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.