financial concerns, skepticism, and real and perceived demand weakness has pushed prices below the long-term economics of the industry.

The supply side of the market still remains severely constrained. As evidenced this past July at $140/bbl, oil producers raced to squeeze as much supply out of the system as possible, yet created only a very modest inventory cushion despite a substantially weaker demand environment. It is this lack of a significant inventory build in July followed by draws in August and a likely draw in September that is one of the key drivers behind a potential fourth quarter rebound in oil prices, as it leaves the market vulnerable to any type of shock. One of the more anomalous aspects of the recent market has been the deep level of contango that has persisted in the face of stock draws. The only dynamic that can explain this pricing anomaly is de-stocking, both physical (the stock of real barrels) and financial (the "stock" of paper barrels), which is just another aspect of the industry-wide de-leveraging that is taking place. The initial impact of physical and financial de-stocking is negative to prices as (1) physical players run down oil stocks to reduce working capital, they reduce their demand for physical prompt crude which creates a prompt contango in the forward curve, and (2) financial players sell out of paper positions to reduce credit exposure and/or cover losses. However, the medium- to longer-term impact of de-stocking to both price and volatility is explosive as it reduces the physical cushion and market liquidity to deal with any future supply or demand shock.

The argument against this vulnerability to a shock is that demand is weak and that any shocks are likely to only have a very small impact. The We weakness in demand has resulted from two transient drivers: (1) current Chinese de-stocking that resulted from forward buying in June and July ahead of both a shift in tax regime and the Olympics, which helped to create the surge in prices earlier this year (significantly overshooting even the bullish forecasts) and then the subsequent collapse to current levels, and also (2) the sharp decline in US crude oil runs due to the two back-to-back hurricane strikes on US Gulf Coast refineries. These two events, combined with financial concerns, largely explain the two-stage pullback in oil prices in the recent period. Using the diesel refinery margin as a proxy for Chinese demand for diesel, as most of the pre-August buying was in low sulfur diesel, the collapse in the diesel margin dragged oil prices from $145/bbl to $115/bbl, which was followed by a short period of consolidation. The hurricanes then struck, which knocked out a massive amount of US refinery demand, creating the second leg down from $115/bbl to $100/bbl and below that was exacerbated by the overlay of heightened financial concerns. This second leg down, however, widened refinery margins, which sets the stage for a rebound in prices once the shuttered refineries restart. While both of these events substantially reduce the current demand for crude oil, they do little to reduce end-use demand for refined products which remain much more stable. The recent sharp rise in prompt refinery margins around the world provides further evidence that end use demand remains stronger than refinery level demand.

On top of these transient negative demand factors, the market is trading with a very high level of skepticism, which has made the market moribund to nearly every bullish headline that has surfaced since early August – loss of Azeri crude oil (10 mmb), problems with Angolan platforms (15 mmb) and more recently real and substantial hurricane supply losses (a net loss of 56 mmb) and a dangerous escalation of civil unrest in Nigeria. Eventually, this string of events will be felt as demand rebounds in the fourth quarter against a small inventory cushion and very little spare production capacity; however, given the current trading bias, it will likely take a real physical catalyst that generates real physical demand to turn the market.

We are now nearly nine years into this current bull market in oil and have nearly no new supplies to show. This stands in sharp contrast to the 9th year of the bull market of the 1970s when Alaska, Mexico and the North Sea were all new projects in the ramp up phase with great prospects in front of them (see below). Today, try and name three new projects in the pipeline that have that same type of potential over the next five years (hint, it can’t be done). Without supply growth and continued economic expansion, demand will need to experience more and deeper adjustments that will only come through higher or more volatile prices in the future.

So what does this all mean for oil prices? I have not done enough research to predict with any level of confidence where prices will go, but I don’t think it will be down (or at least not much further). I know Goldman Sachs is predicted prices $125 by year end. While this could be possible it just says to me given the recent pullback in E&P players, it might be time to start acquiring (I know I have said this before, as prices have fallen further the argument has just gotten stronger). If any readers have any argument against investing in E&P players at these prices please let me know.

Not to cut this post short but I am tired of writing so I will quickly state some viewpoints:

Market will continue to be very volatile and will likely drop as crummy Q3 earnings are reported in October and November. There will be a pull back in select banking players as some have run up a little too much (i.e. WFC and maybe ZION). I would look to put money in wide-moat companies as the consumer will be dominating the news over the next few months. Pay particular attention to spending data, if the consumer pulls back we are headed for very-very tough times.